July 17, 2020
By Steve Blumenthal
“We believe the corona crisis is the most disruptive global event since World War II,
and far surpasses the trauma of the 2007-2009 Great Recession.”
– A. Gary Shilling,
financial analyst and commentator, Insight
As you read today, keep this important point top of mind: In March, the Federal Reserve System came to the country’s rescue, announcing they would buy mortgage-backed securities, investment-grade corporate bonds, and even junk bond exchange-traded funds (ETFs). The Fed created a $750 billion “Corporate Credit Facilities” kitty to be used to stabilize the markets. Considering there is roughly $6 trillion in corporate bonds and another $1 trillion in high-yield bonds, that’s a big number. What’s notable is that the Fed has used just $42 billion of that $750 billion, and just $10.7 billion of that was used to buy corporate bonds. There is a lot more firepower to be spent, however that cash kitty is due to expire on September 30, 2020. But it won’t expire.
The Fed has embraced a “whatever it takes” mentality, and I suspect the facility will be extended. And there is more… at the last Federal Open Market Committee meeting, the Fed said they would buy between $250 and $500 million in commercial mortgage-backed securities (CMBS). These are fixed-income investment products that are backed by mortgages on commercial properties, as opposed to residential real estate. Large retail bankruptcies abound. Landlords are in trouble. No, it won’t expire on September 30, 2020.
The COVID-19 crisis is launching what my partner John Mauldin has coined “The Great Reset.” In other words, it is the challenges faced at the end of long-term debt accumulations cycles and underfunded entitlement issues. In his recent Insight letter, Gary Shilling put it this way:
“Economic privilege becomes a right or entitlement when a free society believes it can afford them. They spawn politically powerful constituencies and are attractive to those granting them, especially when they won’t be responsible for the future when the entitlements’ costs may no longer be sustainable.”
We have reached “no longer sustainable.” He added:
“Decades of overly-optimistic return assumptions, insufficient pension fund contributions and lengthening life spans of public sector retirees have created massive shortfalls that even the 11-year bull market in stocks, from March 2009 to February 2020, didn’t offset. Even before the strains caused by the corona crisis, state pension funds were troubled, as shown by the chronically rising negative funding gap between their assets and liabilities, which reached $1.2 trillion in 2018, (the latest data).”
Here are a few quick data points:
- In 2017, Kentucky was only 34% funded,
- New Jersey was 36% funded, and
- Illinois was 38% funded.
Not all states have huge pension funding shortfalls. In contrast, Wisconsin’s funding level stood at 103%, and South Dakota at 100%. An 80% funding ratio is considered adequate. However, some 20 states were less than two-thirds funded and five were less than 50% funded.
The question is How do we fix this problem? Will Wisconsin be interested in bailing out Illinois? No way.
The ten-year bull market in stocks has not rescued pensions. Taxes will go up and pension benefits will be reduced. Reduced pension benefits and higher taxes translate to a slower economy. Excessive debt remains a drag on growth. A slower economy tied to high stock market valuations means low coming returns.
And coming return probabilities are woefully low.
Here’s how to read this chart:
- The gray line plots “expected 10-year returns” based on a valuation measure.
- The red line plots what actually happened.
- You can see the red line stops in 2010; in 2021, we’ll know the last 10-year return number.
- The point is how highly the “expected” return correlates to what actually happened.
- In 2009, the outlook pointed to an 18% annualized return (but really, do you know anyone who was willing to buy then??? Few were, but it would have been the right move).
- Today, everyone is buying at a time when the 10-year expected return is -0.18% per year.
One more point here: I’ve been writing about high valuations and low coming returns for many years. Take a look at the return expectations in 2018. A low 1% forecast. And then take in this next tweet from friend David Rosenberg:
The forward return probabilities remain low. “But the Fed has our back,” you say…
I want to attempt to answer the trillion-dollar question I heard at dinner last night with some friends: “Can’t the Fed just print unlimited amounts of money and buy all the bad stuff?” The immediate answer is yes. The Fed has already showed its willingness to violate the Federal Reserve Act, though the government will have to raise the debt ceiling set to be reached soon. And, unfortunately, it will.
My answer differs: it’s that the global system is complex. Perhaps it’s a weak answer, but it’s true. And in the end, we’ve been here before. The printing will lead to the debasement of currency, and when confidence is lost in one’s currency, money flees. It is not a smooth and easy ride. Now, that doesn’t mean there isn’t opportunity—there is. But it does mean there will be winners and losers.
I don’t believe there is a magic bullet. For every push there is a pull. I’ll write more about this next week. Hint: The dollar is likely the last to stand (which is short-term bullish for US assets), but this is in relation to the rest of the world. The global picture captures the same debt trap we find ourselves in. We’ve got issues and the virus is dialing up the heat.
“May and June will prove to be the easy bumps in terms of this recovery.
And now we’re really hitting the moment of truth, I think, in the months ahead.”
– Jennifer Piepszak, CFO, JPMorgan
“Our view of the length and severity of the economic downturn has deteriorated
considerably from the assumptions used last quarter.”
– Charlie Scharf, CEO, Wells Fargo
“I don’t think anybody should leave any bank earnings call this quarter simply feeling
like the worst is absolutely behind us and it’s a rosy path ahead.”
— Mike Corbat, CEO, Citigroup
It Feels like 1999 All over Again
Like 1999, the current market speculation is palpable. Investors believe that the Fed has our back; therefore, there is no other alternative but to buy stocks. As was the case then, this narrative will likely turn out to be flawed. I can’t help but hear the words of the late great Sir John Templeton whispering in my ear, “The secret to success is I sell when everyone else is buying and I buy when everyone else is selling.”
Mohamed El-Erian, chief economic advisor at Allianz, wrote an op-ed this week in the Financial Times. He wrote, “The financial stress caused by Covid-19 is far from over. Investors should brace for non-payments to spread far beyond the most vulnerable corporate and sovereign borrowers, in a reckoning that threatens to drag prices lower.”
Funds are running out and businesses are likely entering another round of layoffs. El-Erian added, “Rather than buying assets at valuations stunningly decoupled from underlying corporate and economic fundamentals, investors should think a lot more about the recovery value of their assets and adjust their portfolios accordingly.” I think he’s right. You’ll find the article when you click through below. Some great advice—worth the read.
If it isn’t clear already, I’m cautioning you not to get caught up in the “Fed can save us” narrative. There is nearly $6 trillion in U.S. Investment Grade debt and over $1 trillion in U.S. high-yield debt. There is nearly $12 trillion in foreign debt denominated in U.S. dollars. There is nearly $300 trillion in global debt, $100 trillion in global equities, and $300 trillion in global real estate. Losses will be shared. Short term, the “Fed can save us” narrative works; long term, I don’t think so. The problem is too vast. The Fed and the global central bankers just aren’t big enough. That’s my take.
Defend the “core.” That to me is “Job One.” There are times, like today, when it doesn’t feel necessary. My investment conclusion remains unchanged: keep your stop-loss triggers in place and adhere to your processes. None are perfect but most are very good. Leave your “explore” investments alone. These are the five- to ten-year bets. If you trust in the opportunities they present, give them time.
Grab a coffee and find your favorite chair. On Wednesday, I drove up to Boston for a few masked meetings and snuck out to play golf with an OMR reader who has become a good friend. He hosted me at the famed The Country Club. The course was built in 1894 and will once again host the U.S. Open in two years. It was a much-needed happy pill. I have to admit, I’ve been a little off due to the global pandemic we are all going through.
In today’s missive, I share a great story about a local caddy who went on to win the 1913 US Open at The Country Club… along with few pictures in the personal section including one that will be very hard for a diehard EAGLES fan like me to digest: Tom Brady’s house was along one of the holes. What a house.
I hope you enjoy this week’s post. Thanks for reading. Wishing you a great week.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Investors Must Prepare Portfolios for Covid-19 Debt Crunch, by Mohamed El-Erian
- Trade Signals – Equities Continue Climb with Uncertain Domestic Economy
- Personal Note – Heart of Oak and Nerves of Steel
The financial stress caused by Covid-19 is far from over. Investors should brace for non-payments to spread far beyond the most vulnerable corporate and sovereign borrowers, in a reckoning that threatens to drag prices lower.
There is still time to get ahead of this trend. Rather than buying assets at valuations stunningly decoupled from underlying corporate and economic fundamentals, investors should think a lot more about the recovery value of their assets and adjust their portfolios accordingly.
So far, despite signs of rising stress on corporate and public balance sheets, non-payments have been largely contained to certain badly affected segments.
But the sense that the worst did not come to pass has fed complacency among investors of all stripes. A new generation of retail investors has emerged, helping stocks on their relentless march higher.
Contrast investors’ optimism with companies’ circumspection. While many central governments are focused on reopening economies that were locked down to contain the virus’s spread, most businesses have remained cautious. Many are still looking to further reduce their spending.
The wariness has been encouraged by the resurgence of infections around the world. In the US, a majority of states have now opted to halt or reverse their lockdown easing plans. And there is every reason for businesses and investors to tread carefully. Health experts warn us about over-optimism on a vaccine and, judging from the most affected areas, too many people are yet to properly take on board the infection threat and align their behaviours with the risks facing society.
Such a weak and uncertain economic backdrop reduces borrowers’ willingness and ability to meet contractual obligations. This is particularly the case in vulnerable sectors such as hospitality and retail, and in developing countries with less of a financial cushion and limited room for policy flexibility. Try our newsletter on Sustainable Business Free four-week trial of the Moral Money newsletter Get the newsletter
There are already plenty of worrying signs: a record-breaking pace for corporate bankruptcies; job losses moving from small and medium-sized firms to larger ones; lengthening delays in commercial real estate payments; more households falling behind on rents and continuing to defer credit card payments; and a handful of developing countries delaying debt payments.
Yet, judging from a range of market indicators, investors are showing insufficient concern. Some continue to expect a sharp, V-shaped recovery in which a vaccine, or a build-up of immunity in the population, allows for a quick resumption of normal economic activity. Others are relying on more backstops from governments, central banks and international organisations.
But policymakers’ support actions have already been extensive, including payment deferrals, direct cash transfers, covenant relief, rock-bottom interest rates and corporate bond purchases. The G20 group has agreed a “debt service suspension initiative” for the poorest developing countries.
While notable, such measures will not protect investors from sharing some of the capital losses, whether that is due to companies going bankrupt, or developing countries needing more than exceptional funds from bilateral and multilateral sources. Many have already made it clear that they expect “private sector involvement”. That is likely to mean, at the minimum, the short-term suspension of interest and principal payments.
As neither a quick income recovery nor more financial engineering is likely to avert a rise in non-payments, the best that can be hoped for in a growing number of cases may well be orderly, voluntary and collaborative restructurings, such as the one announced last week in Ecuador.
The complicated negotiations between Argentina and its creditors demonstrate that such deals are far from easy, especially given the lack of cohesion among creditors. But the alternative — a messy default — destroys even more value for debtors and investors.
The potential damage is not limited to finance. Disruptions in capital markets could also undermine the already sluggish economic recovery by making consumers more thrifty, as they worry about their job prospects, and by encouraging companies to postpone investment plans pending a clearer economic outlook.
The investing challenge may well shift in the months ahead from riding an exceptional wave of liquidity, which lifted virtually all asset prices, to steering through a general correction in prices and complex individual non-payments.
No wonder, then, that an increasing number of asset managers are raising funds in the hope of deploying a dual investment strategy.
The first involves waiting for a correction to buy rock-solid companies trading at bargain prices. The second involves engaging in well-structured rescue financing, debt restructurings and collateralised lending as countries, and some bankrupt companies, seek to reorganise and recover.
Liquidity-driven rallies are deceptively attractive and tend to result in excessive risk-taking. This time, retail investors are front and centre. But it is the next stage that we should already be thinking about. That requires much more careful scrutiny from investors than the past few months have demanded.
The writer is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge.
July 15, 2020
S&P 500 Index — 3,225 (open)
Notable this week:
No significant changes to the trade signals this week, although Don’t Fight the Tape or the Fed moved down to -1 from 0, which is a slightly bearish signal. As you will see below in the Dashboard, other equity signals remain in buy signals or are bullish for stocks, notwithstanding uncertain earnings, an uncertain economic recovery, and spiking COVID-19 infections in over 30 states. Investor sentiment remains neutral. I could be wrong, but I suspect a short-term top when sentiment reaches extreme optimism. The Trade Signals Dashboard follows below.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
When I was a kid, my mom bought me a book that contained stories from Grantland Rice, the great sportswriter. I just love that book. I hope you enjoy the following sports story.
The 19th U.S. Open was held September 18-20, 1913 at The Country Club in Brookline, Massachusetts, a suburb southwest of Boston. Amateur Francis Ouimet, at just 20 years old, won his only U.S. Open title in an 18-hole playoff—five strokes ahead of Britons Harry Vardon and Ted Ray.
From “A Heart of Oak and Nerves of Steel”: A Look Back at Golf’s Greatest Upset and the Local Hero of the 1913 U.S. Open by Bruce Coggeshall
Ouimet, a native of Brookline, Massachusetts, had grown up in poor economic circumstances and in 1913 was working at a neighborhood sports store. As the reigning Amateur Champion of Massachusetts, Ouimet was qualified to compete in the 1913 Open. Yet no one expected him to do well; the two best players in the world—British professionals Harry Vardon and Ted Ray—were competing. Vardon had won five British Opens and the 1900 U.S. Open. In the spring of 1913, he and Ray were barnstorming the United States, playing exhibition matches. Many expected their tour to conclude with one of them winning the U.S. championship.
Vardon and Ray didn’t know that Ouimet had grown up right across the street from The Country Club of Brookline, where the 1913 tournament would be played. Even if they had known Oiumet had caddied there and knew the course intimately, they probably wouldn’t have been worried; they had the experience the local youngster lacked.
The scene was set for a thrilling championship due to the large number of talented golfers that came to compete. The Boston Journal reported on September 15, 1913:
The quality of golf to be witnessed on American links has greatly improved in the last ten years. The figures to be gleaned from the national tournaments are proof positive of this. But Vardon and Ray are both capable of playing championship golf every day of the week….
Two rounds and one day of play remained. At the end of it, Ouimet had tied Ray and Vardon. On Sept. 20, 1913, the Colorado Springs Gazette reported:
An American youth—a stripling scarcely out of his ‘teens—carved a niche for himself in international sporting history here today….As the result of his exhibition of nerve and golfing skill he will be America’s sole representative in 18-hole three-ball medal play off of the tie which exists tonight…
When the spectators realized that in this homebred amateur, born and brought up on the edge of the County club course, rested America’s chance of winning the championship, they lost that placid attitude that ordinarily marks the golf galleries and rooted and cheered Ouimet in a manner typical of baseball and football games.
The scenes that attended Ouimet’s march over the last four holes have never been equaled on an American or European golf course.
The American youth need to hole out in one to win and in two to tie. He gazed long down into the bowl where the cup lay, dried his hands and made a 35-foot putt that just missed the hole and rolled three feet beyond. A sigh arose from the crowd and all was still again. Ouimet gently tapped the ball again. Slowly it rolled to the edge of the hole, curled around the lip for an inch or so and then dropped in for the four which tied him with Ray and Vardon.
Instantly a tremendous yell went up. The gallery swept past ropes and guards and closed in on Ouimet in a solid phalanx. He was lifted to the shoulders of the advance guard and carried toward the club house surrounded by several thousand cheering, yelling golfers who forgot their golf in the enthusiasm of being just Americans cheering an American victory. Many, not realizing that Ouimet was an amateur, thrust bills of large denominations at him only to be met with a smile and a shake of the head…
A final day was needed for an 18-hole playoff, which Ouimet won, scoring 72, five strokes better than Vardon and six better than Ray.
A photograph on the front page of the Sept. 21 Sunday Herald (the Boston Herald’s Sunday edition) captured the elation of his “admirers carrying him off the course.” The accompanying article by Walter E. Murphy began:
From caddy a few years back to conqueror of Harry Vardon and Edward Ray of England, two of the greatest golfers that ever lived, was the unparalleled and deserved triumph of Francis Ouimet of the Woodland Golf Club yesterday at The Country Club in the play-off of the tie for the open championship of the United States Golf Association. It was victory for an amateur that is unprecedented in the history of competitive golf.
Ouimet’s total for the 18 holes was 72, Vardon’s 77 and Ray’s 78. The win of the American boy sets forth one of the most notable chapters in the narrative of international competition between the United States and England…
Ouimet won absolutely on his merit. It was no fluke, no flash in the pan. He used his head as well as he played his strokes. The fact that a gallery of about 7000 men and women on all sides of him did not concern the player in the least. When in front of the two Englishmen with but one stroke lead, he went after every hole. He knew his own power better than did any of his partisans. He analyzed every situation at a glance and adapted his game perfectly to the occasion, until near the close of the match it may be said that Vardon broke up. His great game left him. The hero of a thousand tournaments confronted by a lad with a heart of oak and nerves of steel…
Ouimet continued living in Massachusetts, eventually becoming a banker and stock broker. Nearly three decades after his dramatic win, Oiumet and his caddy, Eddie Lowery, “now a successful San Francisco business man,” sat with the sportswriter Grantland Rice to discuss the game. Lowery had been ten years old that weekend in Brookline. He had skipped school to caddy the final two rounds, as he explained in this interview which appeared in the Seattle Daily Times on Dec. 12, 1940:
“As I recall it,” Eddie said, “the three were all even as they passed the turn. I could see a worried look on the faces of both Vardon and Ray. They had expected 20-year-old kid to crack wide open. But here he was cooler than ever. He didn’t watch their drives. He just kept playing his own game. Then on the tenth hole both Vardon and Ray took three putts and Ouimet was out in front. They all played fine golf the next few holes, and then big Ted Ray was the first to break up. This left the battle between Francis and the great Harry.
“It was Vardon who finally couldn’t stand the strain and the fast pace any longer as he, too, cracked and Francis with a birdie picked up two more strokes. He was still as cool and still unruffled as if he was playing a dime Nassau with two old pals.”
Rice concluded his story by calling the victory “the greatest single day American golf has ever known.”
In 1963, on the 50th anniversary of Ouimet’s win, the U.S. Open returned to The Country Club of Brookline. Once again there was a three-way tie. Julius Boros defeated Arnold Palmer and Jacky Cupit to win at the age of 43. Ouimet, now in his seventies and known as “the father of amateur golf,” was alive to see the tournament return to the scene of his stunning victory, the course on which he had taught himself the game, only steps from his childhood home.
Thanks for indulging me. Here are a few photos from yesterday. What a day!
The green behind us in the next picture is said to be the oldest green in the country. It has a false front, so if you come up short your ball rolls back to the bottom of the hill. A challenging green. I missed my tee shot right. Again… ugh.
The U.S. Open will return to The Country Club in 2022. It will be fun to watch. Stay safe. Stay healthy. And get out and do something you’ve really wanted to do!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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