August 28, 2020
By Steve Blumenthal
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
– From Ernest Hemingway’s 1926 novel, The Sun Also Rises
Yesterday, from beautiful Jackson Hole, Wyoming, Federal Reserve Board Chairman Jerome Powell delivered what was dubbed a “profoundly consequential” speech, marking a change in the way the Fed views inflation. He essentially admitted that their longstanding belief in the Phillips curve has failed. The Fed no longer thinks there’s a trade-off between low levels of unemployment and inflation—a historic pivot for the central bank.
Zero-bound interest rates, lower for longer—much longer.
Few had confidence in the Fed in the late 1970s and early 1980s. President Gerald Ford handed out those “WIP” (Whip Inflation Now) buttons. Tough love from Fed Chairman Paul Volker proved to be the cure. In the polar opposite of where we find ourselves today, then, Volker aggressively pushed rates higher. Yielding 4% at the top of the 1966 equity bull market peak, and 7% before the inflation regime took hold in the mid-1970s, by 1981 the 10-year Treasury spiked to nearly 16%. Earlier this month, the 10-year Treasury touched 0.50% (lower right-hand side of the following chart). We sit at 0.74% today.
I thoroughly enjoyed a post from friend Mark Grant called, “Waltzing Through Wonderland.”
“But I don’t want to go among mad people,” Alice remarked.
“Oh, you can’t help that,” said the Cat: “we’re all mad here. I’m mad. You’re mad.”
“How do you know I’m mad?” said Alice.
“You must be,” said the Cat, “or you wouldn’t have come here.”
– Lewis Carroll, Alice in Wonderland
Mark summed it up, “The S&P hits an all-time high. Treasury yields are either at, or right off, their all-time lows. Corporate bonds, high yield bonds, mortgage bonds are all compressing against Treasuries like risk was an outdated subject. The risk premiums for all of these bonds indicates the incredible demand for anything, with any sort of yield.”
Zero-bound rates. Negative in much of the world. I’m mad, you’re mad, we’re all mad. But it is what it is.
It looks like this:
Powell admitted that the Fed’s logic over the last ten years has failed them. Game plan: Whip Deflation Now (“WDN”). Fire up the printing presses. Expect the Fed’s balance sheet to rise from $7 trillion to $14 trillion.
Luke Gromen sent out a quote post-speech, summarizing it in plain English:
“Inflate it away” is the stated plan, though I expect we’ll see both 1 and 2.
What exactly is inflation? Many don’t know. Think of it the way Rudy Havenstein put it: “When you see the word ‘inflation,’ replace it with the phrase ‘the cost of living.’” The price of everything you buy goes up. If your salary doesn’t inflate as quickly as the price of things you need, you’re not happy. And it occurs gradually, then suddenly.
That’s the future risk. Deflation is the current risk. The Fed hopes to soft-land this thing. Not too hot, not to cold, just right. Possible, yes, but the probabilities are extremely low. Powell’s not the only player messing with money supply.
As investors, we’ll have to get this right. Inflation regimes are different. No immediate emergency, but we have to be thinking about what wins in such environments. Gold, hard assets, commodities, agriculture, and TIPS generally perform best. Bonds lose value when rates rise. All things being relative, higher rates means debt costs go up, costs of inputs go up, and profit margins go down, so rising rate regimes are generally not good for equities. Stocks went nowhere from 1966 to 1982.
When I joined Merrill Lynch in 1984, everyone knew you had to be a stock trader to make money. Buy-and-hold? You were thought to be crazy. We all should have gone with crazy. The greatest bull market of all time began in the early ’80s. Today, the majority of investors are “all in” on the buy-and-hold side of the trade. See the big picture? We sit on the complete opposite end of where we were back then. Active money management is dead? I don’t think so… “But I don’t want to go among mad people,” you say. Never feels right.
“Gradually” takes time. “Suddenly” happens seemingly overnight. Like Volker before him, Powell is up for the fight. And his sell is an easy one. Volker took our candy; Powell is giving us more. He and the collective global central banks—all with one mission—will win the fight.
And I knew if I had my chance that I could make those people dance, and maybe they’d be happy for a while… Hum with me!
A long long time ago
I can still remember how
That music used to make me smile
And I knew if I had my chance
That I could make those people dance
And maybe they’d be happy for a while
But February made me shiver
With every paper I’d deliver
Bad news on the doorstep
I couldn’t take one more step
I can’t remember if I cried
When I read about his widowed bride
Something touched me deep inside
The day the music died
Bye, bye Miss American Pie
Drove my Chevy to the levee but the levee was dry
And them good ole boys were drinking whiskey and rye
Singin’ this’ll be the day that I die
This’ll be the day that I die
– “American Pie” by Don McLean
I’ve always loved that song! We have a Sonos speaker system with two outdoor speakers on our back patio. Picture a late dinner outside with volume on high and ice-cold Levante IPAs in hand (Susan’s and mine).
More on Powell:
The Fed will pick up its pace. More printing, more buying: Government bonds (yield curve control), corporate bonds, muni bonds, junk bonds—more is more… Direct lending to you and me? Coming… Whatever it takes really means whatever it takes.
I mentioned that Powell isn’t alone. The Bank of England Governor Andrew Bailey should get the quote of the week award for this one: “There are times when we need to go big and go fast.” Source: Reuters
In the end, there will be inflation. When it comes, people will be upset. The confidence in the Fed will be lost. What happens to record-high overvalued asset prices then? I could be wrong, but I think “then” is not yet here. For now, gradual means we will be “happy for a while.”
The Fed put provides support. Buy the dips. In my opinion, buy what the Fed is buying. But do keep stop-loss triggers in place. To me, it comes down to confidence. When confidence is lost, the Fed put will fail. Markets are far bigger than the Fed.
It’s early Friday morning, and I’m sitting in my favorite chair writing to you with coffee by my side. The U.S. futures are pointing to a higher market open. For now, all hail the Fed. That IPA is going to taste really good this evening.
I quoted my friend and economic hero, Dr. Lacy Hunt, last week. He said,
The problem is people want a financial transaction to cover the problem. They want greater levels of debt — in other words, we’re going to try to solve an indebtedness problem by taking on more debt. Japan has tried many, many heroic measures to try to pull themselves out. Great results were promised.
The production function says GDP is determined by technology interacting with land, labor and capital. If you overuse one of the factors of production, such as debt capital, initially GDP will rise. You continue to overuse that factor of production, GDP flattens out; and if you continue to overuse that factor, GDP declines. More is not more — more is less.
Lacy was asked about the rise of MMT within economics and the proposals that the Fed to give money directly to individuals. He replied:
The great risk is that we become dissatisfied with the way things are, and either de jure or de facto, the Federal Reserve’s liabilities are made legal tender.
The Federal Reserve as it’s constituted today can lend but it cannot spend. Now, they’ve done some things that are different from what the Federal Reserve Act said under the exigent circumstances clauses, but so far they’re lending. They’re not directly funding the expenditures of the government in any meaningful way. But there are folks who want to use the Fed’s liabilities for that purpose.
When the Fed buys government securities all that really happens is you switch to the government having a one-day liability which the banks are holding. And those deposits that the banks own, which have gone up sharply as a result of the Fed buying, are not legal tender. Now, the banks could use them to make loans, but they’re not doing that. Loans are coming off very sharply because you have to have this interplay between the banks and their customers, and the risk premium has to be accounted for.
There are folks who want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off. However, in very short order, everyone would be totally miserable because no one would want to hold money. You would trigger Gresham’s Law — people would only want to hold commodities they can consume and commodities that can be traded for others.
But there is that risk that you could use the Fed’s liabilities to pay directly. The Bank of England has made a small move in that direction — they say it’s temporary. There are others that want to try that because they’re frustrated with the fact that issuing the debt is not getting the job done. So we could significantly alter the whole structure of the U.S. economy. But if you use the Fed’s liabilities for directly funding goods and services, the consequences could be very extreme and very quick.
[SB here: emphasis mine.]
Lacy concluded, “The inflation rate is going to be trending down and there is possibly a much greater risk of deflation than inflation.” He remains invested in long-duration Treasury Bonds.
The move in interest rates the last few days from 0.50% to 0.75% may be a good bond-buying opportunity. How did inflation start? Gradually, then suddenly. We must vigilantly be on the lookout for “suddenly.” My best guess: “suddenly” is two to three years away.
Grab that coffee and find your favorite chair. You’ll find the most recent Trade Signals post, “Is the Current Equity Rally Sustainable?” below. The equity dashboard is mostly green with one exception: Don’t Fight the Tape or the Fed is bearish. Hard to believe, with all that we’ve noted from the Jackson Hole news this week.
I find it concerning that investor sentiment is extremely optimistic. I set aside a quote from David Rosenberg this week: “Nothing to fear but the lack of fear itself.” Courtesy of Ned Davis Research, here is the NDR Daily Trading Sentiment Composite (note the “We are here,” compare it to other lofty levels, and note the markets performance when the reading is above the upper dotted line):
Nobody is short the market, everyone is extremely bullish, mutual fund investors are fully invested… little in cash. The overall evidence has been bullish for a number of months and that condition remains today. Expect some turbulence going into the election.
You’ll also find a fun article from Mark Grant titled “Pushing and Pulling Pugnaciously.” In it, Mark details the underfunded pension problems and quotes his bankruptcy attorney friend who said, “…the surge in reorganizations has only just begun.” Markets vs. Fed.
Thanks for reading. I hope you find this post helpful.
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:
- Pushing and Pulling Pugnaciously by Mark Grant
- Trade Signals – Is the Current Equity Rally Sustainable?
- Personal Note – Embrace the Uncertainty
By Mark Grant | August 24, 2020
We are in the thick of it. We are getting battered by the vagaries of these markets. Treasury yields at, or close to, all-time lows, equities on the rise, the pandemic laid upon the country like a soaked heavy wool blanket and the Fed stretching its tentacles into all parts of fixed-income markets. Corporate bonds, high yield bonds, and mortgage bonds all compressing versus Treasuries where any premium for risk assets is getting squeezed like some orange pouring its juice into your glass. If we were in one of those concrete trucks, where the back end is swirling, it couldn’t be much worse than the manner in which we are being knocked around presently.
U.S. corporate bankruptcy filings are now running at a record pace and are set to surpass levels reached during the financial crisis known as “The Great Recession.” This compares with 38 bankruptcies for the same period during the financial crisis of 2008/2009 and is more than double last year’s figure of 18 over the same time period.
For companies with liabilities over $50 million, 157 have filed for bankruptcy already this year and I predict more will follow, perhaps significantly more. My good friend, Charles Tatelbaum, a Director at the law firm of Trip, Scott has indicated to me that reorganizations are just getting under way. He tells me that many corporations are hanging on for dear life and that the surge in reorganizations has only just begun. Just take a look at retail, the travel industry, hotels, restaurants, commercial office space and the REIT’s connected to them.
In the retail sector, companies with assets of over $50 million, 24 have filed for bankruptcy which is triple the amount of last year. Also check out the energy space where 33 filings have taken place as compared to 14 filing last year. Look all around you and then note the equity markets as well as the bond markets and the real estate markets and, given all of this bad data, it is really quite surprising that the markets are behaving as well as they are, in this environment.
Thank you Jerome Powell.
One area that particularly concerns me are the pension funds. If you have any exposure to them, through bonds or loans, and especially Municipal bonds, I would be paying very close attention to the deteriorating condition of many of these pension funds. The total funding gap for the 143 largest U.S. public pension plans is on track to reach $1.62 trillion this year, significantly higher than the $1.16 trillion recorded in 2009, according to Equable Institute, a New York-based non-profit think tank.
The weak financial condition of the U.S. public pension systems poses severe risks for the living standards of millions of employees and retired workers and the bondholders of these funds. Equable estimates that returns of US public pension plans averaged -0.4 per cent over the 12 months ended June 30, well below the 7.2 per cent targeted by these plans. Make note, this is during the same time period when stocks have been up through the roof. This dire performance has contributed to the aggregate funded ratio, assets as a share of liabilities, sinking to 67.9 per cent.
The shortfall in in pension funding is now at 10 percent of GDP in 9 states and more than 6 percent of GDP in 24 states. The largest share of unfunded liabilities are in New York, California, Illinois, New Jersey, Texas, and Pennsylvania. The total amount of damage here is $693 billion.
Besides the pension funds of the states I would also be looking at your exposure to the pension funds of the municipalities in these states. It is almost impossible to raise taxes now to meet these obligations as the pandemic sweeps both people, and governments, off of their feet. I am reminded of the Moody Blues and their famous song, “Go Now,” and I would. In my opinion the yields on various pension fund obligations, and their ratings, do not accurately reflect the serious conditions that are now present.
The Fed recently stated, in their minutes, that the “restructuring in some sectors of the economy could slow down the growth of the economy’s productive capacity for some time.” I think that “quite some time” is frankly an understatement. If not for the Fed, to be blatantly forthcoming, we would be in real trouble, in my estimation. Our historically low interest rate environment, engineered by the Fed to keep the country’s borrowing costs at levels just off of Zero, has been the major boon for all of the markets, including the equity markets. When there is no yield available, in almost any sector, then bond money flows into stocks but when the market corrects, which it surely will at some point, then “Katie bar the door.”
Between bond yields, stock market prices, and valuations, a soaring real estate market and the cost of leverage, inducing a “Borrower’s Paradise,” we are in a Wonderland of our own making. It is virtually a fairy tale environment.
“When I used to read fairy tales, I fancied that kind of thing never happened, and now here I am in the middle of one!”
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley FBR Inc. & B. Riley Wealth Management
Information herein is for general use; is not unbiased/impartial; is current at publication date, subject to change; may be from third parties; and may not be accurate or complete. Opinions are the Author’s, not B. Riley FBR, Inc., or their respective affiliates.
August 26, 2020
S&P 500 Index — 3,449 (open)
Notable this week:
“Some of our indicators are beginning to move into the ‘euphoria’ stage,
and we caution that managing drawdown risk is coming to the fore.”
– Sean Darby, global equity strategist at Jefferies
On Tuesday, the S&P 500 Index closed at a record high for the third consecutive trading day. It would seem that another record high close would be something investors should celebrate. As advisers, we owe a fiduciary duty to our clients — we elevate our clients’ interests above ours. Accordingly, we’re always on alert for potential risks (and under appreciated opportunities). Some Wall Street analysts are starting to express concerns about the equity market rally. We’ve been talking about excessive valuations (by nearly any measure) for quite some time. Additionally, the swift speed of this rally has not gone unnoticed by strategists.
What’s driving this rally? Of course, there could be many economic, fiscal, political, and emotional factors pushing broader markets to new highs. Many retail investors are piling into stocks because of FOMO (i.e., fear of missing out), hope for another stimulus package from Congress, some good corporate earnings, improvement in the war on COVID-19, reopening of schools and colleges, a very active Federal Reserve in markets, etc.
While virtually all equity and fixed income signals remain bullish at this time, we urge some measure of caution as some investors tend to pile into equities at exactly the wrong time. We believe it’s prudent to have a process and plan and to stick to that plan. Take emotion out of your analysis. Talk to an adviser if you need professional assistance.
No material changes to the trade signals since last week, but we need to point out that the Ned Davis Research Crowd Sentiment Poll now indicates “Extreme Optimism,” which is a short-term bearish signal for equities.
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.
“If you’re feeling frightened about what comes next… don’t. Embrace the uncertainty.
Allow it to lead you places. Be brave as it challenges you to exercise both your heart and your mind
as you create your own path towards happiness. Don’t waste time with regret.
Spin wildly into your next action. Enjoy the present—each moment as it comes—because you’ll never
get another one quite like it. And if you should ever look up and find yourself lost,
simply take a breath and start over. Retrace your steps and go back to the purest place in your heart,
where your hope lives. You’ll find your way again….”
– Thomas Fuller
It was a rough week for me. Daughter Brianna, knowing I was facing a big day this past Wednesday, texted me the above passage. The timing was perfect. Enjoy each moment as it comes because you’ll never get another one quite like it. Amen to that. No hiding it, Wednesday was a challenging day. But sometimes the greatest growth comes through the hardest moments. I’m checking in relaxed, happy, and looking forward to that cold IPA.
Brianna, if you are reading this week’s post, thank you. It really touched me. Grateful.
For our friends in Louisiana, if you’ve found yourself in the path of the storm, I hope you are OK. Know that I—and many others—are thinking about you. And I hope this note finds you happy and well.
Wishing you a great week.
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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