The Recovery Stalls; Fed Pledges “Lower For Longer”
With the Fed pledging to keep rates low even when (or if) inflation rises above its 2% target, it is hard to see why long-term Treasury yields (and those of other quality issuers) won’t move toward yields of similar debt in the world’s other industrial economies (i.e., Europe and Japan).
The economic lull is now showing up in both the labor market (Initial Claims) and in retail sales, likely because the extended and generous benefits via Uncle Sam have, at least temporarily, ceased. It is clear the Q2 GDP bounce is almost entirely due to those benefits.
The equity markets continued to tread water for the week ended September 19. Table 1 shows that the popular indexes (S&P 500 and Nasdaq) fell slightly last week, putting the “tech heavy” Nasdaq into “correction” (-10%) territory. The capitalization weighted S&P 500 was also down slightly because the high flying FAANGM stocks [Facebook (-5.3%), Apple (-4.6%), Amazon (-5.2%), Netflix (-2.5%), Google (-4.0%), and Microsoft (-1.8%) (weekly performance shown in parentheses)] make up such a high proportion of the index.
The equal weighted S&P 500 index, one more likely to mirror what 401Ks and diversified stock portfolios are doing, actually rose +0.7% for the week. Table 1 also shows the results since the September 2nd highs. These were all-time highs for the S&P 500 and Nasdaq, and an interim high for the S&P 500 equal weighted index. The latter peaked on February 12th and, as of September 18th, sits -7.5% below that high. With this last piece of data in mind, and looking at the last column of Table 1 for the S&P 500 and Nasdaq, we can now say that these two “tech heavy” indexes have now “caught down” to the performance of the average stock.
The Fed’s Market Impact
Markets, of course, were waiting for the Fed to announce even more stimulus at its mid-September meeting. Instead, the Fed simply formalized the new policies that Chairman Powell announced at the Fed’s annual Jackson Hole symposium in late August. So, no reason for markets to go on yet another tear. (The Fed’s balance sheet stopped expanding in mid-August; the equity markets peaked on September 2nd. Coincidence? I think not!) The formal announcement did add some detail to the Fed’s thinking. They continued to be worried about the recovery:
The ongoing public health crisis will continue to weigh on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term.
In addition, while the policy is now to tolerate 2%+ inflation, they don’t actually see any:
Weaker demand and significantly lower oil prices are holding down consumer price inflation.
The meeting participants’ median plot of the Fed Funds rate is still 0.1% in 2023 (i.e., no change from today) and, the official inflation forecast is: 2020: 1.2%; 2021: 1.7%; 2022: 1.8%; 2023: 2.0%. In the time period, inflation never rises above 2%. Since the new policy is to tolerate more than 2% inflation for a significant period of time to make up for the years it has been below 2%, it is likely that the Fed will hold the Fed Funds rate at or near 0% for a long period after 2023. This leads to a conclusion and an observation:
· Conclusion: Long duration high quality fixed income assets look to be not only safe in this environment, but also continue to have capital appreciation potential (known as “convexity” in bond parlance);
· Observation: The Bank of Japan (BOJ) and the European Central Bank (ECB) have proven that 0% interest rates aren’t a prescription for moving inflation higher:
- Japan’s 0% policy began in 1999. The rate of inflation then was -0.3%. After more than 20 years of 0%, and a bloating of the BOJ’s balance sheet from 20% of GDP to 128% (the BOJ owns both bonds and equities), in August, Japan’s Y/Y rate of CPI growth was -0.4%;
- A similar result has occurred in Europe. The ECB has been at 0% for six years. It’s Quantitative Easing (QE) program has brought its balance sheet up to 60% of the EU’s GDP from 18%. In Germany, for example, the inflation rate was about 3% six years ago. In August, Producer Prices in Germany were -1.2% Y/Y.
One could reasonably argue that the 0% policies of the BOJ and ECB have prevented deflation. The unemployment rate in Japan is 2.9% (was 2.2% pre-virus) and 4.4% in Germany (was 3.3%). Since the “official” U.S. unemployment rate is 8.4% (the real rate is likely twice that level), one could argue that the deflationary pressures in the U.S. are greater than those in Japan or in the EU. So, it would appear that the most likely path of U.S. monetary policy is the one already mapped by the BOJ and ECB. If, indeed, that is the case, as it appears to be, then it is a foregone conclusion that the performance of long-duration high quality fixed assets will be enhanced.
The pitfalls of such policies ought to be recognized. Most of the time they aren’t. In particular, the current policies have a huge impact on income dispersions. In the last cycle, with the unemployment rate at 3.5%, with huge federal budget deficits, with tax cuts, and with the lingering impacts of a bloated Fed balance sheet, the official rate of inflation never got to 2%. That’s because “inflation” is measured as the prices of consumer goods and services. But we did get inflation from those policies, asset inflation, mainly in the prices of stocks, bonds and real estate. That is what we have now, and what we will continue to get as long as the Fed uses QE and 0% (or lower) interest rates prevail. Talk about ever increasing wealth inequality. It looks to be baked into government policy!
Signs of an Economic Stall
The easy part of the recovery looks to be behind us. TSA data and OpenTable show a significant flattening of travel and restaurant activity after Labor Day. Table 2 shows that, after spiking in May and June (re-opening), retail sales fell almost flat in July and August (re-opening pauses).
The reason for the rapid return of retail in May and June was the transfer payments from the federal government (stimulus checks ($1,200) and the enhanced unemployment benefit ($600/week)). Those ended in July (see chart below) and the table shows what has happened to retail sales.
At the same time, consumers used some of those excess transfers to pay down high cost debt (see chart below). After the pandemic of 1917-18, and the Great Depression, consumers became more cautious, and there was a significant rise in the savings rate. This wasn’t temporary, but a change in consumer attitudes that lasted for years. After the Great Depression, until after World War II. Seems like we are seeing a repeat of those attitudes today. The result is going to be a slow-down in the future rate of potential economic growth.
Another sign that the recovery has stalled comes to us via the Industrial Production (IP) Index. In February, the IP Index was 109.3. By April, it had fallen to 91.0, its nadir. By June, it had snapped back to 97.5, and then to 101.0 in July. So, it was just over half-way back. Like the rest of our August data, the improvement here was minuscule, 101.4.
The key to any economy’s health is always its employment data. In the U.S. for the past few weeks, the results have been “mixed.” I would lean toward “disappointing.” For the week-ended September 12th, initial claims (IC) in the state unemployment programs (Not Seasonally Adjusted – NSA) were 790K, and while lower than the 866K of the week before, that 790K is higher than any IC number ever produced outside of the Covid-19 era. And, it means that huge layoffs are continuing. For context, ICs for the state programs are shown in Table 3.
Looking at the middle column, really not much progress. One might feel better after seeing a drop of -1.1 million in continuing claims (CC) in the state programs from 13.4 million in the week ended August 29th to 12.3 million the week of September 5th. That is, until the eligibility weeks are recognized. Yes, it has been six months since all of this began, and eligibility for some appears to have run its course. A drop in continuing claims may just be a function of eligibility, not of re-employment.
Of relevance, too, is the Pandemic Unemployment Assistance Program (PUA), the CARES Act Program for the self-employed and independent contractors not eligible for the state programs. As shown in Table 3, PUA ICs have grown significantly every week in August (re-opening reversals in some states in July mainly impacting small businesses like salons, restaurants, gyms, bars…). Surveys show that small business closures may rise as high as 40% or 50% before some semblance of normality returns. The table and chart, shown at the top of this blog, confirm what the data in Table 3 are telling us, i.e., the employment situation began to deteriorate in early August, with no real sign, yet, of a turnaround.
- The economic rebound has lost its verve; and despite what will be a 30% growth reading for Q3 GDP, the fourth quarter is going to be a struggle;
- The Fed has announced a policy that means lower for longer on the interest rate scene; and lower for longer means that money can still be made in the bond arena;
- But the equity markets appear to have gone about as far as they could without even more monetary ease which was not forthcoming from the latest Fed meetings (although monetary policy is the most accommodative in history); in addition, the equity markets may be getting worried about the impending election;
- We now await a fiscal response (not holding our breath)!