The markets fully recovered from Covid in the third quarter with the S&P500 back to plus 4% for the year. While the economy hasn’t recovered, the markets are enjoying the Federal Reserve’s efforts to maintain liquidity in the banking system. You can see from the charts below that the Fed has increased the size of its balance sheet from $4 trillion to $7 trillion to combat Covid.
For all intents and purposes, the increase in the Fed’s balance sheet is the modern equivalent of “printing money”. By doing so, the Fed averted a crash with much of the money flowing into the stock market such that stocks returned to pre-Covid levels despite a sharp decline in profits.
By intervening in this way, the Federal Reserve has destroyed the last vestiges of a fundamentals-driven market and replaced it with a market that reflects the exigencies of a political economy. Please forgive me if this seems like a complaint; it isn’t. Our purpose is to grow account values for clients, not to set policy for the US government. As such, we are thankful for this intervention even as we plan for the point where such interventions lose their political appeal.
As I’ve been writing for the last few years, we are experiencing late cycle dynamics in both the economy and the markets. All around the world, it has taken government involvement in domestic economies to move the needle of economic growth. You can see from the chart below that this holds true in the United States as well.
I’ve included this chart before and it shows US gross domestic product (GDP) minus total public debt. Historically, GDP has always been much larger than government debt but that all changed during the 2008 financial crisis. It’s not just in the US; it’s everywhere.
The point is that we have run out of organic growth in the global economy which is a sign that the old post WWII economic cycle is over. Global governments and central banks are attempting to keep the old cycle alive by using government spending and money printing but it’s been 14 years since we experienced real organic growth, which is characterized by growth in productive investment followed by growth corporate profits and remittances to the US government through taxes.
This is clear from a chart of the S&P Bank Index that shows that bank stocks are below where they were in 2006. It takes profitable, growing lending activities to make bank stocks rise and that has been missing since 2006.
We haven’t had bank stocks in our portfolios since 2005 for a very good reason.
The political atmosphere offers further evidence that we are at the end of a cycle. During good times, political competition was akin to a deeply felt sports rivalry but today it has taken on a degree of enmity not seen in my fifty four years. While disturbing, it’s not unprecedented. This type of behavior has historically turned up during major national transitions.
The price of oil supports this cyclical theory. If the global economy were really growing over the past 14 years, the price of oil would be higher instead of lower.
There are many other examples. My main point is that it’s been 14 years since we experienced investment-led growth despite 0% interest rates and massive government deficits. The message is clear – the old cycle is over.
It’s going to take a deep, prolonged global Depression to bring about a new economic cycle but we can already see elements starting to emerge. In many areas, the US is disengaging from the world. We can see this clearly in Europe where the continent doesn’t really matter to the US any longer because the old Soviet Union no longer exists. In its place, we have Russia which is defensively strong but unable to project power around the globe. We no longer need Europe as a counter balance to the USSR, which is why we are demanding an end to trade deals that are favorable to the Europeans and unfavorable to US producers.
China is no longer growing. The pro-western forces of the Chinese Communist Party (CCP) have been replaced by the old guard of Communist Totalitarians. The result is that China’s neighbors are rapidly forming a coalition to protect themselves against expansionist aspirations with India and Japan at its head.
In addition, thanks to its one child policy enacted between 1980 and 2015, China is at the start of a massive demographic decline such that the Middle Kingdom will shortly lack sufficient working age individuals to maintain current economic levels. As China was the locomotive for global economic growth in the last cycle, it’s now clear that global trade will likely continue to decline.
You can see from the chart below that Chinese exports (dark blue line) have largely been in decline since 2014.
The US doesn’t really need global trade because we have excesses in energy and agriculture. Before the 1990’s, we had the industrial capacity to meet all of our own needs and we could get there again within a decade. We have the manpower, infrastructure, and raw materials to accomplish this.
This is why I believe that the next cycle will involve re-industrialization in the US. Europe and Asia are demographically in decline which will hurt production and consumption. Both regions will lack the manpower to produce surplus for export while older generations consume less.
But the US doesn’t have a demographic problem to the same extent as Europe and Asia because our younger generations are equal in size to our older generations. This suggests that we will be able to both produce and consume in the future. This balance of production and consumption should allow us to continue to attract the best and the brightest from around the world.
The problem that we face as a national economy is the transition from one cycle to the next. As cycles change so too does the winners and losers. What worked in the last cycle isn’t guaranteed to work in the new one. Fortunately, the US retains a vibrant entrepreneurial class that has proven itself adept at responding to change. This is a key advantage that separates us from the rest of the world.
During the last cycle, we lost extraordinary amounts of industrial know-how and intellectual property such that our “starting point” is a bit lower than a normal cycle. It also poses a problem for political elements that seek a more equitable distribution of wealth in the US because we lack the industries where wage increases are viable. In a way, you could say that we have to start over.
For the moment, the continuing impact of Covid-19 on small business is proving to be a major barrier to moving forward. So far in 2020, 7% of all small businesses have closed permanently. If we maintain the rate of closures on small business, this number will grow to 12% for the entire year. Let’s not forget that small business employs more than 60% of our nation. This evidence belies the signals given by the stock market that all is well in our economy.
Fortunately, our excellent medical institutions are capable of fighting this dreaded illness. The problem is that our leaders face an unenviable decision as the Covid rates pick up into the flu season – close the economy and destroy small businesses or keep it open and accept an increase in mortality among the most susceptible. Personally, I wouldn’t want to make that decision.
As you can see from the chart below, Chapter 11 bankruptcies are accelerating despite the extraordinary efforts to keep businesses afloat by the federal government.
Bankruptcies have spiked despite the $2.2 trillion spent by the US government in the CARES Act. I shudder to think what would have happened without this legislation but we may soon find out because a deeply divided Congress is holding back on further stimulus. The chart below shows just how much government stimulus aided our ability to consume this year.
As I wrote earlier, the Federal Reserve added $3 trillion to the banking system in response to the epidemic. In many ways, this makes 2020 very similar to 1999 where the Fed added liquidity in response to potential danger from the Y2K transition. And similar to 1999, the beneficiaries have primarily been “story” stocks that rely on belief in a rosy future as opposed to producing real earnings today.
The chart below shows the performance of the S&P500 with and without Facebook, Amazon, Google, Apple, and Microsoft.
All five companies are great in their own way but they are all wildly overvalued compared to a realistic assessment of their growth potential. If we add up the market capitalizations of all five companies, it equals $6.7 trillion or 32% of US Gross Domestic Product.
Amazon alone has a market capitalization of $1.5 trillion or 7% of US Gross Domestic Product despite being an inherently low margin business. Trading at 116X trailing twelve month earnings, the market is effectively forecasting a near monopoly for Amazon in retail spending! If the current cycle follows a similar pattern to 1999/2000, I suspect 2021 is going to be a difficult year for these stocks regardless of the market environment.
We fixate on the stock market because that’s providing sizzle but the real reason for the Fed’s extraordinary intervention was aimed at keeping the bond market from imploding – and by bond market, I mean corporate bonds and municipal bonds. These are the Achilles Heel of the financial system because corporations borrowed aggressively to buy back stock while municipalities borrowed aggressively to fund projects that don’t provide adequate tax revenues.
The chart below reflects the Fed’s influence. The light blue line shows the spike in bankruptcies while the dark blue line reflects the yield on high yield corporate bonds, also known as junk bonds. In normal times, the spike in bankruptcies would have resulted in a spike in junk bond yields but the Fed’s intervention has reversed what would have been a catastrophe for bond holders.
Such is the new reality of investing where the Fed will seemingly bail out bad investment decisions. But this begs the question how long can this last? How long can the Fed bail out companies that took advantage of opportunities in the old cycle when that cycle has clearly come to an end? The chart below shows just how much debt exists relative to corporate earnings. When you realize that much of this debt went to buy back stock and not invested to create new earnings, you start to see the precarious position we face as a national economy.
Nobody knows the full extent of damage done to the economy from the Covid epidemic. Fiscal and monetary stimulus has largely obscured the underlying trends. With interest rates close to 0%, the Fed is running out of road in terms of preventing a bond collapse. In addition, the days of Ronald Reagan and Tip O’Neill sitting down amicably and sorting out their differences are gone. The level of vitriol in Washington creates a real risk that we won’t get another fiscal stimulus until after the election is sorted out – and that could take us well into the first quarter of 2021.
The GeoVest Approach
2020 is a year like no other in the markets save 1999. As such, it pays to be extremely careful when extrapolating market trends because the risk of reversal has to be weighed alongside the impact of intervention. This makes reliance on historical comparisons untenable.
This is why we have chosen to maintain our disciplines at the expense of short term performance while looking beyond the present confusion for long term sustainable trends. We are also putting in game plans for a variety of different election scenarios, knowing each outcome could provide opportunities and threats.
We wish all of our clients and friends good health and hope that you and your families continue to thrive during these difficult times. Thank you and it is our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer