Friday, August 7, 2020

May the Bond Vigilantes Rest in Peace

Bonds I: Eulogy. Let me begin my eulogy for the Bond Vigilantes with apologies to William Shakespeare. The emotional eulogy for Julius Caesar that Shakespeare penned for the character Marc Antony in his play Julius Caesar inspired the words that I would like to share with you on this solemn occasion:

Friends, countrymen, citizens of the world, lend me your ears. I come to bury the Bond Vigilantes, not to praise them. The noble Fed killed its rival, the Bond Vigilantes, because they were too ambitious. If it were so, it was a grievous fault. The Bond Vigilantes sought to marshal market forces to counter the ever-growing power of the government. That cause is noble and good. But while the evil that men do lives after them, the good is oft interred with their bones—so let it be with the Bond Vigilantes. Their well intentioned efforts were doomed to failure. The Fed meant well too, as did Caesar’s assassins. Both comprise honorable men. But men have lost their reason. Bear with me; my heart is in the coffin there with the Bond Vigilantes, and I must pause ’til it come back to me.

Bonds II: Requiem. My friends, I still fondly recall the days when the Bond Vigilantes rode high and mighty. The July 27, 1983 issue of my weekly commentary was titled “Bond Investors Are the Economy’s Vigilantes.” I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”

To this day, every time bond yields rise significantly almost anywhere in the world, I get asked to appear on at least one of the financial news TV networks to discuss whether the Bond Vigilantes are back. Having popularized “hat-size bond yields” and “Bond Vigilantes,” I’ve learned to appreciate the power of coining pithy terms to brand my economic and financial forecasts. Coin a good phrase that accurately describes future developments, and it will appear in your obituary, if not on your tombstone.

The Bond Vigilantes Model tracks the rise and fall of the Wild Bunch. It simply compares the bond yield to the growth rate in nominal GDP on a year-over-year basis (Fig. 1). My model shows that since 1953, the yield has fluctuated around the growth rate of nominal GDP. However, both the bond yield and nominal GDP growth tend to be volatile. While they usually are in the same ballpark, they rarely coincide. When their trajectories diverge, the model forces me to explain why this is happening. On occasions, doing so has sharpened my ability to see and understand important inflection points in the relationship. Here is a brief nostalgic walk down Bond Street:

(1) Getting whipped by inflation. From the 1950s to the 1970s, the spread between the bond yield and nominal GDP growth was mostly negative (Fig. 2). Investors underestimated the growth rate of nominal GDP because they underestimated inflation. Bond yields rose during this period but remained consistently below nominal GDP growth. Those were dark days for bond investors.

(2) Keeping law and order. The Bond Vigilantes were increasingly in command during the 1980s and 1990s. They fought to bring back law and order in the fixed-income markets to the benefit of bond investors. There were several episodes when rising bond yields slowed the economy and put a lid on inflation.

The Bond Vigilantes’ heyday was the Clinton years, from 1993 through 2001. Placating them was front and center on the administration’s policy agenda. Indeed, Clinton political adviser James Carville famously said at the time, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

(3) Long siesta. After the mid-1990s, the Bond Vigilantes seemed less active, because they no longer had to be as vigilant. As inflation fell, the spread between the bond yield and nominal GDP growth narrowed and fluctuated around zero. While today the US government faces the problem of persistently big federal budget deficits, it’s interesting to recall that at the start of 2001, a major topic of discussion was how big the coming surplus in the federal budget might get.

During the early 2000s, after the 9/11 terrorist attacks, the Fed kept the federal funds rate too low, and a global savings glut kept a lid on bond yields and mortgage rates. They remained relatively flat even as the Fed started raising the federal funds rate “at a measured pace” of 25bps moves, from 1.00% to 1.25% on June 30, 2004 up to 5.25% through June 29, 2006 (Fig. 3).

(4) Long good buy. The Great Financial Crisis (GFC) of 2008 caused the Fed to implement ultra-easy unconventional monetary policies. The federal funds rate was pegged in a range of 0.00%-0.25% from December 16, 2008 through December 16, 2015. The Fed’s three QE (quantitative easing) programs caused the Fed’s holdings of bonds to balloon from $0.48 trillion during the final week of November 2008 to $4.19 trillion by the start of October 2014 (Fig. 4). Inflation remained remarkably subdued after the GFC. Starting January 2012, the Fed targeted core PCED (personal consumption expenditures deflator) inflation at 2%, but it has remained below that pace during all but 13 months since then (Fig. 5).

The Fed’s QE3 was terminated near the end of 2014, and the federal funds rate was raised for the first time since the GFC on December 16, 2015. Fed officials continued to ratchet rates higher up to 2.25%-2.50% on December 19, 2018. They were expecting to normalize monetary policy (Fig. 6).

Nevertheless, investors, reaching for yield, poured money into bonds. The 10-year US Treasury bond yield fell to 1.92% at the end of 2019 (Fig. 7). It was a long good buy from the peak in its yield of 15.84% back on September 30, 1981 (Fig. 8).

(5) Last rites. The bond yield fell below 1.00% for the first time on March 5, 2020, and has been consistently below since March 20. The World Health Organization declared a pandemic on March 11. The Fed responded to the Great Virus Crisis (GVC) by lowering the federal funds rate by 100bps to zero and implementing QE4 on March 15. On March 23, QE4 was turned into QE4Ever. The bond yield fell to a record low of 0.55% on Friday. The Bond Vigilantes have been buried by the Fed.

Bonds III: The Inflation Scenario. Many investors who profited from the long good buy are now saying “you are dead to me” to the bond market. They are rebalancing more of their portfolios into other assets, such as US stocks, SPACs (special-purpose acquisition companies), precious metals, and overseas assets including currencies, stocks, and bonds.

The end of the long-term bull market in bonds has been declared, erroneously, by market prognosticators for many years. It may not be over just yet. The yield on the 10-year Treasury could still fall to zero. It could even turn slightly negative, as have comparable yields in Germany and Japan (Fig. 9).

Then again, what if a vaccine and effective treatments are discovered to end the pandemic early next year? Never before has the drug industry received billions of dollars to develop such medicines at warp speed. In this scenario, the global economy could recover quickly next year. Inflation could finally jump above the Fed’s 2.0% target as demand for goods and services outstrips supply, especially if global supply chains have been significantly disrupted by the pandemic and by the worsening Cold War between the US and China.

Would rising inflation cause bond yields to soar? I don’t think so. Both monetary and fiscal officials know that rising interest rates could abort the post-GVC recovery. They also realize that a rebound in interest rates would significantly balloon federal deficits and the debt. Net interest paid by the federal government totaled $346.9 billion over the 12 months through June, down from a record high of $384.8 billion during March (Fig. 10).

I believe that the Fed publicly would welcome inflation in a range of 2.0% up to 4.0% as a long overdue offset to inflation running below 2.0% for so long in the past. In this scenario, the Fed might announce that the federal funds rate will be held at zero and that the bond yield will be pegged below 1.00%. In other words, any sign that the Bond Vigilantes might rise from their graves (along with inflation) would be met by the Fed with whatever it takes to keep them buried. This would be wildly bullish for all of the alternative assets to bonds mentioned above, especially growth stocks and precious metals.

My view that the Fed’s attitude toward rising inflation is evolving into one of benign neglect was confirmed by an important August 2 article by Nick Timiraos, the WSJ’s ace Fed watcher, titled “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation.” Timiraos reports that the Fed “is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.”

The Fed first formally targeted inflation in a January 25, 2012 press release titled “Federal Reserve issues FOMC statement of longer-run goals and policy strategy.” It stated: “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.” The widespread interpretation was that once the target was achieved, it would be a ceiling.

Timiraos reports that some Fed officials wouldn’t mind if inflation were to run hot above 2% for a while since it has run cold for so long. They want to offset previous deviations on the downside with a stretch of inflation overshooting the 2% target for a while.

Might all of this eventually lead to hyperinflation? I am not in the hyperinflation camp. But if that’s the ultimate endgame of Modern Monetary Theory (MMT), then all bets are off.

Bonds IV: The Dollar Vigilantes. Of course, the death of the Bond Vigilantes could lead to the emergence of other vigilantes in the financial markets. The Dow Vigilantes got what they wanted in response to the freefall in stock prices from February 19 through March 23. They got QE4Ever plus the CARES Act. The result has been trillions of dollars printed and spent by Fed Chair Jerome Powell and Treasury Secretary Steven Mnuchin.

The Gold Vigilantes are certainly expressing their fear and loathing of this unholy alliance between fiscal and monetary policies. But they don’t have the kind of power that the Bond Vigilantes once had to rein in policy excesses. The only market players left with any power are the Dollar Vigilantes. They have lots of fear and loathing of MMT and can do something about it.

They can devalue the dollar relative to other currencies, thus putting upward pressure on import prices, which could revive inflation. Even the Wizards of MMT acknowledge that they should at least think about tapping on the brakes if inflation makes a comeback.

Thursday, July 30, 2020

Welcome to Oz, Where MMT Enables the Government to Get Bigger!

We live in surreal times. I’ve previously compared them to the TV series The Twilight Zone. However, a more apt comparison would be with the land that Dorothy and her dog Toto visited in the movie "The Wizard of Oz." When a tornado ripped her house from its foundation, causing it to crash-land in Oz, she emerged safe and sound, looked around in wonder, and famously marveled, “Toto, I’ve a feeling we’re not in Kansas anymore.” Oz had a colorful cast of characters, including assorted Munchkins, the Good Witch of the North, the Bad Witch of the West and her Winkie Guards, and a blustery wizard—not unlike Washington today. And the news these days showcases plenty of national and local leaders behaving like cowardly lions, heartless tin men, and brainless straw men.
The analogy with Oz was first provided by none other than the Wizard of MMT, Professor Stephanie Kelton. In her book The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, she wrote: “Like Dorothy and her companion in The Wizard of Oz, we need to see through the myths and remember once again that we’ve had the power all along.”

Kelton was referring to Dorothy’s power to go back home to Kansas simply by clicking the heels of her ruby-red slippers three times. Similarly, Kelton believes that the US government has always had the power to run huge budget deficits and should be doing so now to cure all our ills. As a result of the Great Virus Crisis (GVC), her theory has taken on a life of its own beyond her wildest dreams. Governments around the world are spending massively on stimulative fiscal policies to offset the recessionary forces unleashed by the GVC.

Most of those contractionary forces have been driven by the extreme government lockdown policies adopted to impose social distancing to slow the spread of the virus. So far, all the government stimulus has provided some support for the global economy. But the virus is still out there, and so are the recessionary forces. As a result, price inflation remains subdued even though much of the ballooning fiscal deficits are being financed by central banks’ purchases of government securities, which MMTers also support.

In Kelton’s dreamland, that’s a perfect outcome, because she and her merry band of arm-linked MMTers believe that the only limit on deficit-financed government spending is price inflation. Sure enough, the US government has responded precisely as she advocates, producing one stimulus program after another. Another one is imminent, sized to the tune of $1.0 trillion, which will most likely cause the Congressional Budget Office to raise its current fiscal 2020 budget deficit estimate from $3.7 trillion to $4.7 trillion…click, click, click (Fig. 1 and Fig. 2). No problem: The Fed will continue to buy more Treasuries…click, click, click (Fig. 3 and Fig. 4).

Melissa and I have written previously about MMT. Our latest analysis, titled “Modern Monetary Theory: In Theory & In Practice,” was in our July 8 Morning Briefing. We wrote:

“Kelton argues that the federal government can and should run large budget deficits as long as inflation remains subdued. MMT opponents’ main objection is that the theory provides a blank check for the government to get much bigger. It provides the government with too much power to allocate resources. Free-market capitalists believe that markets do a much better job of doing so than politicians and bureaucrats. Kelton clearly disagrees. … But whether one is for MMT or against it, Kelton’s book leaves no doubt about what MMT is all about: It’s an agenda for more big government and higher taxes.” In brief, it legitimizes a massive power grab by the government for our own good.

Kelton probably would welcome the opportunity to be Treasury secretary if the Democrats win the White House in November. Ironically, her views already are reflected in the current Republican administration’s fiscal policymaking! By the way, Kelton contributed to the 110-page Biden-Sanders Unity Task Force Recommendations. Other contributing luminaries included former US Secretary of State in the Obama administration and former Senator (D-MA) John Kerry, Representative Alexandria Ocasio-Cortez (D-NY), former US Attorney General under Obama Eric Holder, former White House Chief Economist under Obama Jared Bernstein, and American Federation of Teachers President Randi Weingarten. So Professor Kelton is either in good company or bad company depending on your political leanings.

We concluded our analysis: “But remember, the story was all a bad dream Dorothy had after getting hit on the head. Free market capitalists might exclaim: ‘Pay no attention to the professor behind the curtain!’” We like to think of “The Wizard of Oz” as a long episode of The Twilight Zone.

Saturday, July 25, 2020

More Declarations of War Signal US-China Cold War Heating Up

China’s mercantilist trade war against the US effectively started when China joined the World Trade Organization (WTO) on December 11, 2001. The US supported China’s admission to the WTO, expecting that China would abide by the organization’s rules, which mostly promoted free trade among its 144 member nations back then. (There are 164 members currently.) Instead, the Chinese abused their membership by pursuing mercantilist trade policies. They persistently and systematically violated the organization’s trade rules by using their WTO status to unfair advantage.

However, US officials didn’t publicly acknowledge that the US had been duped until Donald Trump became president. During the presidential election campaign, Trump often promised to take effective measures to correct America’s huge bilateral trade deficit with China. He called China one of the “greatest currency manipulators ever.” He declared that he would instruct the Treasury Department to so label China when he became president.

On April 13, 2018, the Treasury Department, in its biannual currency exchange report, scolded China for its lack of progress in reducing the trade deficit with the US but did not find that it was improperly devaluing its currency, the renminbi. Actually, it was the third time since Trump assumed the presidency that the Treasury Department opted not to accuse China of improper meddling. Instead, the administration opted for tariffs as an alternative means to pressure the Chinese to fix the trade problem.

By the way, previous administrations recognized the problem, but chose a less public and lower-key diplomatic approach to get China to change its ways. For example, to kick-start negotiations to resolve the problem, the Clinton administration slapped the “currency manipulator” label on China in 1994. That was well before China was admitted to the WTO.

In other words, the problem has been festering for a very long time indeed. The US merchandise trade deficit with China was $29.5 billion in 1994 (Fig. 1). Even back then, it was almost 20% of the total US trade deficit (Fig. 2). By 2018, it was up to $419.0 billion, accounting for 48% of the total trade gap.

Let’s briefly review the escalating tensions in the Cold War between the US and China:

(1) Peter Navarro is still Trump’s China hawk. Unlike most of President Donald Trump’s early-term advisers, Peter Navarro is still in the White House. Melissa and I profiled him in our March 8, 2018 Morning Briefing, fittingly titled “Meet Peter Navarro.” We wrote that “the White House director of the National Trade Council seems to be gaining influence and may even be up for a promotion.” Sure enough, he since has been promoted to assistant to the President, Director of Trade and Manufacturing Policy, and the national Defense Production Act policy coordinator.

Navarro long has been a critic of China’s mercantile trade practices. In fact, he literally wrote the book on this subject in 2011, fittingly titled Death by China: Confronting the Dragon—A Global Call to Action. Here is an excerpt from the book’s Amazon description: “The world’s most populous nation and soon-to-be largest economy is rapidly turning into the planet’s most efficient assassin. Unscrupulous Chinese entrepreneurs are flooding world markets with lethal products. China’s perverse form of capitalism combines illegal mercantilist and protectionist weapons to pick off American industries, job by job. China’s emboldened military is racing towards head-on confrontation with the U.S. Meanwhile, America’s executives, politicians, and even academics remain silent about the looming threat.” Most importantly, above and beyond China’s unfair trade practices, Navarro strongly suggested that China posed an existential threat to America’s national security.

(2) The President’s 2018 UN speech. In his September 25, 2018 speech before the United Nations General Assembly, Trump said the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(3) The Vice President’s 2018 speech. In an October 4, 2018 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s case against China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

The rest of the speech was a no-holds-barred blistering attack on the Chinese government. He accused the Chinese Communist Party (CCP) of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment.” He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence.” He accused China of economic and military aggression abroad. Pence also documented instances of China using so-called “debt diplomacy” to expand its influence. Pence accused the Chinese government of oppressing its own people at home. He stated that the US was taking steps “to protect our national security from Beijing’s predatory actions.”

The S&P 500 plunged 19.8% from September 20 through December 24, 2018. In our October 15, 2018 Morning Briefing titled “Panic Attack #62,” we listed six reasons for the selloff. We included the Veep’s speech: “Also setting the stage for last week’s selloff was a 10/4 speech by Vice President Mike Pence detailing the Trump administration’s long list of complaints against China. It wasn’t just about trade ... Pence’s speech made it clear that the problem is that China aspires to be a superpower at the expense of the US. While Trump seems to be winning his trade wars with most of America’s major trading partners, the conflict with China is likely to worsen because it isn’t just about trade. It is about national security.”

(4) The President’s 2019 UN speech. In a September 24, 2019 speech at the UN, Trump again called out China, berating Beijing as follows: “In 2001, China was admitted to the WTO. Our leaders then argued that this decision would compel China to liberalize its economy and strengthen protections … for private property and for the rule of law. Two decades later, this theory has been tested and proven completely wrong. Not only has China declined to adopt promised reforms, it has embraced an economic model dependent on massive market barriers, heavy state subsidies, currency manipulation, product dumping, forced technology transfers, and the theft of intellectual property and also trade secrets on a grand scale.”

(5) No Phase 2 to follow Phase 1. After an escalating trade war between the US and China during 2018 and 2019, with both sides raising their tariffs on the other, both parties signed a “Phase 1” trade agreement at the start of this year. It deescalated the trade tensions but left some of the toughest issues for a future Phase 2 deal. While Phase 1 focused mainly on Chinese purchases of US goods, improved US access to China’s financial services market, and some intellectual property issues, Phase 2 was meant to tackle far more difficult issues associated with China’s technology transfer policies, industrial espionage, and government subsidies to state-owned enterprises.

On Tuesday, July 14, Trump shut the door on the next round of trade negotiations with China, saying he does not want to talk to Beijing about trade because of the coronavirus pandemic. “We made a great trade deal,” Trump said, of the Phase 1 agreement signed in January. “But as soon as the deal was done, the ink wasn’t even dry, and they hit us with the plague,” he said, referring to the novel coronavirus, which emerged from the Chinese city of Wuhan.

At the White House, Trump also announced that he signed legislation and an executive order to hold China accountable for the “oppressive” national security law it imposed on Hong Kong. The measure approved by Congress gives Trump’s administration the authority to penalize banks doing business with Chinese officials who implement Beijing’s new national security law on Hong Kong. Trump said he has no plans to talk with Chinese President Xi Jinping.

(6) Pompeo weighs in. In a statement on Monday, July 13, US Secretary of State Mike Pompeo said he was aligning the US position on China’s maritime claims in the South China Sea with the 2016 ruling of an international arbitral tribunal in The Hague. This places the US squarely behind the interests of Vietnam, Malaysia, Indonesia, Brunei, and the Philippines, all of which have serious disputes with Beijing.

On Thursday, July 16, Pompeo repeated the administration’s charge that the Chinese government “was aware of human-to-human transmission” of the coronavirus “before they shared this with the world.” The day before, he said, “I’m very confident that the world will look at China differently and engage with them on fundamentally different terms than they did before this catastrophic disaster.”

(7) Raising other barriers. The Senate passed legislation on May 15 that could ban many Chinese companies from listing shares on US exchanges or raising money from American investors without adhering to Washington’s regulatory and audit standards. That same day, the Trump administration issued a new rule that will bar Huawei and its suppliers from using American technology and software, a significant escalation in the White House’s battle with the Chinese telecom giant and one that is likely to inflame tensions with Beijing. The rule change, which is slated to go into effect in September, will block companies around the world from using American-made machinery and software to design or produce chips for Huawei or its entities.

On August 15, companies that bid on US federal contracts must certify that they do not use banned products or services from telecom giants Huawei and ZTE, camera makers Hangzhou Hikvision Digital Technology and Zhejiang Dahua Technology, or radio manufacturer Hytera Communications. Washington cites the risk of sensitive information leaking to Beijing.

Taiwan Semiconductor Manufacturing Co. Ltd stopped taking new orders from Huawei in May and does not plan to ship wafers after September 15. On July 14, Britain announced that it would ban equipment from Huawei from the country’s high-speed wireless network, a victory for the Trump administration that escalates the battle between Western powers and China over critical technology.

Last week, reports surfaced that the White House is considering putting TikTok on a blacklist that effectively would prevent Americans from using the popular video app, as one option to prevent China from obtaining personal data via the social media platform.

(8) Japan paying companies to leave China. On July 18, Bloomberg reported that the Japanese government will pay at least $536 million for companies to leave China: “Japan’s government will start paying its companies to move factories out of China and back home or to Southeast Asia, part of a new program to secure supply chains and reduce dependence on manufacturing in China.”

(9) The Attorney General’s speech. On Thursday, July 16, Attorney General William Barr warned that the CCP has launched an “economic blitzkrieg” to topple the US from its perch as the world’s superpower, laying out the threat as the most important issue of this century and calling for the Free World to join together in a “whole of society approach” against it.

“How the United States responds to this challenge will have historic implications and will determine whether the United States and its liberal democratic allies will continue to shape their own destiny or whether the CCP and its autocratic tributaries will control the future,” Barr said during a July 17 speech in Michigan.

In some ways, Barr’s speech was even more blistering than Pence’s speech in 2018. He got personal: “The General Secretary of the Chinese Communist Party, Xi Jinping, who has centralized power to a degree not seen since the dictatorship of Mao Zedong, now speaks openly of China moving ‘closer to center stage,’ ‘building a socialism that is superior to capitalism,’ and replacing the American Dream with the ‘Chinese solution.’”

As Pence had done in his speech, Barr blasted the CCP’s “Made in China 2025” initiative to dominate high-tech industries like robotics and information technology and electric vehicles, which “poses a real threat to US technological leadership.” The 2025 plan is a “state-led, mercantilist economic model. For American companies in the global marketplace, free and fair competition with China has long been a fantasy.” Barr warned that the “ultimate ambition of China’s rulers isn’t to trade with the United States. It is to raid the United States.”

Barr attacked China’s “ruthless crackdown of Hong Kong.” He said that China is as authoritarian now as it was in 1989 when tanks confronted pro-democracy protesters in Tiananmen Square. He criticized American companies that “have come under Beijing’s influence—even at the expense of freedom and openness in the United States.”

(10) Closing consulates. On Wednesday, July 22, we learned that the US State Department abruptly ordered China to shut down its consulate in Houston “in order to protect American intellectual property and Americans’ private information.” In addition, the Justice Department announced criminal charges against hackers, working with the Chinese government, who targeted firms developing vaccines for the coronavirus and stole hundreds of millions of dollars’ worth of intellectual property and trade secrets from companies across the world.

On Thursday, July 23, Secretary of State Mike Pompeo delivered a blistering attack in a speech titled “Communist China and the Free World’s Future.” Here, in his words, is the key theme of his speech: “The truth is that our policies—and those of other free nations—resurrected China’s failing economy, only to see Beijing bite the international hands that were feeding it. ... Securing our freedoms from the Chinese Communist Party is the mission of our time, and America is perfectly positioned to lead it because our founding principles give us that opportunity.” His main conclusion was unambiguously hostile toward the Chinese government: “The free world must triumph over this new tyranny.”

On Friday, July 24, Beijing retaliated by ordering the closure of the American consulate in Chengdu. So far, the Chinese haven’t retaliated for the US moves to block Huawei from doing business around the world. What if the Chinese do so against Apple, Microsoft, NVIDIA, Tesla, or other American companies?

Peter Navarro certainly has won the debate over China within the Trump administration, hands down.

Wednesday, July 22, 2020

Fiscal & Monetary Policies Inflating Bubbles While Fighting Virus

Asset prices around the world are melting up. It isn’t just stock prices that are soaring. It’s also the prices of inflation-protected bonds. Precious metals prices are moving higher too. Home values are appreciating as well. Some of these bullish trends may be driven by expectations that the billions of dollars being spent on a vaccine will pay off. Undoubtedly, the main reason for the widespread bull markets in assets is the fact that governments around the world are spending and printing trillions of dollars, euros, yen, and yuan to offset the economic shock from the Great Virus Crisis (GVC). Consider the following:

(1) Vaccines. Typically, it takes roughly a decade for a new vaccine to go through the various stages of development and testing. However, the urgency of the pandemic, which has killed more than 600,000 people worldwide, has resulted in a mobilization of global medical resources rarely seen before in human history. Billions of dollars, provided by both the public and the private sectors, are funding the global campaign to develop tests, vaccines, and cures for the virus.

For example, the Trump administration has launched “Operation Warp Speed” with the goal of delivering 300 million doses of a safe, effective vaccine for COVID-19 by January 2021, as part of a broader strategy to accelerate the development, manufacturing, and distribution of COVID-19 vaccines, therapeutics, and diagnostics. Congress has directed almost $10 billion to this effort through supplemental funding, including the CARES Act.

More than 100 clinical trials of dozens of potential coronavirus treatments are already underway around the world. Yesterday, we learned that the early trial results for two vaccine candidates—one developed by the University of Oxford and AstraZeneca and the other by the Chinese company CanSino Biologics—showed that both were safe and could induce immune responses in participants. But the next phase will be critical to demonstrate that the potential vaccines can protect against infections.

For the Oxford-AstraZeneca and CanSino vaccine candidates, the next step in testing is known as “Phase Three” of human clinical trials. It’s in this stage that scientists will be able to see whether a potential vaccine truly works to prevent coronavirus infections. The newly released clinical trial results showed that the Oxford-AstraZeneca vaccine candidate triggered the production of both antibodies and T cells, which can recognize and attack virus cells.

(2) EU ups the ante. On April 9, Eurozone finance ministers agreed on a new coronavirus stimulus package worth €540 billion, but couldn’t agree on a crucial decision: whether to issue joint debt instruments, called “corona bonds,” that would combine debt securities from the 19 Eurozone countries. Germany and the Netherlands, traditionally more fiscally conservative than Italy and Spain, were holdouts.

On July 21, a new agreement was reached authorizing the European Commission (EC), the executive arm of the European Union (EU), to create a €750 billion recovery fund, which will be distributed among the countries and sectors most impacted by the coronavirus pandemic, and will take the form of grants and loans.

The new deal means that the EU will become a major borrower in global financial markets for the first time. It plans to repay the money by 2058. Nevertheless, the EC intends to propose new taxes on financial transactions and fines on greenhouse gases released by companies. Tech companies can also expect a “digital levy.”

(3) ECB is on the case. Undoubtedly, some of the new bonds will be purchased by the European Central Bank (ECB), which is currently buying government bonds as part of its Pandemic Emergency Purchase Program (PEPP), which totals €1.35 trillion. The PEPP started on March 18 with a commitment to make €750 billion in open-ended asset purchases. It was expanded on June 4 by €600 billion.

The ECB’s balance sheet has soared by €1.62 trillion since the week of March 13 through the July 17 week (Fig. 1). Securities held for monetary purposes rose €552 billion during that period.

(4) Japan writes a blank check to fight the virus. In Japan, Prime Minister Shinzo Abe’s government has rolled out combined stimulus spending worth ¥234 trillion ($2.2 trillion); that boosts its annual budget spending to ¥160 trillion, with new debt issuance totaling ¥90 trillion. To cushion the economic fallout from the virus, the new stimulus programs include handouts to 126 million residents of ¥100,000 (just under $1,000) each.

On July 21, Finance Minister Taro Aso said that the Japanese government’s budget won’t set a spending cap on requests aimed at fighting the COVID-19 pandemic for the fiscal year that begins in April 2021. The budget ceiling is usually set around mid-year by the Finance Ministry to keep tabs on spending requests from ministries for next year’s budget, to be compiled in December.

The government would ask ministries to keep requests for other spending in line with the current fiscal year’s initial budget totaling a record ¥102.7 trillion, Aso said at a Cabinet meeting. The government then would set aside an unspecified amount of budget requests to respond to “urgently needed expenses” to battle the fallout from the coronavirus.

(5) BOJ is on the case. The Minutes of the June 15-16 Monetary Policy Meeting of the Bank of Japan (BOJ) was released on Monday. After easing monetary policy in March and April, the BOJ kept policy settings unchanged and maintained its view that the economy will gradually recover from the damage caused by the pandemic. The BOJ’s balance sheet has soared by ¥64 trillion ($600 billion) since February, through June (Fig. 2).

(6) Another CARES package in the US. The CARES Act was passed on March 27. It provided $2.2 trillion in various short-term support payments as state governors issued stay-in-place executive orders to slow the spread of the virus. It was widely expected that they would gradually lift these restrictions in a few weeks, reopening the economy. The first round of support payments is running out for many households and businesses, while the reopening of the economy has been slowed by rapidly rising cases.

On Monday, congressional lawmakers returned from their recess and started working on a second relief package. They are under pressure to come up with something this week. Though the CARES Act allows the $600-per-week federal boost to state unemployment insurance to be paid through July 31, most states’ weekly benefits are based on a cycle that ends on a Saturday or Sunday, making this week the last one that recipients will get that extra money unless lawmakers intervene fast.

(7) The Fed is on the case. The US federal budget deficit totaled a record $3.0 trillion during the 12 months through June (Fig. 3). After the CARES Act was passed, the Congressional Budget Office (CBO) estimated that it would total $3.7 trillion this year. The CBO may have to add another $1 trillion to $2 trillion to its estimate if the economic recovery stalls and if Congress passes CARES Act II.

No problem: We are all MMTers now! We all believe in the magic of Modern Monetary Theory. In response to the GVC, the Fed embraced the theory and its practice on March 23 with its programs of QE4Ever and No Asset Left Behind (NALB). The Fed already has financed more than half of the currently projected FY2020 federal budget deficit by purchasing $2.1 trillion in Treasury securities over the past year through the July 15 week (Fig. 4).

Among the biggest proponents of MMT are former Fed Chairs Ben Bernanke and Janet Yellen. Last month, they signed a public letter from more than 150 economists that called on Congress to pass another big spending bill to extend and broaden the CARES Act. In a joint July 17 blog post, they commended the Fed’s response to the pandemic: “Broadly speaking, though, the Fed’s response has been forceful, forward-looking, and comprehensive.” In other words, Fed Chair Jerome Powell did what they would have done. We guess that they’ve provided Powell lots of advice in recent months, which he acted upon.

What about the federal deficit? Bernanke and Yellen are all in on MMT: “Following our advice would further increase the already record-level federal budget deficit. With interest rates extremely low and likely to remain so for some time, we do not believe that concerns about the deficit and debt should prevent the Congress from responding robustly to this emergency. … [A]t some point, we will have to think through how to ensure the long-run sustainability of federal finances. The top priorities now, however, should be protecting our citizens from the pandemic and pursuing a strong and equitable economic recovery.”

Read that excerpt again and think about it. Contrarians should be alarmed. What could possibly go wrong with this who-cares-about-deficits approach? Well, let’s see: i) inflation might make a surprising comeback; ii) bond yields might rise; and iii) if the Fed imposes yield-curve control to put a cap on the bond yield, the dollar might take a dive, which could boost inflation.

(8) The PBOC is on the case. The People’s Bank of China (PBOC) continues to flood the Chinese economy with more and more credit during the GVC, as it has ever since the Great Financial Crisis (GFC). Over the past 12 months through June, social financing totaled a record $4.5 trillion, led by a record $2.7 trillion in bank loans (Fig. 5 and Fig. 6). Bank loans are up a whopping $18.9 trillion to a record $23.3 trillion from $4.4 trillion at year-end 2008, when the government started to respond to the GFC with massive credit expansion (Fig. 7).

(9) Bottom line is a bottomless pit. A billion here, a trillion here and there add up to serious money. With the help of MMT, government deficits are a bottomless pit. If they can be financed so easily with easy money without boosting inflation, why do we bother collecting taxes? I would be a big advocate of MMT if my taxes were cut to zero. Let’s give it a try! Why not? Anything is possible in the Twilight Zone.

While MMT hasn’t boosted inflation as measured by consumer prices, so far, it certainly is boosting asset inflation, potentially fueling the Mother of All Meltups (MAMU), which potentially could set the stage for the Mother of All Meltdowns (MAMD).

Wednesday, July 15, 2020

Best Friends Forever: Powell, Mnuchin, & Stock Investors

What's been driving the stock market meltup since March 23? First and foremost, of course, is the Fed’s shock-and-awe monetary policy response to the Great Virus Crisis (GVC). It has been shockingly awesome! So has been the fiscal policy response. Never before has so much monetary and fiscal stimulus been provided in such a short period of time in response to an economic and financial crisis. It’s actually much more than the virus-challenged economy can absorb, which explains why stock prices are soaring. Consider the following:

(1) The Fed is our friend. Technicians like to say “Let the trend be your friend.” I agree; but from a fundamental perspective, my mantra has long been “Don’t fight the Fed.” Indeed, that’s the main theme of my recently published book, Fed Watching for Fun & Profit.

My book concludes with the events of 2019. I’m working on a follow-up tentatively titled The Fed Fights the Virus. Enough has happened since the start of this year to write a second volume rather than an update to the first book. For now, let’s cut to the chase: By pushing the yield curve close to zero in response to the GVC, the Fed left investors no choice but to either earn close to nothing on their fixed-income securities or rebalance into stocks, which is what many have done since March 23.

Ever since then, Fed officials repeatedly have stated that they intend to keep interest rates close to zero for a very long time. As Fed Chair Jerome Powell famously said at his June 10 press conference: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” In a Freudian slip, Powell said that monetary policy is in “a good place,” as “we’re continuing asset prices in coming months … at a relatively high level.” A footnote in the transcript stated: “Chair Powell intended to say ‘asset purchases’ rather than ‘asset prices.’”

When asked whether he is concerned about high asset prices, he made it clear that the Fed’s main concern is getting through the GVC by “pursuing maximum employment and stable prices.” He added: “we’re not focused on moving asset prices in a particular direction at all. It’s just we want markets to be working, and I think, partly as a result of what we’ve done, they—they are working. And, you know, we hope that continues.” He clearly rejected “the concept that we would hold back because we think asset prices are too high.”

In new projections released after the June 10 meeting of the FOMC, all 17 participants said they expect to hold rates near zero next year, and 15 of them projected that rates would stay there through 2022. As Powell concluded, “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”

Officials made one policy change at the meeting by announcing they would maintain their recent pace of purchases of Treasury and mortgage securities, effectively ending gradual, weekly reductions. They will buy at least $80 billion in Treasuries and $40 billion in mortgage securities, net of maturing bonds, a month (Fig. 1 and Fig. 2). Over the past year through the week of July 8, the Fed has purchased $2.1 trillion in Treasuries, financing 66% of the rapidly ballooning federal budget deficit (Fig. 3 and Fig. 4).

The Fed isn’t even thinking about the possibility that asset prices are too high. Yes, indeed, the Fed is truly our friend for the foreseeable future.

(2) The word at the Fed is “accommodative.” One of the reasons why the stock market rally is continuing so far this month is this: In the Minutes of the June 9-10 meeting of the Federal Open Market Committee (FOMC), released on July 1, the adjective “accommodative” appeared seven times.

For example: “Participants agreed that asset purchase programs can promote accommodative financial conditions by putting downward pressure on term premiums and longer-term yields.” In addition, the noun “accommodation” appeared six times in the context of monetary policymaking. The FOMC’s use of forms of this word have proliferated with the latest Minutes release; in the previous Minutes, for the April meeting, the adjective appeared just once, while the noun didn’t appear at all!

As you can see from the photo above, Fed Chair Jerome Powell and Treasury Secretary Steven Mnuchin are joined at their elbows if not at their hips. The Minutes reported: “Participants also regarded highly accommodative monetary policy and sustained support from fiscal policy as likely to be needed to facilitate a durable recovery in labor market conditions.” In other words, the Fed will continue to finance a large chunk of the federal government’s budget deficit. How long will the Fed do so? The Minutes stated, “Participants noted that a highly accommodative stance of monetary policy would likely be needed for some time ....” The Fed and the US Treasury are Best Friends Forever.

Saturday, July 11, 2020

The Magnificent Six Stocks That Are Gobbling Up Market Share

The S&P 500 stock price index includes 500 companies. On Friday, five of the six so-called FAANGM stocks (all but Netflix) occupied the top spots as the largest S&P 500 companies by market capitalization. They were: Apple ($1,578 billion), Microsoft ($1,564 billion), Amazon ($1,442 billion), Alphabet ($1,002 billion), and Facebook ($665 billion). Netflix ($210 billion) was the 20th largest company in the S&P 500. Collectively, their record-high $6.5 trillion market cap accounted for a record 25% of the S&P 500’s market cap on July 3 (Fig. 1 and Fig. 2). That’s up from around 8% during 2013.

The Magnificent Six are widely referred to by their awkward “FAANGM” acronym. “MAGFAN” would be easier to pronounce. In any event, count us among the fans of these mega-cap companies, though they aren’t cheap since they have so many fans. Consider the following:

(1) Viral stocks. All six of the FAANGMs are among the biggest beneficiaries of the economic upheaval caused by the Great Virus Crisis (GVC) and are likely to continue to benefit from its aftershocks well after the crisis is over. That’s because their businesses are Internet-based, so the more that people’s work, education, and entertainment are home-based, the more these businesses thrive.

(2) One for all and all for one? While all six are widely perceived to be technology stocks, only Apple and Microsoft are actually constituents of the S&P 500 Information Technology sector, accounting for 44.4% of the sector’s market cap (Fig. 3). Classified as members of the S&P 500 Communication Services sector are Alphabet, Facebook, and Netflix, accounting for 66.4% of the sector’s market cap (Fig. 4). Amazon is actually a member of the S&P 500 Consumer Discretionary sector, and accounts for an eye-popping 50.8% of the sector’s market cap (Fig. 5).

(3) All Growth, no Value. All six are included in the S&P 500 Growth index, accounting for a whopping 40.7% of its market cap during the June 25 week (Fig. 6). Given the rapid growth in their earnings and their relatively high valuation multiples, there’s no mistaking the FAANGMs for stocks that should be in the S&P 500 Value index.

(4) Galloping revenues and earnings growth. Since the start of 2015 through the July 3 week of this year, the forward revenues of the FAANGMs is up 115.1%, well ahead of the 2.6% increase for the rest of the S&P 500 (Fig. 7). Over the same period, their forward earnings is up 95.0%, significantly outpacing the 1.9% drop for the rest of the market (Fig. 8). Much of that outperformance occurred this year. Nevertheless, even before the GVC struck, the FAANGM forward revenues rose 101.1% from the start of 2015 through the end of 2019, while the remaining 494 stocks in the S&P 500 registered a 10.9% gain in forward revenues. Over the same period, the FAANGMs’ forward earnings rose 88.1% while those of the other 494 S&P 500 stocks rose 25.3%.

Collectively, the profitability of the FAANGMs is boosted not only by their revenue growth but also by their relatively high profit margins. Their forward profit margin was 15.5% during the July 3 week, well above the 10.3% for the rest of the S&P 500 (Fig. 9). If we exclude low-margin Amazon from the FAANGMs, their collective forward profit margin rises from 15.5% to 21.7%.

(5) Leading from in front. The FAANGMs have led the bull market for quite a while. Since the end of 2012 through the July 3 week, their market cap is up an astonishing 467%, while the rest of the S&P 500 is up just 70.5% (Fig. 10). Since the March 23 bottom, the FAANGMs are up 51%, while the rest of the index is up 35%.

(6) Not cheap. Everyone knows all the above, which is why the stocks are so expensive. The forward P/E of the FAANGMs soared from a recent low of 26.1 during the March 20 week to 40.1 during the July 3 week (Fig. 11). The forward P/E of the S&P with and without the FAANGMs is 21.5 and 18.8 (Fig. 12). Here are the current forward P/Es of each of the Magnificent Six: Alphabet (29.9), Amazon (97.7), Apple (25.2), Facebook (26.9), Microsoft (33.2), and Netflix (62.1) (Fig. 13).

(7) Buying back shares. Collectively, the FAANGMs’ number of basic shares outstanding fell 12.7% from Q1-2013 through Q1-2020 (Fig. 14). That’s a decline of 1.8% per year on average. An amount of share-count decline that small is not a big contributor to their earnings-per-share (EPS) growth rate, which suggests that much of their stock buybacks have been motivated by reducing EPS dilution from shares awarded to employees through compensation plans.

(8) Seven would be even more magnificent. There are other magnificent stocks that we could add to the FAANGMs. Nvidia comes to mind. That would make it the Magnificent Seven, or “FAANNGM.” If Tesla were to join the S&P 500, the Magnificent Eight could be “FAANNGMT.”

Friday, June 19, 2020

Powell's Potent Put Powering Stock Market Meltup

From meltdown to meltup. The Greenspan Put, the Bernanke Put, and the Yellen Put all resulted from actions taken by the Fed under those three Fed chairs to give stock prices a boost when they seemed to need it to avert a meltdown. The Powell Put saved the day in late 2018 when the Fed chair started to pivot away from raising the federal funds rate in 2019 to actually lowering it three times instead. The S&P 500 soared 44.0% from December 24, 2018 to a record high on February 19, 2020.

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.

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. On Monday, June 15, the Fed announced that the SMCCF would start buying corporate debt, and promised to activate the PMCCF soon, as discussed below.

In response to the Great Virus Crisis, Powell provided the biggest Fed put of them all, boosting both stock and corporate bond prices. The result has been to stop the 33.9% meltdown in the S&P 500, which lasted from February 19 through March 23. I'm not sure that deserves to be categorized as a bear market since it lasted only 23 trading days with declines exceeding 20% during only seven of those days! In any event, the meltdown was followed by a meltup with the S&P 500 soaring 44.5% through June 5.

The Fed's actions stopped the credit crunch and allowed corporations to raise piles of money at record low interest rates:

(1) Corporate bond yields. The Aaa-rated and Baa-rated corporate bond yields fell to record lows of 2.44% and 3.45% on Monday, June 15 (Fig. 1 and Fig. 2).

(2) Corporate bond issuance. Over the 12 months through April, nonfinancial corporations raised a record $1,175 billion. I estimate that at least half of that was used to refinance outstanding bonds (Fig. 3 and Fig. 4).

No asset left behind. The Fed is intent on offsetting the adverse impact on financial markets resulting from any flare up in the first wave of the viral pandemic or any second wave that might emerge after the first wave. The stock market sold off sharply last Thursday on fears that reopening the economy will lead to less social distancing triggering another wave of the virus. The market rebounded a bit on Friday, but then proceeded to fall again Monday morning on unsettling news over the weekend about rising cases of infection around the country.

Have no fear, the Fed is here with another wave of liquidity:

(1) Secondary facility is first. At 2:00 pm on Monday, the Fed released a press release with the following rather detailed headline, “Federal Reserve Board announces updates to Secondary Market Corporate Credit Facility (SMCCF), which will begin buying a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers.”

The Fed announced that it was expanding its Secondary Market Corporate Credit Facility (SMCCF) to purchase individual corporate bonds to complement its current purchases of exchange-traded funds. This special purpose vehicle (SPV) is capitalized with $25 billion provided by the Treasury under the CARES Act, and can leverage that up by 10-to-1 to $250 billion.

But wait, there’s much more: The SPV includes the Primary Market Corporate Credit Facility (PMCCF), which will be able to leverage $50 billion in capital to purchase up to $500 billion in corporate bonds directly from issuers.

As part of its (almost) no-asset-left-behind (NALB) program, the SMCCF will purchase bonds rated BBB-/Baa3 (the lowest investment-grade category) as of March 22, 2020, but were subsequently downgraded to junk. Nevertheless, they must be rated at least BB-/Ba3 as of the date on which the facility makes a purchase. These so-called “fallen angels” accounted for 50% of outstanding investment-grade bonds before the virus hit the fan.

The SMCCF began purchasing eligible ETFs on May 12 and will begin purchasing corporate bonds on June 16. Purchases are expected to cease no later than September 30 of this year.

(2) Primary facility is second. The PMCCF is expected to become operational in the near future. Additional details on the PMCCF are forthcoming. It will provide companies access to credit by purchasing qualifying bonds as the sole investor in a bond issuance, or purchasing portions of syndicated loans or bonds at issuance. (For more, see FAQs: Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.)

(3) A big drop in the bucket. A billion here, a billion there, adds up to $750 billion in financial support for the corporate sector. The Fed’s recently released Financial Accounts of the United States shows that during Q1, nonfinancial corporate bonds outstanding totaled a record $6.0 trillion and loans totaled $3.8 trillion (Fig. 5). Loans from depository institutions totaled $1.3 trillion, while “other loans” (including leveraged loans) totaled $1.9 trillion (Fig. 6).

(4) Zombies on life support. The Fed issued its first semi-annual Financial Stability Report during November 2018. The latest one was issued May 2020. All four reports recognized that there was too much dodgy corporate debt. Here is what the latest report had to say on the subject:

“At the beginning of 2020, about half of investment-grade debt outstanding was rated in the lowest category of the investment-grade range (triple-B)—near an all-time high. The amount of debt downgraded from investment grade to speculative grade in 2019 was close to the historical average over the past five years. However, almost $125 billion of nonfinancial investment-grade corporate debt has been downgraded to speculative grade since late February, and expected defaults may rise if the economic outlook and corporate earnings are revised downward. Widespread downgrades of bonds to speculative-grade ratings could lead investors to accelerate the sale of downgraded bonds, possibly generating market dislocation and downward price pressures in a segment of the corporate bond market known to exhibit relatively low liquidity.”

The report sounded the alarm on leveraged loans as well:

“Defaults on leveraged loans ticked up in February and March and are likely to continue to increase, with the specific contour highly dependent on the path of overall economic activity. Such developments would weaken the balance sheets of lenders, including CLOs that hold leveraged loans, and amplify the economic effects of COVID-19.”

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.

As a result of the Great Virus Crisis, we now know how Powell is dealing with the corporate debt crisis. He is buying lots of it and enabling corporations to issue much more of it!

Thursday, June 11, 2020

MAMU: The Mother of All Meltups

As of Friday June 5, the S&P 500 was up 42.8% since March 23. This 52-day meltup is historic. It is the best since bigger gains were recorded during August-September 1932 (up as much as 109.2%) and May-June 1933 (up as much as 73.2%).

The meltup started the day after March 23, when the Federal Reserve announced QE4Ever and started carpet-bombing the financial markets and the economy with B-52s full of cash (Fig. 1). Since then, the Fed’s balance sheet rose by $2.5 trillion to a record $7.1 trillion during the June 3 week (Fig. 2). Its holdings of Treasury securities increased $1.6 trillion over the same period to a record $4.1 trillion (Fig. 3).

The Fed actually started its bombing campaign on March 15, when it announced $700 billion of QE4 purchases of US Treasuries and mortgage-backed securities and lowered the federal funds rate by 100bps to zero. The European Central Bank (ECB) joined the allied bombing campaign on March 18 with its Pandemic Emergency Purchase Programme (PEPP), committing to buy €750 billion of private- and public-sector Eurozone securities. On June 4, the ECB upped the ante by €600 billion to a total of €1,350 billion (Fig. 4). The total assets of the Fed, ECB, and Bank of Japan have soared by $3.9 trillion from mid-March through the end of May to $19.1 trillion (Fig. 5).

The result has been the Mother of All Meltups (MAMU) (Fig. 6).

During the bull market in stocks from 2009 through 2019, some bullish investment strategists claimed that “there is no alternative” to stocks. “TINA” was their stock market rallying cry. In fact, there was a good alternative to stocks, namely bonds. The 10-year Treasury bond yield was 2.89% on March 9, 2009, when the previous bull market started. It fell to a record low of 0.54% on March 9 of this year.

TINA makes more sense during the current bull market than it did during the previous one. The embrace of Modern Monetary Theory (MMT) by US monetary and fiscal policymakers during the week of March 23, when the Fed announced QE4Ever, and on March 27, when the CARES Act was signed into law, triggered a huge wave of TINA rebalancing out of bonds and into stocks. It is likely to continue for the foreseeable future.

The stock market equation since March 23 has been: TINA + MMT = MAMU.

MMT ended the latest bear market, which lasted for just 33 calendar days from February 19 through March 23. During that period, there were 23 trading days, with the S&P 500 down by 20% or more during only seven of those days. Technically, it was still in bear market territory, as the S&P 500 rocketed 18.9% for 11 more trading days after the March 23 bottom, through April 7, before entering correction territory.

Nevertheless, I’m not convinced that the selloff should be classified as a bear market since it was so short. It was more like previous panic attacks during the bull market, which started on March 9, 2009. At the beginning of this year, on February 2, I added the COVID-19 outbreak as Panic Attack #66 on my list with a January 24 date, when the bad news first hit the tape. (See Table of S&P 500 Panic Attacks Since 2009.) It’s staying there in my record books!

On Friday, the forward P/Es of the S&P 500, S&P 400, and S&P 600 jumped to 22.6, 23.1, and 26.1, respectively (Fig. 7). Here’s the latest performance derby of the major MSCI stock price indexes since March 23 through Friday’s close in local currencies: US (43.6), All Country World (37.4), EMU (35.2), Emerging Markets (28.5), UK (28.5), and Japan (25.4) (Fig. 8). Here are their forward P/Es on May 28: US (22.1), EMU (16.3), Japan (15.3), UK (15.1), and Emerging Markets (12.9) (Fig. 9).

Long live the bull market! Now we have to worry that MAMU might lead to its demise since meltups tend to be followed by meltdowns!

Thursday, June 4, 2020

Economic Alphabet Soup: V, U, Z, W, L or Swoosh?

Will the economic recovery be shaped like a V, U, W, L, or Z? Cases can be made for all of these possibilities. There are other possible shapes to the recovery such as a square root sign, and even a “swoosh,” like Nike’s logo. Schematic diagrams of these alternatives can be seen in a May 11 WSJ article titled “Why the Economic Recovery Will Be More of a ‘Swoosh’ Than V-Shaped.”

In the past, economic recoveries from most recessions tended to be V-shaped. The experience of the Great Depression suggests that recoveries after such a severe downturn should be shaped more like an L or W. The recovery following the Great Recession of 2008 was widely perceived to be U-shaped.

The article cited above observed: “Until recently, many policy makers and corporate executives were hoping for a V-shaped economic recovery from the coronavirus pandemic: a short, sharp collapse followed by a bounce back to pre-virus levels of activity. Now, however, they expect a ‘swoosh’ recovery. Named after the Nike logo, it predicts a large drop followed by a painfully slow recovery, with many Western economies, including the U.S. and Europe, not back to 2019 levels of output until late next year—or beyond.”

Consider the following:

(1) Real GDP cycles. The y/y growth rate in real GDP has been mostly V-shaped during recessions and recoveries since 1948 (Fig. 1). There were two nearly back-to-back recessions during the early 1980s with up and down legs that resembled a W. The recovery in the early 2000s appears like a U. While economic growth was subpar and U-shaped during the expansion following the Great Recession, the initial recovery was V-shaped.

Following the June 1 release of the latest purchasing managers survey and construction spending reports, the Atlanta Fed’s GDPNow tracking model estimated that real GDP fell 52.8% (q/q, saar) during Q2, a bit worse than the -51.2% of the May 29 estimate. This increases the likelihood of a V-shaped recovery during Q3 and Q4, with my estimated gains of 20% and 5% (Fig. 2). Beyond that, I agree that it could be a swoosh with low single-digit growth rates. I don’t expect that real GDP will recover back to its Q4-2019 record high until late 2022.

(2) Recoveries in coincident indicators. I track the monthly Index of Coincident Economic Indicators (CEI) as a useful proxy for the quarterly real GDP series (Fig. 3). This index includes four coincident economic indicators: employees on nonagricultural payrolls, real personal income less transfer payments, industrial production, and real manufacturing & trade sales.

The CEI shows that the average time that it took for the economy to recover to its previous peak during the past six economic cycles was 33 months, ranging between 19 months (in the early 1970s) and 68 months (following the Great Recession).

I think it could take 32 months to get back to the February peak in this series, i.e., by October 2022. So the initial V-shaped rebound could eventually turn out to be a swoosh. This outlook allows for the possibility of a second wave of COVID-19 infections, though not as bad as the first wave and without another round of lockdowns.

(3) The first recession in services. Increasing the likelihood of a swoosh rather than a sustainable V-shaped recovery is the fact that the current recession is the first one that has been experienced by—and indeed led by—the services sector of our economy. In the past, recessions were led by downturns in manufacturing and construction. Most services industries were either relatively unaffected or actually continued to grow during previous recessions, while goods production declined, as can be seen by comparing goods versus services in real GDP (Fig. 4).

A glance at historical charts of industrial production and housing starts shows that both typically have V-shaped recoveries (Fig. 5 and Fig. 6). They are likely to do so again this time. The same is not likely to happen for retailers, restaurants, airlines, hotels, casinos, entertainment, and recreation. The article cited above noted:

“Among the reasons for the darker outlook is that lockdowns are being eased more slowly than originally expected in some countries. Even when they do lift, some large-scale activities—such as concerts and professional sports—won’t be possible again for months. Retailers and restaurants that have reopened are allowing in fewer customers at a time due to social distancing. And consumers worried about infection risks may take a long time to return to their old habits.”

(4) Feedback loops and aftershocks. The slow pace of recovery in service-producing industries could, in turn, weigh on the recovery in goods-producing industries. If, in fact, working from home (or from smaller suburban offices) catches on after the Great Virus Crisis (GVC), there is likely to be less business travel, which will depress airlines, hotels, restaurants, and convention centers. Commercial construction of offices, hotels, and retail stores is likely to be hurt by social-distancing aftershocks from the GVC, especially if the virus remains active because an effective vaccine isn’t discovered. Demand for new commercial jets is also likely to remain depressed since the airlines industry is unlikely to be back to business as usual for at least two to three years, if not longer.

(5) Surviving the car crash. One important industry that is very likely to experience a V-shaped recovery during the second half of this year is auto manufacturing, though that also is likely to turn into a swoosh during 2021 and 2022. The Fed’s monthly data on US motor vehicle assemblies plunged from 11.1 million units (saar) during February to 0.1 million units during April (Fig. 7). That’s extraordinary: The auto industry was essentially shut down during April, along with most other businesses.

Production is likely to bounce back smartly in coming months. Sales of domestic-make autos also fell but were well above zero at 6.7 million units during April, though that was down from 13.2 million units during February. That’s actually impressive given that many auto dealerships were affected by the lockdowns. Both sales and output should recover in coming months as the lockdown restrictions are lifted, with the latter outpacing the former.

By the way, contributing to the sharp increase in April’s personal saving rate was the drop in personal consumption expenditures on new motor vehicles and parts. It fell from $814 billion (saar) during February to $528 billion during April (Fig. 8). Since the full value of new auto sales is included in current consumption, that $286 billion drop boosted personal saving by the same amount.

Thursday, May 28, 2020

US Declaration of (Cold) War

Coauthored with Jackie Doherty, the senior contributing editor at Yardeni Research, Inc.

The major US equity market indexes continued to rebound, with the Dow Jones Industrial Average crossing back above the 25,000 marker on Wednesday, fueled by the slow reopening of the US economy in the wake of the COVID-19 shutdown. The S&P 500 is now up 35.7% from its March 23 low and is down only 10.3% from its February 19 high (Fig. 1). Investor confidence in the improving economic outlook helped some of the most cyclical sectors outperform on Wednesday, with the S&P 500 Financials up 4.3% and S&P 500 Industrials up 3.3% (Fig. 2). They both clearly outperformed the 1.5% increase in the S&P 500 yesterday.

The Fed’s ultra-easy monetary policies continue to stimulate rebalancing out of bonds and into stocks, boosting forward P/Es faster than forward earnings are dropping. In addition, the gradual reopening of the US economy confirms that we are making progress in our battle with COVID-19. Social distancing should continue to keep a lid on new infections if we keep our distance from others and wear masks. If we are very lucky, a vaccine may be available later this year or early next year.

Nevertheless, investors also should keep an eye on the battle brewing between the US and China. The Trump administration laid out its approach to the country’s relationship with China in a remarkable report that was sent to certain congressional committees on May 21. It throws in the towel on expectations that China will behave according to the global norms of a developed country, stating that we must be “clear-eyed” in our assessment of China and how it has behaved. It also lays out the Trump administration’s return to “principled realism,” acknowledging the strategic competition between the countries. Finally, it proceeds to list the actions the administration has taken to protect the US from China.

Individually, the ideas and actions listed in the report are nothing new to those who have followed the deterioration of US/China relations over the past couple of years. Indeed, Vice President Mike Pence foreshadowed much of the report in an October 4, 2018 speech. But what the document does very effectively is connect economic, military, and political dots to present a picture of a Chinese government behaving badly under the leadership of the Chinese Communist Party (CCP) and a US government, under the Trump administration, acting to protect its interests. Any doubt that the US and China have entered a cold war will fade after reading this document.

In many ways, the report is a US declaration of a cold war with China that accuses the Chinese government of starting this war many years ago on US interests, in particular, and on the post-WWII global order based on free trade with open markets, in general. The report implicitly declares that it is China, not the US, that has upset this order. Here are some of the highlights:

(1) Seeing China more clearly. The Trump administration’s report, United States Strategic Approach to the People’s Republic of China, first reviews the relevant past developments. It notes that US policy was based on hopes that deepening engagement with China would spur the economic and political opening of that country, leading it to become a responsible global citizen with a more open society. However, China did not become a more open society. Its reforms have stalled or reversed. Instead, China has chosen to “exploit the free and open rules-based order and attempt to reshape the international system in its favor. … The [Chinese Communist Party’s] expanding use of economic, political, and military power to compel acquiescence from nation states harms vital American interests and undermines the sovereignty and dignity of countries and individuals around the world.”

(2) Chinese misdeeds aired. The Trump administration doesn’t hold back when enumerating China’s various wrongdoings. After joining the World Trade Organization (WTO) on December 11, 2001, Beijing failed to continue opening its markets. Instead, the report contends China exploited the benefits of WTO membership by becoming the world’s largest exporter, while protecting its domestic markets. The country’s economic policies have led to “massive industrial overcapacity that distorts global prices and allows China to expand global market share at the expense of competitors operating without the unfair advantages that Beijing provides to its firms.”

In addition, the People’s Republic of China (PRC) does not treat companies operating in China fairly. It forces US companies to transfer technology to Chinese partners, restricts US companies’ ability to license their technology on market terms, directs and facilitates acquisition of US companies and assets to obtain cutting-edge technology, and conducts and supports unauthorized cyber intrusions into US networks to steal sensitive information and trade secrets.

The administration casts aspersions on China’s One Belt One Road projects, which it believes the country uses to advance its interests around the world and reshape international norms. These projects are “characterized by poor quality, corruption, environmental degradation, a lack of public oversight or community involvement, opaque loans, and contracts generating or exacerbating governance and fiscal problems in host nations.”

The report continues its criticisms by noting China’s failure to reduce pollution: China has been the world’s largest greenhouse gas emitter; it exports polluting coal-fired power plants to developing countries; and it is the world’s largest source of marine plastic pollution.

The administration criticized the CCP’s methods of leadership at home. The CCP has purged political opposition; prosecuted bloggers, activists and lawyers; arrested ethnic and religious minorities; censored the media and others; and enacted surveillance and social credit-scoring of its citizens. Beijing has detained more than a million Uighurs and other minorities in indoctrination camps and persecuted people based on religion. And now China is exporting the technology and techniques it uses to control its citizens to other authoritarian states.

The report discusses Beijing’s attempts to compel or persuade Chinese nationals and others living in the US to steal technology and intellectual property from companies and academic institutions. It notes that the country is attempting to intimidate neighboring countries by “engaging in provocative and coercive military and paramilitary activities in the Yellow Sea, the East and South China Seas, the Taiwan Strait, and Sino-Indian border areas” and that it is compelling companies such as Huawei and ZTE to cooperate with Chinese security services, creating security vulnerabilities in foreign countries.

(3) US response. Going forward, the Trump administration intends to respond to the PRC’s “actions rather than its stated commitments.” The Department of Justice and the FBI are working to identify and prosecute China’s attempts to steal trade secrets, hack systems, engage in economic espionage, disrupt US infrastructure and supply chains, and subvert American policy.

The US will counter foreigners seeking to influence US policy and respond to CCP propaganda in the US. “We are working with universities to protect the rights of Chinese students on American campuses, provide information to counter CCP propaganda and disinformation, and ensure an understanding of ethical codes of conduct in an American academic environment.” And it will prevent Chinese companies from accessing US technology “through minority investments to modernize the Chinese military.” The US is looking to prohibit the import of counterfeit items, including drugs. And it will use tariffs and work with the European Union and Japan to counter abusive trade practices, including industrial subsidies and forced technology transfers.

The US continues to improve our own military capabilities, help arm our allies, and encourage China to negotiate new arms-control agreements and enter strategic-risk-reduction discussions. “The United States military will continue to exercise the right to navigate and operate wherever international law allows, including in the South China Sea.” We will maintain strong unofficial relations with Taiwan and, as Beijing increases its military, the US will assist the Taiwan military to maintain a credible self-defense to deter aggression. It reinforced prior US calls to respect the rights of Uighurs, Muslims, Tibetan Buddhists, and others being persecuted.

The report noted that the US will criticize China if it doesn’t uphold its international commitments to Hong Kong. Interestingly, the administration’s accusations about China’s role in spreading COVID-19 were not mentioned in the report.

(4) No retreat. In many ways, the conclusion of the 16-page report appears on page 8: “Similarly, the United States does not and will not accommodate Beijing’s actions that weaken a free, open, and rules-based international order. We will continue to refute the CCP’s narrative that the United States is in strategic retreat or will shirk our international security commitments. The United States will work with our robust network of allies and likeminded partners to resist attacks on our shared norms and values, within our own governance institutions, around the world, and in international organizations.”

In all, the report made clear that the administration has reevaluated how the US understands and responds to China. The US/China cold war passes the duck test: If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.

(5) Bad ending for Hong Kong. Given the events unfolding in Hong Kong, the report takes on even more weight. Protesters returned to Hong Kong’s streets Wednesday after China announced it would write a new national security law for Hong Kong that would prohibit “splittism, subversion, terrorism, any behaviour that gravely threatens national security and foreign interference,” a May 27 FT article explained. The proposal was expanded on Tuesday to also prohibit activities that would seriously endanger national security, which could be interpreted as preventing activists’ protests. If the proposal becomes a law, it would be the first time China bypassed Hong Kong’s legislature and public consultation process to impose a law carrying criminal penalties.

President Trump responded on Tuesday, saying “he is preparing to take action against China this week” over China’s proposed national security laws for Hong Kong, a May 26 Reuters article reported. No details were given. But on Wednesday, Secretary of State Mike Pompeo reported that the US no longer considers Hong Kong autonomous from China. The new designation could change Hong Kong’s favorable trade relationship with the US and open up Chinese officials to sanctions, a May 27 CNBC article reported.

“Hong Kong and its dynamic, enterprising, and free people have flourished for decades as a bastion of liberty, and this decision gives me no pleasure. But sound policy making requires a recognition of reality,” Pompeo said, according to CNBC. “While the United States once hoped that free and prosperous Hong Kong would provide a model for authoritarian China, it is now clear that China is modeling Hong Kong after itself.”

(6) No market impact, so far. It’s interesting to recall that the stock market’s 20% correction in late 2018 was partly attributed to Pence’s belligerent October 4, 2018 speech presenting a litany of complaints about China. The speech was similar to the administration’s latest assessment and set the stage for Trump’s escalating trade war with China until a “Phase 1” deal was reached in January of this year. This time, the market seems totally unfazed by the rapidly deteriorating relations between the US and China. We will continue to monitor the situation to see if this becomes the market’s next worry.