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!

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