The Recovery Will Be Weaker And It Will Take Longer
While markets were slightly higher on the week (see table), there was a clear rotation back toward technology after several weeks of a lull for that sector. This is clearly shown by the week’s Nasdaq NDAQ outperformance.
Markets continue to ignore economic reality and continue to be focused on a rosy set of assumptions about a rapidly approaching post-virus period with demand so pent-up that GDP and corporate profits explode. In addition, inflation will magically appear. None of this is borne out by the emerging set of economic facts. What happens when markets wake up to reality?
On the unemployment front, in the state programs, Initial Claims (ICs) fell -151K from 1.112 million (Not Seasonally Adjusted) the week of January 9th to 961K (January 16th), a seemingly upbeat number, until one views the Pandemic Unemployment Assistance (PUA) programs. ICs there swelled from 285K to 424K, or by +139K over the same week, almost completely offsetting the decline in the state programs. When viewed from this reality, ICs remained at the +1.4 million level. Think about what that means. There were 1.4 million new layoffs the week of ended January 16th! This is clearly the result of new service business restrictions/lockdowns (which don’t seem to be having much of an impact on halting the virus’ spread). The right-hand side of the chart at the top of this blog tells you that things are going the wrong way in the employment market.
I’ve also included a chart of just the PUA programs. Remember, those programs ended abruptly on December 26th just before the new stimulus bill was passed. Look at the huge dip in the data for the week ended January 2nd. With the arrival of the new stimulus package, PUA ICs are now back to their mid-December levels. Again, the data are going the wrong way!
MORE FOR YOU
“V” vs. “u” Shaped Recovery
In past blogs, I have discussed some compelling reasons, once the virus is contained (a big assumption in itself), why we won’t see a “V” shaped recovery. This is an important topic since markets continue to believe that a “V” is in the cards. To summarize:
- The pent-up demand is in the service sectors. The missed demand is gone forever (i.e., you won’t “make-up” for missed restaurant meals, haircuts, air flights…). And, it isn’t likely that we will wake up on a particular-day to find that the virus has been defeated. It will come gradually, and so will our return to a more “normal” use of those services, i.e., there won’t be a big spike beginning the first day of Q3 as is the current market narrative.
- During the lockdowns, a lot of service sector demand was replaced with increased demand for goods, especially those involving “stay at home” activities. Spending on appliances, furniture, groceries, and home-improvement increased significantly. So did spending on autos (especially used-cars) as the public eschewed the use of public transportation. In a return to a semblance of “normal,” the gradual increase in services demand will be offset, to some degree, if not completely, by a reduction in spending on those “stay at home” goods.
Moratoriums on rents and mortgage payments continue to be extended. That was one of President Biden’s first acts. And while the Federal Government may actually forgive/delay student loan payments, landlords and private sector mortgage holders won’t. This has been left out of most “return to normal” scenarios. In all likelihood, the missed mortgage payments will simply extend the life of the mortgage, i.e., if 10 payments were missed, the mortgage will be extended by 10 months. But not so for rents. Likely back rents will have to be made up. What does that do to consumer spending in the “return to normal” scenario? And, think of who the renters are likely to be – those mainly employed in the services sector?
Finally, the “V” shaped recovery scenario has made assumptions about the rollout of the vaccines, i.e., that we reach herd immunity or close within the next couple of quarters.
- In a recent NY Times piece, 25%+ of New Yorkers say they won’t be getting any of the vaccines.
- Current vaccine rollouts have produced disappointing levels of inoculations; even if President Biden’s lofty goal of 100 million inoculations in the next 100 days is met, the math says that herd immunity won’t be achieved until June 2022.
As is evident from the above, the current “V” shaped recovery narrative is full of overly optimistic assumptions. The reality is that we are in for a much slower grind with pitfalls along the way.
Inflation and Rising Rates
In the “V” shaped recovery narrative, the level of activity is so intense that supply cannot keep up, inflation occurs, and, as a result, interest rates must rise. But, if we simply look around the world, what we find is nearly universal deflation with the most current data showing a move deeper into deflation territory. The table shows annual rates of inflation for the developed world.
China’s +2.5% inflation rate for 2020 is the largest in the table. Much of the issue there is due to the swine flu epidemic in its main protein industry causing shortages of pork and rising food prices. Its “core” inflation rate (ex food and energy) is a meager +0.4%. We currently live in a world where deflation is strong and has been since the Great Recession.
I hear the following all the time: “But what about all the debt and deficit financing that is surely coming? That certainly has to cause rates to rise and/or inflation!” Here are some considerations to allay these fears:
- Biden’s $1.9 trillion stimulus is not a done deal. It is likely to be smaller given comments from both sides of the aisle.
- Japan is the poster-child for this argument. The Bank of Japan owns 50% of Japanese government debt and 7% of the country’s equities. All that debt hasn’t produced inflation for the past 30 years. In fact, Japan continues to be plagued by deflation. The reasons revolve around demographics there (the ratio of elderly/retired to younger/workers); the U.S. and Europe find themselves with similar demographic challenges.
- Last week’s blog contained a chart of sovereign yields. U.S. Treasuries, still the world’s gold standard, are the highest yielders in the modern world. Foreign demand, alone, will put downward, not upward pressure on those yields.
- Zombie companies (those that can’t meet their debt service out of current cash flow) make up 20% of the S&P 500 index. What happens to those zombies if rates rise? In 2021, $15 trillion of debt must be refinanced. Rising rates would bankrupt many of those zombies; last year the Fed moved to make sure that those zombies had access to a liquidity life line, and there is no evidence that their position on this matter has changed. In fact, the Fed has assured markets that rates won’t rise until, at least, 2023.
The other argument I hear about inflation involves the Biden Administration’s stated objective of raising the Federal minimum wage to $15/hour from the current $7.25 rate. “That certainly has to be inflationary,” I’m told. Not so! Every academic study of a rise in the minimum wage shows no or negligible impact on inflation. Those studies show that when the minimum wage floor rises, those industries that employ minimum wage workers take immediate steps to reduce the number of such workers, oftentimes using automation. In our current case, most minimum wage workers are from the already hard hit services sectors. Raising the minimum wage now would only serve to move the “temporarily unemployed” to the “permanently unemployed” ranks. It would be a huge policy error for the Biden team to push minimum wage legislation before the economy “normalizes.” That’s at least some time in 2022 (and, by my reckoning, that is optimistic). The last note on this file is that Economist David Rosenberg’s team modeled a $15/hour minimum wage impact and determined that its maximum impact on inflation (CPI) was 20 basis points (i.e., 0.2 percentage points).
While the equity markets have recently made new all-time highs, there seems to be less enthusiasm. All the action is in the penny stocks and momentum plays (e.g., Bitcoin – see Appendix to this blog). Perhaps the recent $600 gifts from the U.S. Treasury have had a hand in this (i.e., Robinhood traders). We know for sure that in past modest emergency government transfers and in the recent CARES Act gifts, most of the funds were not spent on consumption. They were “saved” in a broad economic sense. Such “savings” includes everything from traditional savings instruments (like bank CDs) to debt pay-downs to “investments” (even including Bitcoin). Reports are that most of the recent funding flowing to equities have been from the “retail” sector (i.e., not from ETF or other fund managers). That has always been a sign that the market top is near. Bob Farrell, one of Merrill Lynch’s legendary investment managers had 10 market rules; one of them was “the public buys most at the top and least at the bottom.”
Markets believe: 1) that the recovery will be “V” shaped, 2) that record levels of government stimulus will continue, 3) that inflation’s return is imminent, 4) that the vaccines will usher in a “new normal” by Q3, and 5) that what is going on in today’s economy doesn’t matter. I have laid out several reasons why the recovery will not be “V” shaped, why deflation will prevail for the foreseeable future, and that herd immunity is not achievable by Q3. What happens to markets when the current narrative is discredited? Is it replaced by another fantasy? Or, does reality set in?
Appendix: Bitcoin and Gold
Some of the luster has come off the momentum trade. Bitcoin surpassed $40K on January 8th (I wonder who purchased at the top price of $40,667?) It closed closer to $30K ($30,818) a couple weeks later (January 22nd), a fall of -24% in just nine trading days. Not long ago, that was called a “bear market” (i.e., a -20% correction). Today, that is just “somewhat volatile!” This is the third such “somewhat volatile” market in Bitcoin since late 2017, one being a -73% correction, the second “only” -40%.
Some refer to Bitcoin as the new “gold.” Like gold, Bitcoins are limited (there can only be so many of them, and the Bitcoin miners must spend more and more time and energy to get a new one). But, unlike gold, the “limitation” is a human pledge and can (and likely will) be broken, either by its caretakers or by hackers. A hacker just needs a powerful enough computer, and we know that such computer power is close at hand. Gold, on the other hand, is physically limited (imposed by the divinity). Can it be created in a lab? Perhaps, someday. (My bet is that the Bitcoin code is broken long before we get lab created physical gold.) Bitcoin has no real intrinsic value, just a set of computer code. Its value is in the belief, by the next purchaser, that it is worth something. Gold, on the other hand, does have commercial uses and has been used in jewelry and art for thousands of years.
The primary purpose of gold in a portfolio is to hedge against financial calamity, be it caused by inflation or just market panic. It is a portfolio stabilizer and protector. Bitcoin, on the other hand, is one of the most volatile things one can put in their portfolio. It isn’t a hedge against financial calamity or panic. Quite the opposite. Owning it will increase a portfolio’s volatility, not stabilize it. “Bitcoin – the new gold!” Are you kidding me?