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.

Saturday, April 11, 2020

Tech Is Going Even More Viral

Anyone who wasn’t a tech addict before the Great Virus Crisis (GVC) turned our lives upside down certainly is now. For many of us, working from home has only emphasized our need for fast wireless connections to the cloud. Cocktails and conference calls via Zoom have helped us connect despite the separation. And Netflix and video-gaming systems have kept the whole family entertained. Technology has become a GVC staple, right up there with food and toilet paper.

The tech names helping us during this time of social distancing are scattered primarily throughout the S&P 500 Information Technology and Communication Services sectors. Both sectors are leaders in the performance derby among S&P 500 sectors ytd through Tuesday’s close: Information Technology (-9.4%), Consumer Staples (-9.7), Health Care (-11.2), Utilities (-14.7), Communication Services (-14.9), Consumer Discretionary (-16.7), S&P 500 (-17.7), Real Estate (-18.8), Materials (-23.5), Industrials (-26.1), Financials (-30.9), and Energy (-46.1) (Fig. 1).

The stocks of tech-related companies involved in cloud computing and gaming have been particularly strong ytd. That’s easier to see when they are grouped together in a hypothetical index that uses their market weightings. An index of Activision Blizzard, Akamai Technologies, Amazon, Electronic Arts, Microsoft, Netflix, Nvidia, and Take-Two Interactive would have returned 6.5% ytd through Tuesday’s close, vastly outperforming the S&P 500’s 17.7% decline.

Let’s take a look at these tech staples that are helping us all maintain some semblance of normalcy during this surreal time:

(1) Not all tech is equal. The tech sector is very diverse, and not all areas will go untouched by the pandemic. Global tech spending will grow 2% this year assuming that the US and other major global economies decline in the first half of 2020 and recover in the second half, Forrester Research estimated in a March 16 blog post. If the recession is longer lasting, there’s a 50% probability that US and global tech spending will decline by 2%.

Communication equipment spending may post declines of 5% to 10%; tech consulting and systems integration services spending could be flat to down 5%; and software spending growth could post 0% to 4% growth. Samsung underlined this risk when it warned that its Q1 profit would be up 3% y/y, near its lowest level in five years due to the global fallout from COVID-19, an April 6 FT article reported.

“Demand for mobile phones, automotive and consumer electronics is falling sharply, which could negatively affect chip demand in the second half [of the year] if the coronavirus outbreak is not brought under control,” according to SK Securities analyst Kim Young-woo, the FT article reported.

But all things related to the cloud still appear to be growing, recession or no. “The only positive notes would be continued growth in demand for cloud infrastructure services and potential increases in spending on specialized software, communications equipment, and telecom services for remote work and education as firms encourage workers to work from home and schools move to online courses,” the Forrester post states.

(2) Welcoming clouds. In my 2018 book Predicting the Markets, I wrote: “When the fax machine first came out, I remember telling my team that we one day would be working from the beach. I foresaw that with technology, we could be productive from anywhere. Since 2007, when I formed my own company, we have been virtual. We don’t have any offices. Everyone works from home or from wherever they like. We replaced a couple of servers we had at a ‘server farm’ with a virtual server on the Amazon cloud in 2012. We subscribe to Microsoft’s Office 365, which allows us to rent the software over the cloud. Our Morning Briefing is delivered to all our accounts by email and posted on the website. Its production is a collaboration among my colleagues and me, invariably entailing a daily flood of email messages among us to get the job done. All these technologies have enhanced our productivity and allowed us to compete in a very competitive market for what we do.”

I was wrong about the beach, but early on the cloud and on working from home at least. Now demand for cloud services undoubtedly is increasing significantly in these troubled times. Jackie joined our firm during 2015 from Barron’s. She reports that she has worked from home for many years. But now she’s joined by her husband, who’s working online and conducting meetings via the Internet, and her kids, who are learning online. Her daughter is taking guitar lessons online, in fact, and her son is glued to Xbox Live, the online gaming system. The whole crew keeps in touch with friends and family via video calls on Zoom and watches Netflix and Apple TV. That’s a lot of bandwidth! Our other team members report similar lifestyles, and so do all of our accounts during our Zoom conference calls.

Microsoft recently gave a small glimpse into the surge of usage its various business lines are experiencing in a March 28 post. The number of Microsoft Teams’ daily active users has more than doubled to 44 million in March from 20 million in November, and Windows Virtual Desktop usage has grown more than threefold. Comcast’s peak Internet traffic has increased 32% since the start of March, an April 4 blog post by IEEE.org stated.

Cloud providers are scattered among three different S&P 500 industries. Microsoft is in the Tech sector’s Systems Software industry (up 2.7% ytd), Amazon is in the Consumer Discretionary sector’s Internet & Direct Marketing Retail industry (up 3.3% ytd), and Google is a member of the Communication Services sector’s Interactive Media & Services industry (down 14.0% ytd) (Fig. 2, Fig. 3, and Fig. 4). The share prices of Google and Facebook both have fallen by more than 10% ytd because the advertising dollars on which they depend have dried up during this time of uncertainty.

(3) Entertainment at home. Much of our at-home entertainment is also delivered via the cloud and Internet connections. Xbox is part of the Microsoft family. Activision Blizzard, Electronic Arts, and Take-Two Interactive Software are members of the Communication Services sector’s Interactive Home Entertainment industry (Fig. 5). It’s down fractionally, -0.3%, ytd.

While Netflix shares are up 15.1% ytd, the industry to which it belongs, Movies & Entertainment, has fallen 14.9% ytd. Other members of the industry, which resides in the Communication Services sector, are suffering from the drop in advertising (Viacom and Fox) as well as the closure of amusement parks, hotels, and cruises (Disney) (Fig. 6).

(4) The tech behind the services. Companies making the hardware and services to make the cloud expand quickly and work seamlessly also have benefited from lifestyle changes during these pandemic times. Akamai Technologies provides web security and cloud services through 240,000 servers in 130 countries. It’s a member of the S&P 500 Tech sector’s Internet Services & Infrastructure industry, which has risen 3.7% ytd and is the third best-performing industry we track (Fig. 7).

At the core of these technologies are semiconductor companies. Their stocks are down ytd but are still outperforming the broader index. The S&P 500 Semiconductor industry has fallen 9.2% compared to the S&P 500’s 17.7% decline (Fig. 8).

Nvidia is a chip maker with products in cloud servers and in high-end gaming laptops. Its exposure to the market’s hottest areas no doubt has helped its stock climb 10.1% ytd. At an analyst meeting in late March, Nvidia said “demand remains strong from ‘hyperscal’ cloud service providers that use Nvidia’s chips in their data centers” and the company is enjoying a “‘surge in PC game play’ as more workers and students are sent home,” a March 24 WSJ article reported. The company also has encouraged investors by maintaining its revenue forecast.

Tuesday, March 31, 2020

The Most Common Sense Way To Stop Spreading the Virus (#masks4all)

Executive Order To Slow Spread. The President of the United States should issue an executive order immediately requiring everyone to wear surgical masks or washable DIY masks made from cotton t-shirts when they go out. Along with social distancing and widespread testing, #masks4all is likely to dramatically slow the spread of the COVID-19 virus.

Experts Changing Their Minds on Masks. In our March 25 Morning Briefing, we wrote: “Hopefully, social distancing for a few weeks and widespread testing will allow us to return to our normal lives in a few weeks. Meanwhile, we should produce billions of surgical masks to wear when we venture out of our homes. Indeed, the government should mandate that everyone wear a mask outside their homes until the crisis passes. Authorities are doing that in many places in Asia now. ….

“Yes, we know: The Centers for Disease Control and Prevention (CDC) does not recommend that the general public wear N95 respirators or surgical masks to protect themselves from respiratory diseases, including COVID-19. In particular, the latter don’t filter or block very small particles in the air transmitted by coughs and sneezes. However, a friend in the medical supply business tells us that they are effective in stopping the release of those particles by infected people who wear them. Surgeons wear masks to protect patients from their mouth-borne germs, not the other way around. The CDC warning seems to be about saving the masks for the hospital workers. The solution is mass production in the millions per week.”

Subsequently, medical experts have changed their minds: They now think we should wear face masks. Their advice is laid out in a new report in Science magazine. Even the CDC is coming around, according to a March 30 article in the The Washington Post titled “CDC considering recommending general public wear face coverings in public.” Here is the relevant excerpt:

“CDC guidance on masks remains under development, the federal official said. The official said the new guidance would make clear that the general public should not use medical masks — including surgical and N95 masks — that are in desperately short supply and needed by health-care workers.

“Instead, the recommendation under consideration calls for using do-it-yourself cloth coverings, according to a second official who shared that thinking on a personal Facebook account. It would be a way to help ‘flatten the curve,’ the official noted.

“Such DIY cloth masks would potentially lower the risk that the wearer, if infected, would transmit the virus to other people. Current CDC guidance is that healthy people don’t need masks or face coverings.

“At the daily White House briefing Monday, President Trump was asked if everyone should wear nonmedical fabric masks. ‘That’s certainly something we could discuss,’ Trump said, adding, ‘it could be something like that for a limited period of time.’”

Models Support Universal Masking. A doctor friend claims that if everyone wore a mask, the pandemic would end in a matter of a few weeks. This view jibes with a March 2019 study titled “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak.” Here is a very relevant excerpt:

“Outbreaks of influenza represent an important health concern worldwide. In many cases, vaccines are only partially successful in reducing the infection rate, and respiratory protective devices (RPDs) are used as a complementary countermeasure. In devising a protection strategy against influenza for a given population, estimates of the level of protection afforded by different RPDs is valuable. In this article, a risk assessment model previously developed in general form was used to estimate the effectiveness of different types of protective equipment in reducing the rate of infection in an influenza outbreak. … An 80% compliance rate essentially eliminated the influenza outbreak.”

Jeremy Howard, a research scientist at the University of San Francisco, found 34 scientific papers indicating basic masks can be effective in reducing virus transmission in public—and not a single paper that shows clear evidence that they cannot. In a March 28 op-ed in The Washington Post, he wrote:

“Masks don’t have to be complex to be effective. A 2013 paper tested a variety of household materials and found that something as simple as two layers of a cotton T-shirt is highly effective at blocking virus particles of a wide range of sizes. Oxford University found evidence this month for the effectiveness of simple fabric mouth and nose covers to be so compelling they now are officially acceptable for use in a hospital in many situations. Hospitals running short of N95-rated masks are turning to homemade cloth masks themselves; if it’s good enough to use in a hospital, it’s good enough for a walk to the store.”

DIY in Czech Republic. The March 30 issue of The Guardian reports: “Czech citizens have mobilised in a national effort to make and distribute home-made masks after the government decreed face-wear mandatory for everyone in an effort to combat the coronavirus pandemic. The government, led by the prime minister, Andrej Babiš, has trumpeted mask-wearing as vital in controlling the spread of the virus and has urged other governments to follow suit. The Czech Republic and neighbouring Slovakia are the only two countries in Europe to impose mandatory mask-wearing...”

Taiwan’s Masks. Wearing masks to eliminate the virus pandemic seems to be working in Taiwan, which has a population of 23.8 million. Taiwan is right next to mainland China, and lots of businesspeople and tourists travel between the two countries. Indeed, hundreds of thousands of Taiwanese work and invest in China.

As of yesterday, Taiwan had just 306 cases of COVID-19 and five deaths! Consider the following points gleaned from a February 10 VOA article titled “Taiwanese Scramble for Face Masks to Stop Deadly Virus From Nearby China”:

(1) The island nation has a dense population where multiple generations live under the same roof. The Taiwanese are prone to influenza and a contagious gastrointestinal illness that has killed small children. They also recall the severe acute respiratory syndrome (SARS) epidemic of 2003. SARS originated in China and spread to Taiwan, killing 73 on the island.

(2) The disease-wary Taiwanese tend to wear surgical masks as a precaution against airborne pathogens at higher numbers than people elsewhere. In Taipei, a city of 2.6 million, 50% of people routinely wear face masks.

(3) The island’s 80 mask producers have raised production recently to meet rising demand amid the COVID-19 pandemic, despite a rationing of sales to ensure that no one hoards the supplies.

(4) Demand for surgical face masks—to prevent cough-borne COVID-19 droplets from landing on others—has surged throughout East Asia. That’s particularly true in Malaysia and Thailand, which get high numbers of Chinese tourists. Malaysia, with a population of 32.3 million, has had 2,626 cases of COVID-19 and 37 COVID-19-related deaths. Thailand has a population of 69.7 million, 1,524 cases, and 9 deaths.

We will survive this crisis. But let’s not lose our minds, our jobs, and our businesses without considering our options and the consequences of our actions.

Wednesday, March 4, 2020

Stock Market Fears Virus of Socialism Almost as Much as COVID-19

I’ve been asked several times since last week’s stock market correction whether the selloff might not be just about the COVID-19 virus outbreak. Might the emergence of Bernie Sanders as the Democratic party’s frontrunner—and the possibility that it will be a “democratic socialist” running against Donald Trump in the general election—in part explain the stock market rout? The S&P 500 peaked at a record high of 3386.15 on Wednesday, February 19. It plunged 12.8% to 2954.22 on Friday, February 28. There were lots of headlines about the spreading virus that coincided with the plunge in stock prices. However, also coincidently, Bernie won the New Hampshire primary on Tuesday, February 11.

Sanders took New Hampshire with the support of a majority of the voters aged 18 to 29, winning 51% of their votes. Former South Bend, Indiana, Mayor Pete Buttigieg trailed him with 20% of the youth vote, followed by Massachusetts Senator Elizabeth Warren at 6%. On Saturday, February 22, Sanders had another big win in the Nevada primary. Last week, Sanders had the momentum, and the market plunged.

But then on Sunday, March 1, Joe Biden handily beat Sanders and the other contenders in the South Carolina primary, with lots of support from black voters. CNN enthusiastically reported: “Former Vice President Joe Biden’s blowout South Carolina win reshaped the Democratic presidential campaign and positions him as the surging moderate alternative to Vermont Sen. Bernie Sanders in a 48-hour sprint to Super Tuesday.”

On Monday, March 2, Joe Biden welcomed former rivals Pete Buttigieg, Amy Klobuchar, and Beto O’Rourke into his camp in a show of force by the Democratic party’s establishment against frontrunner Bernie Sanders the night before Super Tuesday. Buttigieg and Klobuchar dropped out of the race and threw their support behind Biden, whose decisive win in South Carolina on Saturday appears to have cemented his status as the moderate alternative to Sanders’s democratic socialism.

On Monday, March 2, the S&P 500 jumped 4.6%. The DJIA soared 5.1%, the biggest such gain since March 23, 2009. The Dow’s 1,293.96-point gain was its largest one-day gain ever.

Is it possible that stock market investors may fear Bernie Sanders almost as much as they fear the coronavirus?! Yes, it’s possible. After all, the widespread view is that the virus pandemic will probably abate in coming months. Monday’s stock market rally might also have been fueled by news reports—such as Reuters’ March 1 report—that China’s efforts to halt the spread of the virus are paying off.

Socialism, on the other hand, is a virus that won’t go away even though extreme versions of it have immiserated and killed millions of people since it started to spread after infecting the French during the French Revolution. The philosophical founding father of socialism was Jean-Jacques Rousseau. He inspired Maximilien Robespierre, literally the first politician to execute socialist principles. He headed the Jacobin terrorist group that led the French Revolution during the eighteenth century. He was a big fan of the guillotine. Rousseau said lots of crazy things, but here is my personal favorite:

“There is therefore a purely civil profession of faith of which the Sovereign should fix the articles, not exactly as religious dogmas, but as social sentiments without which a man cannot be a good citizen or a faithful subject. While it can compel no one to believe them, it can banish from the State whoever does not believe them—it can banish him, not for impiety, but as an anti-social being, incapable of truly loving the laws and justice, and of sacrificing, at need, his life to his duty. If anyone, after publicly recognizing these dogmas, behaves as if he does not believe them, let him be punished by death: he has committed the worst of all crimes, that of lying before the law.”

Look it up; it’s in his seminal book The Social Contract (1762), which is appropriately posted on the Marxist Internet Archive. (Hat tip to Mark Melcher and Steve Soukup, my friends at The Political Forum. Read their excellent and provocative book, Know Thine Enemy: A History of the Left, Volume 1, 2018.)

Investors fear Bernie because he wants to cut off the head of capitalism by raising taxes significantly on the rich and using the funds to provide free everything to everybody else. He also wants to regulate everyone. On his website, he promises college for all. He will cancel all student debt and medical debt. He’ll expand Social Security. Medicare will be for all. His program includes housing for all and universal childcare and pre-K. He will embrace the Green New Deal: “Reaching 100 percent renewable energy for electricity and transportation by no later than 2030 and complete decarbonization of the economy by 2050 at latest.” In effect, he will either privatize or destroy the health care and fossil-fuel energy sectors. He will break up any company he deems to be a monopoly.

All we need to know is that Sanders is a fan of Fidel Castro. He said so in a town hall meeting on Monday, February 24:

“[W]hen Fidel Castro first came into power ... you know what he did? He initiated a major literacy program. It was a lot of folks in Cuba at that point who were illiterate. And he formed a literacy brigade ... [they] went out and they helped people learn to read and write. You know what? I think teaching people to read and write is a good thing.

“I have been extremely consistent and critical of all authoritarian regimes all over the world including Cuba, including Nicaragua, including Saudi Arabia, including China, including Russia. I happen to believe in democracy, not authoritarianism. ... China is an authoritarian country ... But can anyone deny—I mean the facts are clear—that they have taken more people out of extreme poverty than any country in history? Do I get criticized because I say that? That’s the truth. So that is the fact. End of discussion.”

Getting everything for free trumps freedom, according to Bernie. No wonder investors are reacting to him as though he is going to infect us all with the virus of socialism.

No wonder that stocks soared on Wednesday as Biden’s major victories during Super Tuesday sparked a massive rally led by the health-care sector

Wednesday, February 26, 2020

Government Measures To Stop COVID-19 Triggering Pandemic of Fear

Our rapid-response team at Yardeni Research first responded to the coronavirus outbreak in the Monday, 1/27 issue of our Morning Briefing, which was titled “Going Viral?” That was the next business day after the outbreak first hit the headlines on Friday, 1/24. Let’s review some of our initial assessments and the latest developments:

(1) Panic attack #66 could be the one that causes a global recession and a bear market. In our 1/27 analysis, we suggested that the outbreak had the potential to be added to our list of 65 panic attacks since the start of the current bull market: “Will the coronavirus outbreak that started in the Chinese city of Wuhan, Hubei turn out to be just the latest panic attack that provides yet another buying opportunity for stock investors? Fears that it could turn into a pandemic knocked stock prices down last week, especially on Friday.”

The S&P 500 peaked at 3329.62 on Friday, 1/17. It then fell 3.1% through the last day of January. Joe and I added the outbreak to our list of panic attacks on 2/3 (Fig. 1).

The S&P 500 proceeded to rally 5.0% to a record high of 3386.15 last week on Wednesday, 2/19 (Fig. 2). It dropped on Friday of last week, 2/21, by 1.1%, and plunged 3.4% on Monday, 2/24, as reports showed that the virus was spreading globally, particularly to Iran, Italy, and South Korea.

It plunged again, by 3.0%, on Tuesday after an official at the Centers for Disease Control and Prevention (CDC) that day said Americans should prepare for COVID-19 to spread in their communities and cause disruption after Iran, Italy, and South Korea reported a rapid uptick in the number of people who have been sickened.

“We really want to prepare the American public for the possibility that their lives will be disrupted because of this pandemic,” Dr. Nancy Messonnier, director of the CDC’s National Center for Immunization and Respiratory Diseases, told reporters. She said that Americans should talk to their children’s schools about contingency education and childcare plans and discuss tele-working options at work if community spread is reported in the US.

When asked by a reporter on a conference call if her tone had changed compared to previous calls, the CDC official said: “The data over the last week and the spread in other countries has certainly raised our level of concern and raised our level of expectation that we are going to have community spread here ... That’s why we are asking folks in every sector as well as within their families to start planning for this.”

Messonnier said that she herself spoke to her family over breakfast on Tuesday, and that while she feels the risk of coronavirus at this time is low, she told them they needed to be preparing for “significant disruption” to their lives. (See the Fox News article “Coronavirus disruption to ‘everyday’ life in US ‘may be severe,’ CDC official says.”)

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, may be creating a pandemic of fear, increasing the risk of a global recession and a bear market in stocks.

(2) To be contained. We expect the coronavirus outbreak to be contained, as the previous three major viral outbreaks were. SARS (2003-04), MERS (2012), and EVD (2014-16) all were contained using traditional public health measures—e.g., testing, isolating patients, and screening people at airports and other public places. Eight months after SARS began circulating, for example, the virus died out. A 2/18 LA Times article explains how SARS, which had reached 29 countries at its peak, suddenly disappeared. The seriousness with which governments and health organizations around the world are taking the coronavirus suggests its spread likewise will be minimized.

(3) People get sick. According to a Live Science article written last week (“How does the new coronavirus compare to the flu?”), the virus, officially “COVID-19,” infected more than 75,000 people and killed 2,000, primarily in mainland China. Not to minimize the suffering behind those numbers, in the US alone, the flu has already caused an estimated 26 million illnesses, 250,000 hospitalizations and 14,000 deaths this season, according to the CDC.

In the largest study of COVID-19 cases to date, China’s Center for Disease Control and Protection analyzed 44,672 confirmed cases and found 80.9% to be mild, 13.8% severe, and 4.7% (2,087) critical. They estimated the death rate at 2.3%; that’s much higher than the death rate from US flu cases, at around 0.1%—but both rates are extremely low. According to the article cited above, nobody under 10 years old has died of this coronavirus to date.

What’s unknown about the new virus is the problem. Nobody knows exactly how it will spread or how many serious cases will develop. “Despite the morbidity and mortality with influenza, there’s a certainty … of seasonal flu,” Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, said in a White House press conference on 1/31, according to the Live Science article. The course of the flu is predictable, he said, down to the number of hospitalizations and mortalities to expect before cases drop off in spring. “The issue now with [COVID-19] is that there’s a lot of unknowns.”

(4) The asymptotic difference. Unlike with previous headline-making viral outbreaks, asymptomatic people can have and spread the new coronavirus; that’s less likely with the flu, which spreads mostly from persons with symptoms. Cases have been reported on every continent but South America and Antarctica, most recently in Europe, East Asia, and the Middle East, according to the CDC’s website.

A 2/24 article in The Atlantic quoted Harvard epidemiology professor Marc Lipsitch saying he doesn’t think COVID-19 will prove containable. His “very, very rough” estimate was that 100-200 people in the US were infected (versus 35 cases confirmed cases as of Sunday, 2/23), which would be enough to spread the disease widely. The article observed that Chinese scientists reported an apparent case of asymptomatic spread of the virus from a patient with a normal chest CT scan. If this finding is not a bizarre abnormality, the scientist stated, “the prevention of COVID-19 infection would prove challenging.”

(5) Will warm weather kill the virus? Might the coming warm weather months halt COVID-19’s spread? David Heymann of the London School of Hygiene and Tropical Medicine, who led the global response to the SARS outbreak in 2003, says not necessarily. The MERS coronavirus spread in Saudi Arabia during August, he pointed out. The flu might spread less readily in summer simply because people spend less time together in confined spaces in summertime, per a 2/12 NewScientist article.

Drug manufacturers are rushing to develop a vaccine. On Monday, drug maker Moderna delivered its first experimental coronavirus vaccine for human testing, with a clinical trial scheduled for April.

The bottom line is that we aren’t too afraid of the virus right now. While we are not virologists, our take is that there are two sanguine outcomes: (#1) the virus spreads to lots more people, but most cases are mild, and we learn to live with the threat; and/or (#2) public health efforts and less togetherness during warmer months cause the virus to die out.

(6) Fear going viral. More fearsome than the virus itself is the global contagion of fear it could spawn as governments continue to react with extreme measures and the media continues to hype the threat up. Governments’ responses have been drastic, as discussed in a 2/24 WSJ article; they include China’s quarantine of 60 million people in Hubei province, halting economic activity, and the US’ travel warnings and ban on entry of any non-American who has been to China in the past 14 days. As noted above, just yesterday, the CDC warned Americans to prepare for a severe disruption to everyday life in the US in the event of an outbreak here.

We hope that people soon will have good reasons to conclude, as we have for now, that this too shall pass.

Wednesday, February 19, 2020

Powell Says Economy Is ‘In a Very Good Place.’ Time To Worry?

Fed I: Balanced MPR. My colleague Melissa Tagg and I read the Federal Reserve’s 71-page semi-annual Monetary Policy Report (MPR) to Congress dated February 7. We concluded that Fed officials believe the US economy is well balanced and that they will keep the federal funds rate in the current range of 1.50%-1.75%. Nevertheless, they are concerned about several global issues, which they are monitoring closely.

Federal Reserve Chair Jerome Powell emphasized during his MPR congressional testimony on February 11 and 12 that the “US economy is in a very good place.” The threat from the coronavirus is something to watch, he said, but too early to understand. Nevertheless, he affirmed that “there is no reason why the expansion can’t continue.”

Below, we review reasons that Fed officials are sanguine about the US economic outlook, followed by the concerns they are monitoring. Most of the issues discussed in the MPR have been around since the current expansion began. The two new exceptions are trade tensions, which started in 2018 but have recently diminished, and the coronavirus, which has been a global risk to health, economic growth, and stock markets only since the start of this year.

Fed II: In a Good Place. Powell first used “in a good place” in reference to inflation during his 9/26/18 press conference. In his 1/30/19 presser, he said, “The US economy is in a good place.” He used “in a good place” to describe the economy and Fed policy four times during his 3/20/19 presser. The four-word phrase appeared again at the following pressers: 5/1/19 (once), 6/19/19 (thrice), 7/31/19 (once), 9/18/19 (nope), 10/30/19 (thrice), and 12/11/19 (once). At his 1/29 presser this year, he said that “household debt is in a good place, a very good place.” In his latest congressional testimony, he upgraded his assessment of the US economy as being in a “very good place.”

We wish he would stop using that expression. Our contrary instincts come out every time he says it. Nevertheless, he is right: The US is currently in a very good place compared to China. Let’s review what’s so good in the good old USA according to the Fed:

(1) US manufacturing slump not severe. After increases in 2017 and 2018, manufacturing output declined in 2019. But do not be alarmed; the report dismissed the decline as too small to “initiate a major downturn for the economy.” The MPR observed that mild slowdowns are not atypical during business-cycle expansions; to signal a broad recession, manufacturing would need to be experiencing a severe downturn. Every recession since 1960 included some months when the 12-month change in industrial production was at least 7 ppts below trend. The recent US data are well above that threshold: 2019 growth averaged 2 ppts below trend (Fig. 1).

(2) Solid labor market gains. Overall, the Fed has been pleased with the pace of gains in the job market. The MPR noted the following supportive data: The average monthly pace of payroll gains in 2019 of 176,000 was slightly below the pace of 2018 but faster than required to allow for net new labor force entrants as the population grows. During December 2019, unemployment fell to the lowest level since 1969, 3.5%, down from 3.9% a year ago. It ticked up just slightly m/m during January to 3.6% (Fig. 2).

Labor force participation increased, including for prime-aged individuals. Wage gains remained moderate. Powell indicated he was pleased to see labor force participation picking up as a result of stronger labor market conditions forcing employers to hire and train less skilled employees (Fig. 3).

(3) Residential investment moving up. “Financing conditions for consumers remain supportive of growth in household spending,” the Fed reported, observing that housing starts and permits for new construction rose to the highest levels in more than 10 years (Fig. 4). Sales of new and existing homes also increased during 2019 despite home price appreciation, reflecting reduced mortgage interest rates.

(4) Consumer spending strong. Strong consumer spending last year was supported by the “relatively high level of aggregate household net worth” as both house prices and US equity prices increased.

(5) Growth for advanced economies stabilizing. Growth in several advanced foreign nations has shown tentative signs of “steadying.” Brexit risk has lessened, but the final resolution of the UK’s divorce from the EU remains to be settled. Economic growth in Japan has deteriorated, but that’s expected to be a transitory effect of the October consumption tax increase. Following the report, Japan’s Q4 GDP was released at an annualized rate of -6.3%, largely attributable to weak private consumption given the sales tax increase to 10% from 8% (Fig. 5). For the US, fewer Fed officials “judged the risks to the economic outlook to be tilted to the downside” in their projections made in December versus last June, observed the report.

(6) Trade policy progress made. Uncertainty around trade policy recently “diminished somewhat,” the report highlighted, reflecting progress in the US–China trade negotiations.

(7) Global monetary policy accommodative. The current stance of monetary policy and low level of interest rates remain supportive of global growth. “Amid weak economic activity and dormant inflation pressures, foreign central banks generally adopted a more accommodative policy stance,” according to the report. Long-term interest rates in many advanced economies remained low. Indeed, central bank balance sheets continue to grow, as we discussed yesterday. For example, China’s central bank has moved aggressively to combat the coronavirus on the economic front by injecting more liquidity into the credit markets.

(8) Financial stability solid. The Fed believes that the US financial system is “substantially more resilient than it was before the financial crisis,” primarily because leverage in the financial sector and total household debt have moderated.

(9) Fiscal policy boosting growth. Current fiscal policy is expected to continue to boost growth. The Tax Cuts and Jobs Act of 2017, which lowered personal and business income taxes, and the recent boost in federal purchases have added to growth, the report said—a point Powell reiterated in his testimony. Following the report, news broke that the Trump administration is planning another possible US fiscal stimulus package—including middle-class income and capital-gains-tax cuts—should Trump be reelected.

Fed III: When China Sneezes. The coronavirus has led to unprecedented quarantines throughout China’s Hubei province and several of the country’s major cities. In effect, China has been quarantined from the rest of the world, as international flights have been suspended until the virus stops spreading and goes into remission. As a result, supply chains that go through China are being disrupted. China’s overall GDP, along with consumer demand, could either stop growing or actually turn down as a result of the epidemic. All this was confirmed by Apple’s warning on Monday that it does not expect to meet its quarterly revenue forecast because of lower iPhone supply globally and lower Chinese demand as a result of the coronavirus outbreak.

Not surprisingly, therefore, the MPR includes the coronavirus on the Fed’s worry list. The report was released to the public on February 7, two weeks after the outbreak hit the headlines. Let’s review the Fed’s worry list:

(1) Weak pace of inflation. According to the Fed, low readings in the US inflation rate were attributed to possible transitory influences, specifically “idiosyncratic” declines in “specific categories such as apparel, used cars, banking services, and portfolio management services.” After briefly rising toward the Fed’s 2.0% inflation goal during 2018, the pace of inflation during 2019 dropped well below that target again. The 12-month change in the PCED (personal consumption expenditures deflator) for both the headline and the core rates were just 1.6% as of December 2019, below year-ago readings for both (Fig. 6). Global inflation also remains subdued. Powell expects US inflation to move closer to 2.0% over the next few months, according to his testimony.

(2) Declines in business investment. The report voiced concerns about the stalling of business investment in structures, equipment, and intangibles last year. Private nonresidential fixed investment in real GDP was flat y/y during Q4, the weakest growth rate since Q1-2016 (Fig. 7). That reflected trade policy uncertainty and weak global growth, according to the Fed’s report, among other factors (including the “suspension of deliveries of the Boeing 737 Max aircraft” and “the continued decline in drilling and mining structures investment”). Going forward, the Fed expects business investment to remain subdued.

(3) Weak productivity trend growth. Wage gains remained moderate despite solid job market improvement. The Fed attributed this to weak productivity growth, partly as a result of “the sharp pullback in capital investment … during the most recent recession” and the slow recovery that followed. “While it is uncertain whether productivity growth will continue to improve,” the Fed said, “a sustained pickup in productivity growth, as well as additional labor market strengthening, would support stronger gains in labor compensation.” Powell said in his testimony that boosting productivity “should remain a national priority.”

Following the report, data covering last year’s productivity growth was released showing a 1.7% gain (Fig. 8). As we see it now, GDP has been growing at a little over 2.0%, so we are getting more of our economic output from productivity, which bodes well for real wages and profit margins (Fig. 9). In other words, we may be able to cross this one off the Fed’s worry list soon.

(4) Weak emerging markets growth. Growth in many Latin American and Asian economies (e.g., China, Hong Kong, and India) has slowed markedly. Social and political unrest in Hong Kong and Latin America have resulted in severe economic disruptions. In India, the “ongoing credit crunch continues to weigh on activity.”

(5) China spillover potential. In China, GDP growth slowed further in 2019 against the backdrop of “increased tariffs on Chinese exports, global weakness in trade and manufacturing, and authorities’ deleveraging campaign that continued to exert a drag on the economy” (Fig. 10). “[S]ignificant distress in China could spill over to U.S. and global markets through a retrenchment of risk appetite, U.S. dollar appreciation, and declines in trade and commodity prices,” the report stated.

(6) Coronavirus possible contagion. Coronavirus was mentioned eight times in the report, including “[M]ore recently, possible spillovers from the effects of the coronavirus in China have presented a new risk to the outlook” and “The recent emergence of the coronavirus … could lead to disruptions in China that spill over to the rest of the global economy.”

(7) Corporate debt & asset valuations elevated. “[A]sset valuations are elevated and have risen since July 2019, as investor risk appetite appears to have increased,” the report observed. Business debt remains elevated as well, whether viewed as a ratio of business assets or growth measures. In addition, that debt has gotten risker: The lowest investment-grade category (triple-B) represents about half of investment-grade-rated debt outstanding; that’s near an all-time high. Economic deterioration could lead to a liquidity crunch in the credit markets.

(8) Uncertainty in setting monetary policy. The report dedicated a box to discussing the Fed’s concern about the future effectiveness of its current approach to conducting monetary policy. The US economy has “changed in ways that matter for monetary policy. For example, the neutral level of the policy interest rate appears to have fallen in the United States and abroad, increasing the risk that the effective lower bound on interest rates will constrain central banks from reducing their policy interest rates enough to effectively support economic activity during downturns.”

Wednesday, February 12, 2020

With Immunity to Coronavirus, US Stocks Melt Up with Impunity

I discussed the possibility of a meltup in stock prices in my 12/18/19 Morning Briefing titled “2020 Vision.” I wrote: “Another risk is that investors could conclude that there is nothing to fear but fear itself. That could lead to a meltup. When the S&P 500 rose to our 3100 target for this year on 11/15, we started to consider the possibility of a meltup scenario involving an advance to our 3500 year-end 2020 target well ahead of schedule in early 2020. We may be experiencing that meltup now given that the S&P 500 is getting close to 3200 already!”

I reiterated this view in my first commentary of 2020, dated 1/6 and titled “Nothing to Fear But Nothing to Fear (and Iran).” As it turned out, the crisis with Iran didn’t last long enough to merit adding it to our Table of S&P 500 Panic Attacks Since 2009. However, we did add the coronavirus outbreak as #66 on our list with a 1/24 date, when the outbreak news first hit the tape. So far, it has turned out to be among the very short and minor selloffs, as the S&P 500 dropped only 3.0% from 1/23 through 1/31 (Fig. 1). The index is up 4.6% ytd, closing at a new record high of 3379.45 on Wednesday. A gain of just 3.6% would put it at our 3500 target for year-end!

That’s quite a remarkable development. Recall that there were a couple of panic attacks in 2018 and again in 2019 triggered by Trump’s escalating trade war with China (Fig. 2 and Fig. 3). One of the big worries was that the trade frictions would disrupt supply chains and force companies to spend money to move them out of China. It seems to me that the coronavirus outbreak in China poses a more immediate and greater threat to supply chains. Yet here we are at record highs in the S&P 500, DJIA, and Nasdaq.

There was also a minor panic attack when the yield curve inverted last summer (Fig. 4). But the Fed reversed that problem by cutting the federal funds rate for a second and then a third time last year on 9/18 and 10/30. The yield curve since has flattened again and may be about to invert again too. Yet this story is getting no play in the financial press as a pressing concern about an imminent recession the way it did last year.

The markets must figure that the coronavirus outbreak will be contained soon and go into remission, as did SARS, MERS, and Ebola. If that doesn’t happen, then there will be a vaccine that will make us feel better. It won’t be a miracle cure coming from a drug company. Rather, it will be injections of more liquidity into the global financial markets by the major central banks.

On Tuesday, Fed Chair Jerome Powell implied that the Fed is on standby to do just that. In his testimony on monetary policy to Congress, he said, “Some of the uncertainties around trade have diminished recently, but risks to the outlook remain. In particular, we are closely monitoring the emergence of the coronavirus, which could lead to disruptions in China that spill over to the rest of the global economy.”

Meanwhile, I continue to monitor the weekly fundamental indicators for the S&P 500 for signs of the viral infection:

(1) Forward revenues & earnings. It’s too soon to tell whether the virus outbreak is starting to weigh on S&P 500 revenues and earnings. S&P 500 forward revenues remained at a record high during the 1/30 week. Forward earnings edged down 0.3% during the 2/6 week from its $179.01 record a week earlier (Fig. 5). The forward profit margin remained at 12.0% during the 1/30 week.

(2) Q1-Q4 earnings. Nevertheless, industry analysts may have just started to cut their Q1-Q3 earnings estimates during the 2/6 week to reflect the possible negative consequences of the virus on the companies they follow (Fig. 6). They seem to be doing their best to offset those cuts by boosting their Q4 estimates, by which time the virus problem should have passed, in their collective estimation.