Money Never Sleeps | Can printing $10 trillion be all pleasure and no pain?

August 12, 2021 | Vito Finucci


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Source: usdebtclock.org as of August 2, 10:00 a.m. EST

“If I was Darth Vader and I wanted to destroy the U.S. economy, I would do aggressive spending in the middle of an already hot economy… What are you going to get out of this? You’re going to get a sugar high, the higher inflation, then an economic bust.”

—Stanley Druckenmiller, July 23, 2021

 

As the autopsy on the year 2020 continues, we can comfortably say that the word “unprecedented” became an overused term over the past 18 months. But when it comes to the economy and financial markets, I’m not sure there’s a better word to describe what actually happened in those areas. 

With the benefit of hindsight, we can say that 2020 was a year full of “Black Swans” (i.e. “unprecedented” / unexpected) events:

  1. A global pandemic that has killed more than 4 million people worldwide to date

  2. The first ever complete shutdown of the global economy

  3. The greatest-ever contraction of the U.S. economy

  4. The U.S. Federal Reserve (and most central banks) completely abandoned their playbooks

  5. The embracing of MMT and similar programs


Interestingly enough, the double-dip recession that so many pundits called for in Q4 of 2020 never arrived, and hasn’t so far in 2021 either. But don’t let that fool you, the growth we are seeing now is being “borrowed” from the future. Many parts of the economy that are not lifted by deficit spending remain in pain.

Having been around for some time, I have the benefit of being able to recall past cycles. Everyone loves technology today, and the sector has been very good for investors.

But if you had bought the Nasdaq at the March 2000 peak, and simply held on, it took about 15 years to get back to breakeven. And now, 20+ years later, your annualized return for those two decades would be about 4%. Not terrible, you beat inflation by 2%, but probably not what most would have thought. The prevalent thought prior to the top was that 15% annualized returns were easily had. The moral of that story is this: starting valuations matter. Buying them just two years afterward would have created amazing returns.

For the better part of over a year now, the wind has been at investors’ backs, driven by massive injections of monetary and fiscal liquidity. It hasn’t mattered that inflation is running at its hottest pace in decades, and well above the Federal Reserve’s 2% target. The Fed has declared the bump to be “transitory” (without ever defining what that exactly means) driven by COVID-19-caused bottlenecks and supply chain breakdowns. The majority of investors seem to be accepting of the Fed’s premise, and feel comfortable that the Fed (and other central banks) have it under control. I have my doubts. I think a lot of the bottlenecks are becoming structural shortages. I’ve talked to so many people that haven’t been able to get an appliance for 6-8 months, or need repair parts but have no determined arrival date. And of course, all this happened by design, due to policy. For many, many years, central bankers complained that they couldn’t achieve any inflation when they desired it and used unconventional policies to try to create it – with no success.

Well, inflation is now here, and it’s here with a vengeance. What’s that old line? “Be careful what you wish for, because 
you might just get it.” Have we reached a structural point of change in inflation? We haven’t even seen the rising cost of labour – yet. When the sitting president of the U.S. says, “if you are having trouble finding enough labour, simply pay them more,” well, that’s inflationary, too.

Markets this week gave us another example of how fixed income often doesn’t fit the tidy narratives we construct to understand price movements on a day-to-day basis. The latest example of this was this week’s Fed meeting, where the statement indicated that the FOMC took a step closer to a taper, while Fed Chair Jay Powell made upbeat comments about the labour market, and seemed relatively benign about the economic impacts of a potential fourth wave from the Delta variant. What was the result? Another week of flattening, with the U.S. 10-year declining ~5 bps by market close on Friday, around 1.23%.


And speaking of Mr. Powell I said it about Janet Yellen in the back-end of her term, and I will repeat it about Mr. Powell.

His term as Fed Chair is up in Feb. 2022:

 



Source: Gavekal Research

 

Since he was appointed by the prior administration, my guess is that he won’t be reappointed, and will be replaced by an administration “friendly,” who will try to keep the train rolling. Mr. Powell, to use a sports analogy, is simply “running out the clock” and is not going to do anything to rock the boat or create a disaster on his watch. Right now, he’s thinking ahead to the speaking circuit, where he could command around $100K a speech, and perhaps release a book or two (even though Powell is the wealthiest person to ever hold the position, as a former Wall Street insider at the Carlyle Group). It’s no coincidence that Fed fund interest futures right now are showing the first rate increase to come in March 2022 – you got it – right after Powell’s exit.

The asset valuations are not only in stock markets and real estate. They’re in commodities. They’re in bonds. Even in old collectibles like art, music and wine. Heck, even sports collector cards, which last peaked in 1989, have exploded again. This chart shows the Bank of America’s “High-Yield Spread” for the lowest-rated junk bonds. The spread is the amount by which these bonds yield more than Treasury debt of the same maturity. You can think of it as a measure of excess risk. How much riskier than Uncle Sam are these low-rated companies?

 



Source: FRED Charts


Here is a variation of the Fed balance sheet graph with the Bank of Japan’s assets. Japan has been doing what North America has been doing for the past decade, but they’ve been doing it for 30+ years. The Bank of Japan (BOJ) was buying everything in sight. The blue line represents the US Fed, the red line is the BOJ’s assets:

 



Source: FRED Charts


Keen market observers will know these factoids from recent markets:

  1. Small- and mid-caps peaked in mid-February

  2. Treasury yields peaked around the same time

  3. The U.S. dollar bottomed on May 20

  4. Lumber peaked in June

  5. Credit spreads (as shown above), keep widening

These are historically the most sensitive areas to a strengthening economy narrative. So, what gives?

We are in approximately day 510 or so of 15 days to flatten the curve. Masks are still required, even though the majority of people have now been vaccinated. Interest rates are still at zero, and the Fed and other central banks are still participating in unprecedented (that word again!) QE. Fed repos are about $1 trillion per day right now. Prices of everything are hitting records. Wealth inequality is also breaking records. As one of the best posts I’ve read recently on Twitter said, “when the price of your used car keeps rising, something might be wrong with the entire monetary system.”


The U.S. has added $20 trillion to its balance sheet (nearly 100% of their gross domestic product), or 66% of all its debt outstanding, in just 13 years. I don’t think anyone can logically argue that is the sign of a structurally sound economy. Don’t believe me? What’s happened each and every time the Fed has tried to back off on QE and stimulus? Markets had a hissy fit and sold off, each and every time.

Here’s what U.S. growth in real annualized GDP per capita by decade has looked like:

 

U.S. growth in real annualized GDP per capita by decade

1950s

1960s

1970s

1980s

1990s

2000s

2010s

2020s

(so far)

2.53%

3.06%

2.19%

2.14%

2.10%

0.83%

1.58%

0.13%





Source: FRED Charts

No, it doesn’t seem that anyone is really thinking about the longer-term consequences right now. Most are in a linear, shorter-term thinking patterns. Once dealing with the virus is over, there are many longer-term considerations:

  1. Inflationary pressures everywhere

  2. Dealing with the debt that’s been put on

  3. Changes in social behaviour

  4. Changes in consumer conduct

  5. De-globalization vs. globalization of the past few decades?

  6. Unemployment. There could be up to about 17 million unemployed in the U.S., as initial claims become permanent.

  7. Did all the stimulus really work, and was the price worth it?


The narrative happening right now is to pay for infrastructure everyone can use by “taxing the rich.” Fine on a dais, but how about paying all the prior debt accrued with those taxes instead of taxing more to justify more spending? For decades, increased taxation has become an excuse to put on more debt, when it should be used to pay down what is already on the books.

Obviously, the Fed is still a long way off from raising short-term interest rates. At the same time, government in the U.S. has never been larger or more intrusive. That makes economic forecasting and investing a balancing act between the “supply side” and the “demand side” of government intervention


Inflation isn’t the only worry right now. Even though hospitalizations and deaths from COVID-19 remain way down versus previous spikes, concerns about the “Delta” variant remain, and we can’t dismiss the possibility that some states (countries?) are going to retighten limits on economic activities and schools later in 2021. However, I would suspect that the hurdle to impose new restrictions is going to be very high. Remember, the policy makers are now starting to look at U.S. mid-term elections, which are right around the corner in 2022.

I also wanted to note that we are entering a seasonal time of the year that is typically weaker. This graph shows the seasonal composite of the S&P 500 for the past 10 years.

August has been lower in seven of the past 10 years, followed by September, lower in five out of 10.



Yes, the global economy is recovering, the secular bull market remains intact, and technology remains a big factor to raise future potential growth. In my experience, in all prior cycles, that usually undermines and ends the cycle. The last three bubbles and market downturns ended on a policy error, were all fuelled and exacerbated by the Fed and were preceded by yield curve inversions and excessive valuations.

Such as:

  1. The 1987 low interest rates bubble and one-day drop of 23%

  2. The dot-com peak of technology in 2000–01

  3. The high debt leverage of the subprime housing bubble in 2007–08

Both the Fed and the government are treading on a fine line.

What’s next? It’s not what the Fed says weekly or monthly at FOMC meetings – that narrative hasn’t changed in some time (although the probability that they make a policy error is not zero). It’s what the data (and the markets that front-

run said data) do before they speak at the annual meeting of the globe’s central bankers in Jackson Hole. We haven’t had a decent correction in some time, but that usually isn’t enough of a reason for it to happen when it does arrive. And it will.

History has shown us that the biggest risks in a typical year aren’t usually from out of left field (although that happened in 2020 with COVID-19). Rather, they are usually hiding in plain sight. Right now, there are several to keep an eye on:

  1. Problems with vaccine rollouts and / or potential for different levels of efficacy

  2. Geopolitical tensions with China

  3. Fiscal / monetary policy tightening

  4. A “zombie” economy with stagflation (no growth with high inflation)

  5. Interest rate increase via market forces or U.S. dollar collapse shock

Whether or not some or all of these come to pass, having a well-balanced, diversified portfolio and being prepared

with a plan to be able to react in the event of an unexpected outcome have always been the keys to successful long-term investing. We do our best on a daily basis to make sure we are doing just that.

Be well, 
V


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