July 31, 2020
By Steve Blumenthal
“So I’m agreeing with Gary on the deflation front but to a point.
We know we’ve had a demand detonation, but at some point, at some point
when we have herd immunity or we get a vaccine (in the next twenty-four months or so),
demand will stabilize.
I like to stay ahead of the curve, in three to five years from now, we should
contemplate what the world will look like when we fully reemerge because
with this [large increase in] money supply, it will be sloshing around.”
– David Rosenberg,
President and Chief Economist & Strategist, Rosenberg Research
(on a client call with A. Gary Shilling and David Rosenberg, July 27, 2020)
News flash: The 10-year Treasury yield falls to 0.52% after record GDP contraction. The yield on the 30-year Treasury bond was lower at 1.18%. The bond market has it right.
Every weekday, an Axios Markets email hits my inbox. This morning’s post caught my eye: Five years of U.S. economic growth vanished in the span of three months. From Axios:
- The decline between April and June brought the U.S. GDP back to levels last seen in 2015.
- While we fell into the hole swiftly, economists are dashing hopes of an equally swift recovery. They warn it could take years for the U.S. to recover.
Check out the following chart.
Source: Axios Markets
Meanwhile, record-breaking economic drops are being recorded across the globe.
- Massive economic contractions happened across the European Union, data out this morning shows: Spain’s economy fared the worst with an 18.5% drop from the prior quarter.
- Mexico’s Q2 GDP fell 17.3% from the prior quarter—the biggest quarterly contraction on record, according to data released yesterday.
One of our trade execution partners sent us a note late yesterday afternoon. We see a very large buy order for the junk bond ETFs. Wonder who that could be? I want my SPV.
Now look at them yo-yo’s, that’s the way you do it
You play the guitar on the MTV
That ain’t workin’, that’s the way you do it
Money for nothin,’ and your chicks for free
Now that ain’t workin’, that’s the way you do it
Lemme tell ya, them guys ain’t dumb
Maybe get a blister on your little finger
Maybe get a blister on your thumb
– “Money for Nothing,” Dire Straits
Money ain’t for nothing, get your stocks for free (and junk bonds too).
As a subscriber to David Rosenberg’s daily research updates, I was invited to listen to a web call on Wednesday, July 27, 2020. The call featured A. Gary Shilling and David himself. It was excellent. Both sit firmly in the deflationary camp, seeing U.S. Government rates declining even lower. Neither have moved off their bullish bet on the 30-year Government bond. David said, “What idiot would buy a 30-year bond on December 31, 2019? The idiot that wanted a 30% return due to the decline of rates from 2.40% to 1.25%.”
That was pre-pandemic, and the economy was already slowing. As indicated, we touched a yield of 1.18% yesterday.
Gary, David, Dr. Lacy Hunt, and your humble OMR author were in the bullish long-bond camp in late December. We all think rates will move lower. We could be wrong, of course. For now, deflation has us in its grips. I believe policy response will eventually lead us to inflation (actually “stagflation”—low growth coupled with price inflation) in two to three years.
Gary and David pointed out something many investors forget. Because rates are low, further declines in interest rates equate to a large price appreciation gain in bonds—something called convexity. It means the price appreciation gain for every basis-point drop in yields on a bond yielding 1.18% is higher than for the same basis-point drop for a bond yielding 5%. However, one must get the directional call right, for the convexity play works both ways.
So where do we go from here? Grab that coffee and find your favorite chair. You’ll find my bullet-point notes from that terrific Shilling-Rosenberg call. David said, “Would anyone have thought that after a 45% rally in the S&P 500 from the lows that we’d be sitting at 1.25% on the long bond right now?” You go through all the money printing, all the optimism around re-openings, and this is what you get in the Treasury market? Yields down from 1.80% to 1.25%? You have to ask yourself, “What is the bond market telling us?” Read on for my summary notes from the excellent Shilling-Rosenberg call. You’ll also find a link to Dr. Lacy Hunt’s most recent quarterly letter (worth the read).
The link to Wednesday’s Trade Signals post is below as well. The signal dashboard is mostly green across the board. Bonds and gold trends remain bullish and investor sentiment is neutral. It’s been a great month for high yield. Fundamentally it makes zero sense, but there is money in those SPVs and the big guy is buying. The trend in HY is bullish. Ditto for equities, with the FANGMAN stocks providing the bulk of the lift.
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:
- A. Gary Shilling and David Rosenberg – Notes from the Research Call
- Trade Signals – Stocks, Bonds, and Gold Continue Rise as COVID-19 Maintains Grip on US
- Personal Note – How We Think About Wealth
Following are my bullet-point notes from the call. I hope you find them helpful.
First up, A. Gary Shilling’s thoughts:
- Gary sees an equity market that is similar to 1929-30. After the crash, the stock market recovered 52%.
- Everyone thought all was OK; however, the market then retraced 75% of the decline.
- Recently, when we reopened the economy people gathered and the virus spread rapidly in places like California, Florida, and Arizona. COVID-19 won’t go away until we get a vaccine and that is many months or maybe even years away.
- COVID is a huge disruption to the economy, to supply chains.
- The big fight is between those who think fiscal and monetary stimulus is so great that you don’t have to worry about the basic economy, and those like David Rosenberg and A. Gary Shilling who think the basic economy is important.
- We are going to see as time moves forward that the economy is not going to be revived in the second half of the year. You don’t see the notion of a “V” shaped recovery mentioned much anymore.
- Gary sees an L-shaped recovery with a downward-sloping lower leg. We are getting an agonizing reappraisal now.
- A rally in bonds preceded stocks in January this year and it wasn’t until Feb.19 that stocks keeled over. Bonds were anticipating the recession, and he thinks the recent rally in bonds is telling a similar story.
- Gary believes the rally in bonds is foretelling of a coming 40 to 50% decline in the S&P.
- You have a real bifurcated equity market. Just a handful of stocks account for more than a quarter of the index, which is more concentrated than in 2000 at the peak of the dot-com bubble. If you look at industrials, consumer cyclicals, and financials, they are down 23% from their pre-recession peak.
- Anybody long those stocks would be asking, “What sort of bull market are people talking about?”
- Interestingly, David tracks a “stay-at-home” index (the tech and delivery part of the market) and a “reopening” index, which he created. The stay-at-home index is absolutely walloping the reopening index.
- So maybe if we dig beneath the surface, the stock market—absent a few big names—isn’t telling us anything different than the bond market is telling us.
In terms of economic statistics, David said,
- “I have stated this repeatedly—people hate me to say it—but we are in a depression. If you read history books, you learn that the dynamics of a depression are different than the dynamics of a recession. Because recessions invoke a secular (long-term) change in behaviors.”
- Classic business cycle recessions are forgotten about a year after they end. So, we want to take a look at the things that tell us there is a fundamental change in behavior. What he is focused on:
- Personal savings rate.
- Spending behaviors: How much and where are households spending their money? This because consumers drive 70% of the economy.
- We are finding that people are spending money not on what they want, but on what they need.
- Savings are at a new secular high. This will have a meaningful impact on any potential recovery. [SB here: Your spending is someone else’s income. Less spending means lower growth.]
- He’s also focused on the growth rate in part-time employment. Part time has outperformed full time by a factor of 4 to 1. People blindly look at the headline numbers and draw the conclusion that the labor market is healing. “No, not really—the labor market is not healing.”
- David added, “I’m also looking at the liquidity ratio in the corporate sector. You find that corporations are using the words, cash conservation, balance-sheet strength, etc. This is about survival of a business. Notwithstanding their nose-bleed valuations, there is something to be said about survival.”
- [SB here: Governments spend, corporations spend, and people spend. If there is less spending, the economy slows. If there is too much debt, more money has to go toward paying off the debt. If the overall economy slows, earnings slow. This is in conflict with record-high stock market valuations. Government is stepping in with the spending and the manipulation of stock and bond market prices. My point is the stresses are real, large, and not going to go away soon. Thus, seek growth but risk-manage against extreme downside, because no one knows when the confidence in the government’s ability to hold up the house will be lost.]
- As for the economy, Rosie is focusing on behavior change coming out of the crisis. Makes sense.
A bit of trivia from Gary: The word depression in the 1930s was used to replace the word panic, as authorities wanted a softer connotation. That changed… Today, we all know the implications of a depression.
David said to Gary, “Only you can use the word depression and make it optimistic.”
To which Gary replied, “David, we are both struggling to see who can be the most optimistic.”
Gary was asked, “You are getting signals from the bond market, how much is left in the bull market tank?”
- Gary’s been a bull since 1981. He wrote a book back then titled, Is Inflation Ending: Are you Ready?
- In it, he wrote: “Inflation is ending and you are not ready. Stocks and bonds are going to do well as inflation unwinds.”
- He recommended long-term Treasurys. The longer the maturity, the better the gain.
He said, “People ask me if I would buy Treasurys today with long-term yields at 1.40% (the 30-year is at 1.18% now).” His answer:
- He doesn’t care what the yield is as long as it is going down.
- He buys Treasurys for the same reason people buy equities: for appreciation.
- Since October 1981, L/T Treasury bonds have outperformed equities by six times.
- He doesn’t think the rally is over. And because of convexity, with rates so low, the appreciable gain is even higher.
- Inflation vs. deflation is about supply and demand. Gary thinks we are heading for deflation. When you have excess supply around the world, you get deflation.
- Unless we cut off imports, we are going to continue to see excess supply, so he expects we may see another 100 bps decline in Treasurys.
He doesn’t believe we will see negative interest rates. Japan and Europe show that doesn’t work: “Thank you very much, we are not going to bother.”
- He thinks we are going to see further decline in yields. With deflation, you want to be long Treasury bonds.
David’s view on bonds:
- Gary and David are going to come to the same conclusion.
- Here are some data points:
- The guys on bubble vision at the end of last year would say, “What idiot would buy a 30-year bond on December 31, 2019 at a yield of 2.40%?”
- David’s answer is that the idiot that wanted a 30% return due to the decline of rates from 2.40% to 1.25%. That’s the idiot that would buy.
- The U.S. Treasury Bond yield at 1.25% is an absolute bargain.
- The German long bond yields negative 0.08%.
- The Netherlands long bond is negative 0.07%.
- Switzerland, negative 0.39%.
- He doesn’t believe Canada is a better credit than the U.S. The long Canadian bond yields 0.98%. France: 0.5%, UK: 0.62%.
- Spain and Portugal are about 1% and those are triple B-rated bonds. The U.S. last he saw is still AAA.
You have to ask, “Would anyone have thought that after a 45% rally in the S&P 500 from the lows that we’d be sitting at 1.25% on the long bond right now?”
- So, you have to think to yourself, You go through all the money printing, all the optimism around re-openings, and this is what you get in the Treasury market? Yields down from 1.80% to 1.25%?
- You have to ask yourself, What is the bond market telling us? What happens if the stock market goes down? What happens if we reach the fiscal cliff? What happens if there is some policy mistake? And if there aren’t enough downside risks, now we are in a geopolitical riff with China?
- So, what happens to the long-bond yield if the stock market goes down? Normally, they are inversely correlated. There will likely be a race to safety (more demand for bonds, lower yields).
- The stock market is so concentrated that if these mega caps correct, the rest of the market will not be able to rally enough to offset it. Where does that take equities if the mega caps roll over?
- Where do you think the flight to safety then takes Treasury yields? A lot lower.
- You can argue that we are in the late stages, but he doesn’t care if it’s the 7th or 8th inning in the Bull Run. What’s more important is that there is probably an inning or two left.
Gary noted that there is a high 60% correlation between inflation and interest rates. So, keep an eye on inflation. In other words, if you are right on inflation, you are going to get most of the move in Treasury yields right. It is inflation that most affects Treasurys.
- If you are in the deflation camp, you’ve got to be long Treasurys.
- The question is, Is monetary stimulus going to be so big that it will create inflation?
- Gary said, “Well, we had that post-2008. The money went into stocks. Gains not driven by economic growth but by excess funds, corporate share buybacks—not great economic growth.”
- The Great Financial Crisis affected just a few people. Mortgage and housing and took out a few big banks. This event is much greater than that. This will overwhelm everyone, everywhere. The monetary stimulus is small in terms of overall economic impact.
- David mentioned the need for recurring stimulus. No doubt we are going to be seeing much more stimulus.
- There is another $3.5 trillion fiscal plan proposed in the House and a $1 trillion plan proposed in the Senate, and there is no way to stop the Fed—they are full speed ahead.
- We have an output gap of 7% between aggregate supply and aggregate demand.
- This is very consistent with a depression.
- How do you close that gap if you are an academic working at the Fed?
- The Fed has to synthetically create a negative interest rate of -14%. David doesn’t believe the Fed can go to negative interest rates, so they will do this by printing money.
- To do this, the Fed balance sheet has to go up to at least $11 trillion. So, call it another $4 trillion. Maybe we’ll just create asset bubbles the whole way through. That’s the side effect of what the Fed is trying to do for the greater good, which is to put a floor under deflation.
- If they don’t eliminate the output gap, the deflation is not going to go away.
- We have to figure out what that time frame might be.
- To get to -14%, the Fed has to take the balance sheet to $14 trillion. Maybe we create asset bubbles even more…
From David: “So I’m agreeing with Gary on the deflation front, but to a point. We know we’ve had a demand detonation, but at some point, at some point where we have herd immunity or we get a vaccine in the next twenty-four months or so demand will stabilize.”
David also said, “I like to stay ahead of the curve. In three to five years from now, we should contemplate what the world will look like when we fully reemerge, because with this money supply, it will be sloshing around.”
- We’ve had a 37% growth in M1, a 24% growth in M2, and velocity is collapsing (Gary is right), but we can’t assume that is what will be in three to five years from now.
- There is risk of inflation on the other side of this, so we can’t be overly complacent.
SB here: I’m going to stop here, as we are thirty minutes into a sixty-plus minute research call and your eyes are likely turning red. I’ll share the balance of the conversation next week. Two very smart and successful economists and investors. Take their thoughts in. More next week.
My view remains unchanged: Deflation now, inflation later and I’ll keep you up to speed with the recession and inflation data I share with you each week in Trade Signals.
Here is a link to Dr. Lacy Hunt’s most recent quarterly letter. Worth the read if you have the time.
July 29, 2020
S&P 500 Index — 3,227 (open)
Notable this week:
No major changes to equity and fixed income indicators this week. Fixed income and equity signals remain bullish, notwithstanding a raft of macroeconomic, political, and public health issues. The current news cycle consists of today’s FOMC statement following its two-day policy meeting, debate, confusion, and negotiation of Congress’ next economic relief package, corporate earnings announcements, state and federal responses to COVID-19, protests (and law enforcement response) in major U.S. cities, and continuing spread of COVID-19 infections in the majority of U.S. states.
Notably, Ned Davis, founder of Ned Davis Research, published a note today regarding short-term sentiment on equities, the dollar, and gold. Ned notes that the NDR Daily Trading Sentiment (which we monitor and discuss below), has hit “mildly excessive optimism,” which is a bearish signal for stocks. Additionally, Ned states that foreigners have been record buying U.S. equities, while there’s been record corporate selling. Finally, according to Ned, gold is not yet overbought.
Consumer confidence dipped in July, due to concerns about coronavirus spread. The Conference Board’s Consumer Confidence Index fell 5.7 points in July to 92.6, below the consensus of 96.0. On a year-over-year basis, confidence is down 43.2 points, near its steepest decline since the Great Financial Crisis, and consistent with recessionary fears.
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.
Just a quick thought on portfolio risk management: I’m not worried about the stock market and I don’t think you should be, either. I am uber-concerned about not losing my core wealth. It’s about having a game plan. At my firm, we call it “Core and Explore.” Simple, yes, but it works.
We believe it is vitally important to defend and carefully grow core wealth. This is where risk management comes into play. Protect the core. Doing so enables you to explore with the balance of your wealth. If you have great conviction in the return of your “explore” investments, hold them, and add to them as the businesses improve. For my largest personal holding (a private equity investment), I’m looking out ten years or more.
Meanwhile, if you are an unaccredited investor and unable to access private investments, there are still ways to “explore.” We’ve recently added ARK Invest Disruptive Technology Portfolio – a high-conviction top-ten stock ideas strategy to our TAMP platform. It will be volatile but I believe the rewards in ten years will outpace the S&P 500 Index. There are no guarantees, of course.
Partner John Mauldin and I share our thinking around Core Wealth and Explore Wealth in a paper titled, “How We Think About Wealth.” If you’d like a copy of the paper, click here.
Thanks for reading. Hope you found the Shilling-Rosenberg notes insightful. 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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