Thursday, May 14, 2020

Stock Market Keeping Score in the Three-Front War Against the Virus

We are still in the midst of VWW-II, the second world war against the coronavirus. VWW-I occurred from 1918-19 as the world battled the Spanish Flu pandemic. It is estimated that about 500 million people, or one-third of the world’s population, became infected with the Spanish Flu virus. The number of deaths is estimated at 50 million worldwide, with about 675,000 in the US. In some ways, the damage from VWW-I exceeded the destruction resulting from WW-I.

So far during VWW-II, 4.1 million people have been infected globally and more than 283,000 have died. Potentially just as deadly is the economic impact of the government-imposed shutdowns around the world to enforce social distancing to reduce the spread of the virus. Millions of people are out of work, and hundreds of thousands of businesses are at risk of going out of business. The resulting human toll in poverty, mental illness, suicides, spousal and child abuse, murders—as well as deaths from non-COVID-related diseases going untreated now—could easily exceed the case count and death count directly attributable to the virus once the war is over.

The stock market is probably the best scorekeeper in the battle between humans and the coronavirus. The virus outbreak in China first made the headlines on Friday, January 24. The S&P 500 dropped 2.5% by the following Monday’s close, but then moved higher to peak at a record 3386.15 on February 19 (Fig. 1). It then plunged 33.9% in just 33 days to 2237.4 on March 23 (Fig. 2). That was the fastest bear market in history, assuming that it ended on March 23, as I believe. It certainly correctly anticipated the economic retreat and calamity that have resulted from the government-imposed lockdowns around the world.

The question now is whether the 30.9% rally in the S&P 500 since the March 23 low through Friday’s close of 2929.80 is correctly predicting a remarkable victory against the virus in coming months. VWW-I has been a three-front war, with a health, economic, and financial front. Lots of progress was made on the financial front since the Fed launched its B-52 bombers and carpet-bombed the markets with liquidity starting on March 23. Undoubtedly, that explains most of the rally in stock prices since then.

I believe that the S&P 500 may consolidate for a while around 2900 until we see significant signs of progress on the health and economic fronts. The lockdowns have successfully imposed social distancing, resulting in the flattening of the case and death curves. Now, as governments are starting to open their economies, there are likely to be flare-ups in so-called hot spots or even widespread second waves of infection. Progress on the health and economic fronts is likely to be in fits and starts, giving investors the jitters.

We saw a bit of those jitters in Monday’s trading action, when South Korea’s capital closed down more than 2,100 bars and other nightspots Saturday because of a new cluster of coronavirus infections, Germany scrambled to contain fresh outbreaks at slaughterhouses, and Italian authorities worried that people were getting too friendly at cocktail hour during the country’s first weekend of eased restrictions.

Meanwhile, the best way to win VWW-II would be to discover a weapon of mass destruction to destroy the virus. Progress is being made on the health front in devising tests, cures, and vaccines. Consider the following recent developments:

(1) Tests. The Food and Drug Administration (FDA) granted emergency-use authorization for Abbott Laboratories’ new coronavirus test that detects COVID-19 antibodies, the company announced Monday. Abbott plans to ship nearly 30 million tests—which can indicate whether a person has had COVID-19 in the past and was either asymptomatic or recovered—in May and will have the capacity to ship 60 million tests in June, the company announced in a press release.

(2) Cures. The S&P 500 rallied 2.7% on April 29, when Gilead Sciences released a study conducted by the National Institute of Allergy and Infectious Diseases. It found that the company’s experimental drug, remdesivir, was the first treatment shown to have even a small effect against COVID-19. The median time that hospitalized COVID-19 patients on remdesivir took to stop needing oxygen or exit the hospital was, at 11 days, four days shorter than those who were on placebo. Critics argue that the reason we have shut our whole society down is not to prevent COVID-19 patients from spending a few more days in the hospital. It is to prevent patients from dying, which the study did not address. (See the May 11 article on statnews.com, “Inside the NIH’s controversial decision to stop its big remdesivir study.”)

Dr. David Agus, a Professor of Medicine and Engineering at the University of Southern California, was interviewed on May 7 by Howard Stern. He acknowledged that remdesivir isn’t a miracle cure. But he claimed that if the drug is taken as soon as symptoms appear and a test confirms the infection, the outcome for the patient is likely to be less severe and shorter illness and less chance of death. He compared it to taking Tamiflu right away when flu symptoms occur.

On Tuesday, Gilead Sciences announced the signing of licensing agreements with five generic drug makers to manufacture remdesivir in 128 countries, including the US. The deal is “royalty-free” until the World Health Organization says the COVID-19 outbreak is no longer a global health crisis or “until a pharmaceutical product other than remdesivir or a vaccine is approved to treat or prevent Covid-19, whichever is earlier,” the company said.

(3) Vaccines. There are more than 100 different COVID-19 vaccine candidates in various stages of development. So far, eight are already in human trials. Experts are “cautiously optimistic” that the world will get a vaccine, according to a May 9 Deseret News article, which added: “They just don’t know when.” It also reported: “But there’s a big difference between identifying a successful COVID-19 vaccine in a lab and having a studied-at-length, licensed vaccine available in every corner pharmacy. The entire process is laden with potential setbacks—not the least of which is finding enough vials to hold the life-saving serum.”

Here is the real problem with fast-tracking a vaccine: “The next step would be getting emergency use authorization from the FDA, which would allow policymakers to offer the vaccine to health care workers, first responders and essential workers like grocery store clerks and delivery truck drivers. Yet never before has the US vaccinated millions under emergency use authorization.” In the past, vaccine development was “measured in decades—not months, with each step taking years, not weeks.”

Meanwhile, Reuters reported that French drug maker Sanofi SA said on Wednesday that it is working with European regulators to speed up access to a potential coronavirus vaccine in Europe. Sanofi, whose Pasteur division has an established track record of producing influenza vaccines, teamed up with British rival GlaxoSmithKline Plc last month to come up with a candidate that it hopes will be ready next year. The companies have received financial support from the Biomedical Advanced Research and Development Authority (BARDA) of the US Health Department. Given the support from BARDA, doses produced in the US are expected to go to US patients first, a prospect that has raised concern in Europe.

Tuesday, May 5, 2020

Fed Eats Buffett's Lunch

In my recent conference calls with our accounts, I’ve been making the case for investing in crony capitalism. This system differs from entrepreneurial capitalism where the business of companies is to compete with one another fairly and squarely for their customers’ business. Entrepreneurial capitalists who fail to do so go out of business. Those who succeed prosper.

The problem is that successful entrepreneurial capitalists tend to become crony capitalists when they pay off politicians to impose legal and regulatory barriers to market entry by new competitors. It doesn’t seem to matter to them that they succeeded because no such barriers blocked their access. Rather than cherish and protect the system that allowed them to succeed, they cherish and protect the businesses they have built.

A related problem is that politicians view successful entrepreneurial capitalists and their companies as ideal candidates for so-called “rent extraction,” otherwise known as “extortion.” Politicians threaten to use their powers to regulate business to the disadvantage of companies that don’t cooperate with their agenda, which is mostly about getting reelected and more power. Crony capitalism is the result of Big Business colluding with Big Government for their mutual benefit.

President Calvin Coolidge, in a January 1925 speech to newspaper editors, famously said, “The business of America is business!” That’s no longer true for many big enterprises. Doing business with the government has become increasingly essential for companies, as the government has become a bigger customer for many of them and also more powerful in regulating all of their businesses. Despite recurring promises by presidential candidates to banish “special interests” from running Washington, the lobbying industry continues to flourish and grow in our nation’s capital, reflecting the symbiotic growth of Big Business and Big Government, i.e., the triumph of crony capitalism. The lobbying industry is their love child.

President Ronald Reagan famously said, “The nine most terrifying words in the English language are “I'm from the government, and I'm here to help.” On November 18, 2008, Rahm Emanuel, the chief of staff for President-elect Barack Obama, famously stated, “You never want a serious crisis to go to waste. ... This crisis provides the opportunity for us to do things that you could not before.” Lots of politicians and policymakers follow “Rahm’s Rule for Politicians,” as I call it. If Rahm’s advice seems Machiavellian, well, it is. Sixteenth-century Italian political theorist Niccolò Machiavelli advised in his famous treatise The Prince: “Never waste the opportunity offered by a good crisis.” However, it was Winston Churchill who reputedly popularized the sentiment.

Which brings us to the Great Virus Crisis (GVC). The government is here to help, and to get bigger trying. The CARES Act signed by President Donald Trump on March 27 gave the US Treasury Secretary Steve Mnuchin the power to provide up to $2 trillion in assistance to rescue the economy.

The Act provided for $32 billion in grants for the airline industry for payroll support and $25 billion in direct loans or loan guarantees from the Treasury to support passenger air carriers. The CARES Act “requires the Secretary to receive warrants, equity interest, or senior debt instruments issued by the loan recipients as compensation for providing the loans,” according to the Congressional Budget Office.

Businesses that need bailouts, such as the airline industry, will be beholden to the whims of politicians to manage their affairs. That’s why I advocate investing in companies that are likely to benefit from the triumph of crony capitalism. They are big businesses with strong balance sheets that are positioned to survive and even to prosper during the post-GVC era ahead. They don’t need rescuing by the government.

Warren Buffett seems to agree, at least about the prospects for the airline industry. He is widely revered as one of America’s great capitalists. While there is some debate on where he is on the spectrum between entrepreneurial and crony capitalism, his annual meeting of Berkshire Hathaway shareholders is dubbed “Woodstock for Capitalists.” Consider the following:

(1) Dumping airlines. On Saturday, at Berkshire Hathaway’s first virtual annual meeting, Buffett revealed that he sold his sizeable stakes in all his airline stocks. He said: “The world has changed for the airlines. And I don’t know how it’s changed, and I hope it corrects itself in a reasonably prompt way. … I don’t know if Americans have now changed their habits or will change their habits because of the extended period.” But, he added, “I think there are certain industries--and unfortunately, I think that the airline industry [is one], among others--that are really hurt by a forced shutdown by events that are far beyond our control.”

(2) Praising the Fed. Buffett was impressed by the Fed’s QE4ever announcement on March 23. In addition to unlimited and open-ended QE purchases, the Fed moved for the first time into corporate bonds, purchasing the investment-grade securities in primary and secondary markets and through exchange-traded funds. On April 9, the Fed provided term sheets explaining that Special Purpose Vehicles (SPVs) to do so would be funded by capital provided by the Treasury through the CARES Act.

Buffett said, “They reacted in a huge way.” The bond market “had essentially frozen” just prior to the Fed’s action. Yet April turned out to be “the largest month for corporate debt issuance … in history,” he said. He added, “Every one of those people that issued bonds in late March and April ought to send a thank you letter to the Fed because it wouldn’t have happened if they hadn’t operated with really unprecedented speed and determination.” On Thursday, April 30, Boeing was able to raise a stunning $25 billion in funding, allowing it to avoid government help even after it said last month that it would seek $60 billion in federal bailout money.

(3) Getting outbid by the Fed. Buffett isn’t a sore loser. But he should be, given that the Fed acted before he had time to do what he does best—i.e., to take advantage of a financial crisis to buy cheap assets with the record $137 billion on Berkshire Hathaway’s balance sheet. He hasn’t made a major acquisition in several years, not having found anything “that attractive.”

Actually, there were lots of attractive distressed assets resulting from the 33-day bear market in stocks from February 19 through March 23. But Buffett couldn’t act fast enough since the Fed and the Treasury came to the rescue so quickly with so much cash. They are here from the government, and here to help.

(4) Fort Knox. Then again, Buffett seems to be spooked by the GVC, and is worrying about a second wave of infection. Rather than using his cash for acquisitions, he prefers to use it to fortify his company against “worst-case possibilities.” He said, “Our position will be to stay a Fort Knox.”

An October 16, 2008 NYT op-ed by Buffett was titled “Buy American. I Am.” Now, as then, Buffett believes in America. At the recent meeting he said, “The American miracle, the American magic has always prevailed, and it will do so again.”

Thursday, April 30, 2020

The Twilight Zone: Where Is Everybody?

The very first episode of The Twilight Zone aired on CBS on October 2, 1959. It was titled “Where Is Everybody?.” The TV series was created by Rod Serling and broadcast from 1959 to 1964. Wikipedia observes: “Each episode presents a stand-alone story in which characters find themselves dealing with often disturbing or unusual events, an experience described as entering ‘The Twilight Zone,’ often with a surprise ending and a moral. Although predominantly science-fiction, the show’s paranormal and Kafkaesque events leaned the show towards fantasy and horror.”

Each episode started with Serling explaining: “There is a fifth dimension, beyond that which is known to man. It is a dimension as vast as space and as timeless as infinity. It is the middle ground between light and shadow, between science and superstition, and it lies between the pit of man’s fears and the summit of his knowledge. This is the dimension of imagination. It is an area which we call The Twilight Zone.” That is a remarkably good description of the predicament that we humans are confronting during the current Great Virus Crisis (GVC).

Although the phrase “submitted for your approval” from Serling’s opening narration is closely identified with the show (and often used by Serling impressionists), it is actually heard in only three episodes. Now, submitted for your approval are the following surreal developments:

(1) Pandemic of fear. In The Twilight Zone, fear is the all-consuming emotion that often leads to madness. On February 26, when the S&P 500 closed at 3116.39, Joe and I wrote: “We have come to the conclusion that even if the virus turns out to be no more dangerous to global medical and economic health than previous outbreaks (as we still expect), extreme government responses aimed at containing the virus, while effective, will create a pandemic of fear, increasing the risk of a global recession and a bear market in stocks.” On March 10, we wrote: “The pandemic of fear continues to spread faster than the cause of that fear, namely, the COVID-19 virus.” On March 12, we pushed our 3500 year-end target for the S&P 500 out to mid-2021, and targeted 2900 for year-end 2020 instead. On March 16, we started to monitor the “mad dash for cash.”

We’ve been monitoring this madness in our chart publication titled Mad Dash for Cash. Liquid assets soared $1.3 trillion from the end of February through mid-April (Fig. 1). Commercial and industrial loans jumped $553 billion over the same time span (Fig. 2).

As a result, credit-quality spreads widened dramatically last month until the Fed expanded QE4, which had been announced on March 15, to QE4ever on March 23. The Fed’s balance sheet has increased by a whopping $2.4 trillion from the end of February through the April 22 week (Fig. 3 and Fig. 4). Credit-quality spreads have narrowed significantly since then as the pandemic of fear abated in the capital markets. The S&P 500 soared as liquidity returned to the bond market, allowing investors to rebalance their portfolios by selling their bonds to buy stocks.

(2) So where is everybody? Meanwhile, a pandemic of fear continues to weigh on our economy. As a result of voluntary and enforced social distancing and lockdowns, the streets are empty, as are office buildings, shopping malls, restaurants, hotels, and airports. It all started when President Donald Trump pivoted on March 16 from his position that COVID-19 is just a bad flu to advising Americans to listen to their governors if they issue 15-day stay-in-place executive orders.

By the end of the week, the governors of both California and New York did so. Other governors followed shortly thereafter. That was the easy part. Now the hard part: They have to decide when and how to open up their states. Even if they soon start to do so gradually, many people may opt to continue to work from home (if they can) and to stay away from public places. We’ve previously written that the best cure for a viral pandemic is a pandemic of fear. However, lingering fear of a second wave of infection and a seasonal return of the virus in the fall might continue to weigh on the economy. So a V-shaped recovery back to normal is unlikely. Hopefully, the recovery will be more U-shaped than L-shaped.

Many of us may or may not be virologists now that we have become very informed (and disinformed) about viruses over the past three months. In any case, we certainly are all germaphobes now. On the other hand, even though most of us are staying healthy at home, we are all getting cabin fever, for sure. One day soon, we will venture out of our cabins wearing surgical masks and bandanas and keeping our distance from all our germ-infested fellow humans. In this light, reread Serling’s opening narrative to his TV series, and “welcome to The Twilight Zone.”

(3) MMT to infinity and beyond. On Friday, March 27, four days after the Fed’s QE4ever announcement, Trump signed the CARES Act. It provided $2.2 trillion in rescue programs for the economy, including $450 billion for the US Treasury to provide as capital to the Fed to make $4 trillion in loans through Special Purpose Vehicles (SPVs). SPVs were newly created for the singular purpose of providing the Fed with a legal way to lend directly to Americans.

In other words, without any discussion or debate, the federal government has embraced Modern Monetary Theory (MMT), which advocates unlimited government borrowing unless and until inflation heats up. The act has already been followed by a $484 billion package of additional spending signed by Trump on Friday. Undoubtedly, there will be more packages to rescue state and local governments and to fund public infrastructure projects.

The federal deficit—which was already back to $1.04 trillion over the 12 months through March—is likely to exceed $4 trillion on a comparable basis by the end of this year, with outlays jumping from $4.6 trillion to $6.6 trillion and revenues falling from $3.6 trillion to $2.6 trillion (Fig. 5 and Fig. 6). Have no fear of these death-defying deficits because the Fed is here to help: Keep in mind that the Fed has already purchased $1.4 trillion in US Treasuries since the end of February! That’s MMT at work on steroids, for sure.

In my numerous conference calls with our accounts in recent days, I was frequently asked about the inflationary consequences of MMT-on-steroids. Yes, I acknowledged, it could all lead to Weimar-style hyperinflation. More likely, though, in my opinion, is that we are going down the same road as Japan, which has a rapidly aging population and lots of government spending that has been financed by the Bank of Japan’s QE4ever without any inflationary consequences.

By the way, on Friday, the Congressional Budget Office (CBO) released a preliminary economic damage assessment. The CBO is projecting that real GDP will fall by 40% (saar) during Q2 and that the unemployment rate will average around 14% for that quarter. For fiscal-year 2020, which ends September, the federal deficit is projected to be $3.7 trillion, with federal debt likely to be 101% of GDP by the end of the fiscal year.

(4) The end of globalization and the new world order. In my recent conference calls, I was also frequently asked about the prospects for globalization. “Not good,” is my short answer. On Saturday, the World Health Organization warned governments against issuing “immunity passports,” saying that there was not enough evidence that a person who has recovered from COVID-19 is immune from a second infection. Nevertheless, borders are likely to make a big comeback as countries require visas from foreigners proving that they’ve had medical checkups, including COVID-19 vaccine shots or antibody certifications.

Perhaps the biggest threat to globalization is that China and the US are already in the early stages of a Cold War with escalating cybersecurity and disinformation campaigns. Many US companies are likely, either voluntarily or as a result of government decrees, to move their supply chains out of China.

(5) Capitalism for cronies. Also in my conference calls, I’ve been making the case for investing in crony capitalism. I am an entrepreneurial capitalist. In providing investment strategy research to institutional accounts, I have many competitors. In my 2018 book, Predicting the Markets: A Professional Autobiography, I explained: “I have no lobbyists or political cronies in Washington, DC to protect my interests. So the forces of the competitive market compel me to work as hard as possible to satisfy my customers more than my competitors do.”

I differentiated entrepreneurial capitalism from crony capitalism as follows: “Admittedly, this is an idealized version of capitalism. It does exist, especially in the United States in many industries. However, it also coexists with crony capitalism. Actually, it can degenerate into crony capitalism and other variants of corruption. Successful entrepreneurial capitalists have a tendency to turn into crony capitalists when they pay off politicians to impose legal and regulatory barriers to entry for new competitors. It doesn’t seem to matter to them that they succeeded because there were no barriers or they found a way around the barriers. Rather than cherish and protect the system that allowed them to succeed, they cherish and protect the businesses they have built.”

As entrepreneurial capitalism evolves into crony capitalism, the government naturally becomes a bigger and more powerful participant in the economy and financial markets. That certainly describes what just happened with the passage of the huge CARES Act and the Fed’s unprecedented actions in the credit markets.

I’m not a preacher, so I am not going to dwell on whether this is a good or bad development. As an investment strategist, I focus on assessing whether the government’s policies are bullish or bearish. The latest developments are bullish for stocks, especially of companies that are likely to benefit from the triumph of crony capitalism. Most importantly, they are the ones that don’t need rescuing by the government, so they won’t be beholden to the whims of politicians to manage their affairs. (I wouldn’t be surprised if the airline industry, which received a $25 billion bailout under CARES, becomes nationalized on a de facto basis.)

Companies that have strong balance sheets with lots of cash will be like kids in a candy store, buying up distressed assets and companies with little resistance from anti-trust regulators, in my opinion. That’s because many of them also have lots of lobbyists in Washington who are vital intermediaries between big business and big government. They grease the wheels of crony capitalism.

(6) Good news: plenty of distressed assets. Several of our accounts told me during our recent audio and video conversations that they are getting inundated with calls from distressed asset fund managers. A few of our accounts are managers of such funds. Last year, they were bemoaning that they were attracting lots of reach-for-yield investors but couldn’t find enough distressed assets. Furthermore, intense competition in the industry for distressed assets boosted their prices, making these dodgy assets more expensive, thus reducing their risk-adjusted expected rates of return. It’s always better to buy a distressed asset at 25 cents on the dollar than at 50 cents on the dollar. But there have been slim pickings even at the higher prices until now.

The good news for distressed asset fund managers is all the bad news for the economy that’s been caused by the GVC: As a result, there’s no longer a shortage of distressed assets. The good news for the economy is that distressed asset funds are already scrambling to buy distressed assets. They have SWAT teams of professionals who are very skilled at restructuring these assets.

I’ve been saying since 2016 that distressed asset funds are the new shock absorber in the credit markets. It will be interesting to see if they can successfully absorb the latest shock to the benefit of both themselves and the economy. They’ll undoubtedly have plenty of assistance from cash-rich companies that will be scooping up cheap assets and companies. That’s certainly starting to happen in the oil patch, just as it did in 2015 and 2016 when the price of oil plunged. Of course, the Fed’s recent actions have also greatly reduced the pool of distressed assets.

In The Twilight Zone, good news can be bad news and bad news can be good news. Only in The Twilight Zone is it possible to go from desperately reaching for yield to madly dashing for cash, to scrambling to rebalance from cash and bonds into stocks, to snapping up distressed assets—all within a four-month period since the beginning of this year! That’s all truly surreal!

Wednesday, April 22, 2020

Fed Trying To Contain Zombie Apocalypse It Created

Creating the Zombie Apocalypse. Fed Chair Jerome Powell is doing an admirable job of playing the action hero in “2012 Zombie Apocalypse,” a 2011 film about a fictional virus, VM2, that causes a global pandemic. He is doing whatever it takes to stop the zombies from killing us by ruining our economy and way of life.

In my recently released book Fed Watching for Fun & Profit, I defined the zombies as living-dead firms that continue to produce even though they are bleeding cash. In a purely capitalist system, they should go out of business and be buried. However, these firms survive only because they are kept on life support by government subsidies, usually because of political cronyism, which corrupts and undermines capitalism. In recent years, the Fed’s ultra-easy monetary policies have created and exacerbated the zombie problem. I wrote:

“And why are lenders willing to lend to the zombies? Instead of stimulating demand by borrowers, historically low interest rates incite a reach-for-yield frenzy among lenders. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.”

Now consider the following developments just before the Great Virus Crisis (GVC) significantly increased the odds of a zombie apocalypse:

(1) The IMF’s script. In my book, I wrote: “If you want to read a very frightening script of how this horror movie plays out, see the October 2019 Global Financial Stability Report prepared by the International Monetary Fund (IMF). It is titled ‘Lower for Longer’ but should have been titled ‘Is a Zombie Apocalypse Coming?’ Here is the disturbing conclusion: ‘In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.’”

(2) The Fed’s script. Also in my book, I observed that the Fed’s second Financial Stability Report was released in May 2019. It had the same don’t-worry-we-are-on-it tone as the first report released during November 2018. However, credit quality had clearly eroded in the corporate bond market. The second report observed: “[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”

The report also raised concerns about leveraged loans, as follows:

“The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”

(3) The man who saw it coming. During his October 30, 2019 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses, which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.” He didn’t specify those steps. However, the Fed’s three interest-rate cuts during 2019 undoubtedly kept lots of zombies alive and fed their appetite for more debt.

Containing the Zombie Apocalypse. On March 11, the World Health Organization declared that the COVID-19 outbreak had turned into a global pandemic. The pandemic of fear spread just as rapidly in the US capital markets, especially in the bond markets, which seized up as credit-quality yield spreads soared. The zombie apocalypse had arrived.

On Sunday, March 15, the Fed responded by cutting the federal funds rate by 100bps to zero and announcing a $700 billion QE4 program of Treasury and mortgage-backed securities purchases. That week, the governors of California and New York issued executive orders requiring nonessential workers to stay home. Credit-quality spreads continued to widen significantly. So on March 23, the Fed introduced QE4ever and posted term sheets on five major credit facilities.

Three of the new facilities dated back to the Great Financial Crisis and were reactivated. The big shockers were the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). For the first time ever, the Fed was going to lend a hand to the investment-grade corporate bond market. Here are the specifics from their term sheets:

(1) PMCCF. The Fed is prohibited by law from purchasing corporate bonds. To get around this restriction, the Fed will lend to a special purpose vehicle (SPV) on a recourse basis. “The SPV will (i) purchase qualifying bonds directly from eligible issuers and (ii) provide loans to eligible issuers.” This backstop for investment-grade corporate bonds and loans (with maturities of four years or less) will be backstopped by $10 billion in equity provided by the US Treasury’s Exchange Stabilization Fund. Borrowers may defer paying interest for six months (extendable at the Fed’s discretion), but they must not pay dividends or buy back shares during the period they aren’t paying interest. The facility is scheduled to be terminated on September 30 of this year.

(2) SMCCF. This facility is structured in the same way as the PMCCF, but it purchases eligible individual corporate bonds as well as eligible corporate bond portfolios in the form of exchange-traded funds (ETFs) in the secondary market with maturities of five years or less. Both programs set limits per issuer and ETF.

(3) Another round of drinks for my friends. On March 27, President Donald Trump signed the CARES Act, which gave the US Treasury $450 billion to invest in the Fed’s SPVs, thus effectively converting the Fed into the Bank of the United States, or “T-Fed” as I call it. On April 9, the Fed announced how it would leverage up all that capital, initially up to $2.3 trillion in loans and possibly up to $4.0 trillion in total.

That sum includes $750 billion in lending by the two corporate liquidity facilities leveraging up (on a 10-to-1 basis) the Treasury’s $75 billion in capital from the original $20 billion. The ironic shocker was that the eligible bonds now included those BBB-rated bonds that the Fed had warned about in its FSR (cited above) less than a year ago. If those dicey bonds dropped below that rating after March 22, they could still be purchased by both facilities, according to the updated term sheets of the PMCCF and the SMCCF. The Fed opened up these two liquidity facilities for homeless investment-grade corporate bonds to the so-called fallen angels as well.

Now what will the Fed do about all the junk bonds issued by zombie energy companies that are about to blow up? Probably nothing. Large oil companies and distressed asset funds are likely to scoop up all the frackers, who can’t service their debts, at big discounts. Some portfolio managers will have to take big hits in their junk-bond portfolios. That’s the downside of associating with zombies.

Thursday, April 16, 2020

From Reach for Yield to Mad Dash for Cash to Rebalancing into Stocks

We live in an age of future shocks. It wasn’t too long ago that everyone seemed to be reaching for yield in the bond and stock markets. Actually, that was evident as recently as January 17 of this year, when the yield spread between high-yield corporate bonds and the 10-year US Treasury bond fell to 322bps, the lowest since October 8, 2018 (Fig. 1). That was followed by a mad dash for cash, as evidenced by the jump in this spread to 1,062bps on March 23, which was the highest reading since May 26, 2009. That also happened to be the day that the Fed announced QE4ever. Since March 24, it’s been a mad dash to rebalance away from cash and bonds into stocks.

That’s evidenced by the 27.2% jump in the S&P 500 since March 23 through Tuesday's close (Fig. 2). The index is still down 15.9% from its record high on February 19 but down just 2.1% versus a year ago. Joe and I have been among the few optimists lately: We declared on March 25 that the S&P 500 had bottomed on March 23 and forecast that it would reach 2900 by year-end. It has to rise only another 1.9% to get there, well ahead of schedule. That’s truly astonishing under the circumstances!

Admittedly, before the virus hit the fan and spread throughout the world, our year-end target had been 3500. We got close when the index peaked at a record 3386.15 on February 19, appearing at that point to be on track to hit that target well ahead of schedule.

So where do we go from here? We are sticking with 3500 by the end of next year. There will obviously be setbacks along the way, but we don’t expect to see the March 23 low again as long as progress continues in the war against the virus.

By the way, here are some updates on the unprecedented mad dash for cash that occurred during March:

(1) Bond and equity funds. During the four weeks through April 1, bond and equity funds, including mutual funds and exchange-traded funds (ETFs), had estimated net outflows of $301.6 billion, according to the Investment Company Institute (Fig. 3 and Fig. 4). Bond funds had outflows of $277.9 billion, while stock funds lost $23.7 billion.

(2) Liquid assets. During the four weeks through March 30, liquid assets jumped by $1.1 trillion, led by money market mutual funds held by institutions ($511.8 billion) and savings deposits ($492.9 billion) (Fig. 5).

(3) Bank balance sheets. Total deposits at US commercial banks jumped $811 billion during the four weeks through April 1 (Fig. 6). Their borrowing increased $330 billion over the same period. On the asset side of their balance sheets, commercial & industrial loans rose $486 billion, while their portfolios of US Treasury and agency securities rose $38 billion.