Ain’t Misbehavin’
Like a modern muse, I find that music from different genres and time periods helps me to understand and articulate the prevailing forces of the day in ways that a wider audience can relate. This isn’t a coincidence as the word music is derived from the Greek word “mousike” which means the Art of the Muse.
I chose the title because at GeoVest, we “Ain’t Misbehavin’” which is a song about a young man in 1929 who isn’t interested in the roaring night life that preceded the 1929 stock market crash. At GeoVest, we’ve maintained our disciplines and perspective during these unusual times but the same can’t be said for other market participants. At a time when the Federal Reserve has made it their mission to prevent bad investments from hurting investors, some investors see it as an opportunity to make larger returns by using ridiculously risky investments in the belief that the Fed will always be there to bail them out. It has largely worked but there are some investors who have been so ridiculous in their decisions that not even the Fed can bail them out.
A couple of months ago it was Greensill which was supposedly a “supply-chain finance firm”. In the old days, we called this business factoring and it was a great business if you knew what you were doing. It’s how Goldman Sachs got its start. Unfortunately, for the major Wall Street banks that financed Greensill’s risky portfolio, the firm was investing in risky projects run by unscrupulous people. Naturally, the Fed needed to make sure these projects were liquidated without incurring a domino effect in the markets. In Greensill’s case, the UK government is one of the biggest losers as it will cost UK taxpayers billions of dollars in fallout.
The latest evidence of silliness comes from Archegos Capital Management. In this case, the firm borrowed money from major Wall Street banks to make levered investments in some really questionable companies like ViacomCBS and Farfetch. Both are what I would call terrible businesses. The only thing that made them attractive was the heavy short position that hedge funds had on both companies. When firms like Archegos started buying these stocks in 2020, thanks to the Fed flooding the market with liquidity, short sellers were forced to buy back the stock they had “sold short” making both companies jump in 2020. Both had heavy short positions on them because other investors saw what I see – terrible businesses that are over-valued.
Not content with the strong gains experienced in 2020, firms like Archegos got greedy and used complex strategies to increase the amount borrowed from Wall Street firms, normally 50% of the value of the stock. When ViacomCBS dropped from 100 to 45 in March, the losses were magnified. Credit Suisse, one of the great old Swiss banks, is believed to have lost $5 billion in their dealings with Archegos while their losses due to its relationship with Greensill are still unknown.
The Federal Reserve
Not willing to risk a domino effect like we experienced in 2008 when the insolvency of Lehman Brothers caused the stock market to crash, I believe the Fed engineered another “pop” in the stock market into the end of the first quarter.
The Fed has created the “Moral Hazard Paradox of Financial Safety Nets”, coined by John Crawford in the Cornell University Journal of Law and Public Policy in 2015. The paradox is that each time the Fed bails out the stock market, they incentivize more bad actors such as Greensill and Archegos to develop even riskier strategies to take advantage of the Federal Reserve’s benevolence. In this way, the Fed is caught in a web of its own making and they are the ones who are making the system increasingly unstable.
As I see it, if the Fed fails to support the market just one time, the markets will crash.
Economic Growth
In addition to incentivizing risky behavior in the markets, the Federal Reserve also de-incentivizes real investment of corporate earnings and cash flow. Instead, thanks to stock options, corporate America invests as little as possible to maintain operations in the US while using corporate cash flow plus borrowing in the bond markets to use the proceeds to buy back stock. Corporate Chieftains get the majority of their compensation through stock options and those options increase in value when the value of their company’s stock goes higher. The fastest way for a company’s stock to move up is by having the company buy back its own stock. I’ve mentioned in the past how this behavior has destroyed once great companies like General Electric. But it also has another impact – it hurts US economic growth.
This situation is reflected in the flat corporate earnings of the past ten years. Yes, earnings per share have risen but not total earnings. If we use corporate earnings as a proxy for US GDP growth, it shows that corporations have had no impact on the growth of the past ten years.
This is why it was so important for the federal government to act quickly when Covid struck a year ago; companies weren’t about to invest aggressively when the Fed lowered interest rates. Instead, US federal debt has grown by $4.9 trillion over the past year and that’s before the $1.9 trillion from President Biden’s Covid-relief bill is added in. In addition to this recent bill, the President is attempting to garner support for another spending bill that will invest $2.5 trillion infrastructure. For all intents, the government is taking over the role that was once reserved for business.
Inflation
With the US government injecting nearly $5 trillion into the US economy over one year combined with the Federal Reserve injecting an additional $3.2 trillion into the US banking system (markets), you would expect inflation to rear its ugly head. And it has.
The only question is whether this inflation is sustainable?
When you consider the last 12 months, we experienced a pandemic, a global economic shutdown, restrictions on travel/gathering, and unprecedented levels of government spending without a war. People had to rapidly change the way they work and the way they attend school. This resulted in a sharp drop in demand for services such as vacations and a huge, short-term increase in demand for electronic devices, exercise equipment, and building materials, among others. When demand is greater than supply, prices rise.
If the higher demand for these products proves to be permanent, suppliers will increase the amount produced to the point where prices move lower. That’s not possible today because the global supply chain has been shocked by the impact of Covid such that ships, trains, trucks, and containers are caught in bottlenecks all around the world. The most obvious of these bottlenecks occurred when the Ever Given ran aground and blocked the Suez Canal. Over three hundred ships were stuck at various points along the canal. Lloyds of London estimated that the cost of the blockage was $400 million per hour for six days! Bottlenecks such as the above example add to the cost of shipping items ranging from raw material to finished goods. When you consider that a generation ago, manufacturers held large inventories of material inputs to maintain production until new material was delivered to holding no surplus inventories and relying on an efficient supply chain to keep the assembly lines humming, you can see how pernicious the current situation is. Assembly lines are forced to stop until inputs arrive and that adds a lot to the final cost of items regardless of where they’re produced.
The point I’m trying to make is that we have no idea whether the inflation we are presently experiencing is temporary or permanent. Much will depend on whether the federal government can continue spending trillions of dollars on stimulus plans.
Markets versus Economy
If we’ve learned anything over the past twenty years it’s that when the Federal Reserve increases money supply, that money goes into the markets as opposed to the economy. When we combine this sentence with our previous discussion of the impact of stock buybacks on the economy, we get the picture of an economy where major corporations don’t see lower interest rates as an opportunity for growth. Instead, lower interest rates make borrowing money for further stock buybacks cheaper. In this way, lower interest rates do not help the economy as they once did.
If you look at this situation from the bank perspective, they can take the risk of lending that money to a risky borrower or they can put that money to work in the markets where they are increasingly sure of generating a positive return with less risk. They’re going to choose this easy route all day.
We can see this illustrated in the chart below that represents the Velocity of Money. The definition of which is GDP/Money Supply or the size of the economy divided by money supply.
Velocity of money has been declining for 25 years and it indicates how the Federal Reserve’s policies are increasingly proving futile as it relates to the economy. The Fed has sparked inflation in asset prices but not in general economic prices. This is why I’m more sanguine about the threat of inflation than most other analysts.
Today, the real threat of inflation comes from the US government.
Demographics
Demographic analysis is a slow moving yet highly accurate predictor of future economic activity. It takes a fertility rate of 2.1% for a country’s population size to remain constant. The extra 0.1% accounts for mortality prior to adulthood.
Most of the consumption in an economy takes place between the ages of 30 and 65. This makes sense when you consider that this 35 year span represents our primary working/earning/spending years.
The good news is that the US is set to experience a small expansion in economic activity thanks to children born in the early 1990’s reaching their 30’s. It suggests that we’re looking at flat economic activity for the next ten years.
Unfortunately, this isn’t the case for the rest of the world. Japan’s fertility rate is 1.4%, China’s fertility rate is reported as 1.6% but is widely believed to be 1.1% due to its former one child policy. Western Europe is in economic trouble as its fertility rate has averaged around 1.5% for the past 50 years.
Putting this all together, it suggests economic contraction for Western Europe, Japan, and China with the US holding steady. Some will disregard this data but demographics are the most accurate economic variable that exists.
The GeoVest Approach
Corporate America has been in “harvest mode” for the past forty years and this is why Federal Reserve policies have a greater impact on markets than on the economy. That’s going to need to change before much longer because our biggest trading partners are rapidly aging as well as turning “hostile” in some cases.
For the next few years, we’ll continue to focus on government-driven investment ideas as the government becomes a bigger portion of the economy. I view this as a temporary situation until market forces once again move to the fore.
With less consumption coming from Asia and Europe, we’re at greater risk of deflationary pressures as opposed to inflationary pressures, with the caveat that the US government is somehow held in check from all-out spending. This suggests that we can expect interest rates to stay low for a long time and the Federal Reserve to maintain its focus on the markets.
Regardless of the direction this takes, at GeoVest, we will be prepared to remain vigilant to ensure that our clients continue to prosper from the vicissitudes of our present economy. Thank you for investing with GeoVest. It is our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer
