Summary: the stock market’s rise since its extreme sell-off in March isn’t surprising, given the degree of government support that has been provided by the Federal Reserve and Treasury. But this support may have unintended consequences, and it could induce inflation, which most investors are unprepared for.
About two months ago the United States enjoyed its lowest rate of unemployment in the past fifty years. Since that time nearly 40 million people have lost their jobs and the US has reached its highest rate of unemployment in eight decades. Air travel, hotel stays, and most brick-and-mortar retail shopping virtually ceased, threatening sector-wide bankruptcies that have begun with some familiar household names, including Nieman Marcus, J.C. Penney, J.Crew, Hertz, Gold’s Gym, and Pier 1. Even as the coronavirus has swept across the US, multiple hospitals have closed and countless medical practices are threatened with insolvency for a lack of patients. Global supply chains have been thrown into disarray, farmers have been destroying unharvested crops and culling herds, and a glut of oil supply briefly drove the price to buy a barrel in the US below zero, meaning that traders would pay you to take this essential commodity that it took some $50 per barrel of input costs to produce.
The commercial mortgage market has been teetering on collapse, as many business tenants have ceased making rental payments to their landlords. Prices for residential real estate, meanwhile, have risen due to a dearth of supply, with the median price of an existing home in the US rising to a record high in April. In mid-May the Mortgage Bankers Association reported that 4.1 million homeowners were in mortgage forbearance plans and overall 8.16% of all mortgages in the US were past due.
In the midst of all this, financial markets are witnessing a strong bull rally in bonds and stocks, with the S&P 500 Index (SPX) up +43% and the Russell 2000 Index (IWM) up +52% from their lows in late March. The S&P sits at about -5% below its all-time highs reached before the coronavirus pandemic, and above where we were at this time last year.
In our email of March 15, written in the midst of the sell-off, we wrote: “There is some reason therefore to think that after the virus is contained the economy and financial markets could come roaring back with a quickness that rivals its recent decline. This possibility means that investors cannot reasonably ‘go to cash’ with the bulk of their portfolio.” This assessment seems to have been borne out thus far, although it’s premature to say that the virus is “contained.”
What’s going on? Our answer, which may be surprising, is that everything is more or less proceeding according to plan. This suggestion may sound absurd at first hearing, but consider: as the gravity of COVID-19 became widely appreciated in March, state and Federal governments set about a coordinated plan to fight the virus. This fight (the war analogies were explicit) involved intentionally separating the real economy from financial markets, not just in the United States, but across the world. Everything may be proceeding more or less according to governments’ plan, but the plan is still fraught with enormous execution risk and the possibility of longer-term unintended consequences.
It’s dangerous to try to float financial markets on government stimulus while shutting down economic production, and it can only go on for so long—how long, nobody knows. But the advent of rioting and looting across American cities in the aftermath of the George Floyd tragedy suggests not much longer. Would legitimate protests have morphed into violence if the lockdown hadn’t been in place? This is a question worth pondering. Given what we knew about the virus in February and March, the economic shut down was defensible, and perhaps the most reasonable course of action available.
Travel and industry were forcibly closed and over 90% of the US population put under “stay at home” orders to slow the spread of the virus, even as financial markets remained open. More importantly, financial markets weren’t left to themselves, but immediately received trillionsof dollars of subsidy from the Federal Reserve, which already dwarfs the entire monetary response to the 2008-2009 financial crisis. The European Central Bank, Bank of England, and other central banks deployed subsidies that are even larger than the US’s, relative to the frequency of their currencies’ use. Japan, which has the third-largest economy in the world, recently doubled its COVID stimulus package to $2.2 trillion or 40% of the country’s entire annual economic output. The total amount of US government stimulus deployed in 2019 is estimated to be equivalent to a full five years’ worth of Federal tax receipts.
This Response is Different
Unlike the government response to the 2008-2009 financial crisis, the present bout of government stimulus packages from central banks and treasuries has three important features: first, it has come very quickly, in a few weeks instead of many months. Second, financial authorities across the world have responded uniformly, with more or less coordination. Also unlike ’08-’09 is a widespread determination by governments to push money into the entire economy and into the hands of ordinary businesses, individuals and families, and not just to provide financial liquidity that remains trapped inside the banking system.
The US Treasury began mailing $1,200 checks to home-bound workers and paying supercharged unemployment benefits to those already furloughed or laid-off. According to a University of Chicago study, over 60% of unemployed workers are currently receiving considerably more in unemployment benefits than they did in income when they were working full-time. In the United Kingdom, the central government directly assumed responsibility for most companies’ employee payrolls and the Bank of England began printing money directly into the government’s checking account in order to fund its pandemic response measures. Thus far the Bank of England has created half a trillion pounds using this “temporary” policy of direct monetary financing, which is historically associated with failed banana republics, and not the founding country of modern capitalism.
In the United States the Federal Reserve has hired BlackRock, the largest investment manager in the world, to oversee a portfolio of corporate paper, bonds, junk bonds, and municipal bonds on its behalf, funded by new money that the Fed creates. The Fed even has a Main Street Business Lending Program (MSBLP) that will make loans directly to small businesses. The only asset class that the Federal Reserve has yet to buy directly is equity, and this will surely come when the next crisis hits. (The Swiss National Bank and the Bank of Japan have been buying stock exchange-traded funds for years in order to manipulate their currencies and stimulate their economies.) Thus the pandemic has prompted the gradual nationalization of financial markets by the central banks and government treasuries across the developed world.
Nothing in the Federal Reserve’s legal charter empowers it to take these extraordinary measures. The Fed’s gotten around this inconvenience by having the Treasury make the actual purchases, while it provides the financing. This workaround has the effect of fusing the Treasury with the Fed, in spite of the fact that the former is meant to be a creature of the sitting presidential administration, and the latter is meant to be politically “independent.” The Fed is now committed—in a presidential election year, no less—to provide unlimited financing to the Treasury to boost the stock and bond markets. President Trump hasn’t been shy about trying to influence Fed policy via Twitter.
But now he needn’t take such an indirect route, since the Treasury secretary serves at his pleasure. If the stock market falters before the November election, Trump’s appointee will have a new and powerful tool to do something about it.
Taking full view of the size and scope of the government response to the pandemic, it shouldn’t be surprising that financial markets have rallied since the sharp sell-off in March. Large public companies and the wealthy have generally avoided the harshest effects of the lockdown measures, which have fallen disproportionately on the poor and on independent, small businesses. According to the Federal Reserve, 63% of workers with a college degree can fully work from home, while only 20% of workers with a high school degree can do so. The Fed also estimates that a full 40% of households that earn less than $40,000 per year and had a job in February lost that job in March. The recent rioting and looting across the United States only serves to aggravate the collateral damage from the pandemic response: outside perhaps of corporate commercial real estate, the unrest will disproportionately harm small business owners and the urban poor.
Assessing the Virus
Markets price in known risks. As the COVID-19 pandemic has unfolded, it has increasingly become a “knownunknown,” and to that extent the market can adjust to the risks it presents. We don’t know whether a vaccine will be developed or if so, how long it will take, and we don’t know how many or how severe follow-on waves of infection will be in the future. But we do know a lot more now that we did in late February and early March, when the market began to crash. We now know that the US hospital system had enough capacity to meet the initial surge in acute infections and that for most people under 65 and without certain underlying conditions, COVID-19 appears to be less life-threatening than the ordinary flu. In our home state of Pennsylvania, the median reported age of death from COVID-19 is 84, while general life-expectancy in the state is just 78. The majority of reported deaths have occurred in nursing homes.
Compare the economic significance of a virus that does not seriously threaten the working-age population, like COVID-19, with the Spanish Flu epidemic of 1918, in which half of all deaths occurred among otherwise young, healthy people aged 20-40. Now that government lockdowns are easing, and evidence is emerging that some lockdowns may have been too broad or long-lasting, we may witness an additional relief rally in financial assets, as investors get further clarity about how extensive the longer-term impact of COVID-19 will be. The great challenge in the coming months will be the re-coupling of financial markets with the real economy, which will be made harder by the civil unrest. Everything may be proceeding more or less according to plan so far, but “the plan” is still fraught with enormous execution risk and longer-term unintended consequences.
Recommendations
We draw several investing lessons from the experience of the past two months:
Introduce a portfolio allocation to gold, sized at about 10% of bonds, which is an alternative to excessively low or negative-yields and provides protection against debasement of fiat currency due to extreme monetary policy;
Maintain a diversified portfolio and avoid piling into what’s performed best through the pandemic;
Maintain a cash balance in portfolios that allows for any foreseeable income needs over the next twelve months to be met, and which provides a store of “dry powder” that can be used for new investments that appear favorable as bouts of volatility emerge.
The recommendation of gold deserves some comment. In the context of financial history, we believe that gold may now serve as a better store of value than many segments of the bond market. In previous periods when bond yields fluctuated within their historic range, the argument against gold was simple: it wasn’t a productive or earning asset like an ownership interest in a business, and it didn’t generate a stream of income like a bond, even as it had a cost of ownership due to storage and security. Furthermore, some forms of gold ownership had unfavorable tax treatment.
Persistently low interest rates have dissolved most of this argument’s force. The attraction of gold lies in its resilience as a store of value: unlike bonds or fiat currency, gold isn’t a promise to pay that is contingent upon the faithfulness of counterparties, but gold is payment in and of itself. The extraordinary monetary policies of central banks around the world have destroyed large swaths of the bond market by making it suitable only for short-term speculators. The US dollar may be the reserve currency of the world, but this status creates perverse incentives for US policy makers, who in the short term are insulated from the bad effects of policies ultimately undermine the dollar’s value. There are now some twelve trillion dollars’ worth of negative yielding bonds across global markets. Even many bonds that aren’t negative in nominal terms produce a nearly guaranteed loss after inflation is taken into account. In the aggregate, the bond market has become extraordinarily exposed to real losses if interest rates rise to levels that are modest by historical standards, and new catalysts for inflation’s return are appearing by the day.
At present there is still comparative value in segments of the US municipal bond and corporate bond market, but low rates and negative yields have made gold a uniquely attractive asset for risk management within a diversified portfolio. Before the adoption of extreme quantitative easing programs by central banks, bond yields would function as indicators of market expectations about future inflation. Quantitative easing has destroyed the information value of bond yields; they no longer reflect investors’ expectations and indicate risk, but they express improvisational policy targets of central bankers.
One consequence of this situation is that investors will have little warning about a pick-up in inflation before it is upon us. It’s possible that inflation never returns and the US and the rest of the world gradually slide into Japan-style price deflation for decades. But it’s also possible that inflation does return, as COVID-related supply chain disruptions, a politically induced reversal of globalization, and government stimulus programs combine to drive up costs across the economy. In either scenario, pronounced deflation or inflation, a modest allocation to gold will likely be a more resilient store of value than near-zero yielding bonds or even cash, because deflation will increase the burden of debt and insolvency risk for companies and states alike.
At the end of June we will send our regular portfolio accounting and appraisal letter. In the meantime we will post some economic and investment commentary on our website www.obriengreene.com. These shorter posts will try to share some of our thinking about these extraordinary times in which we find ourselves.
DISCLAIMER: Please note that this letter does not constitution the recommendation to buy or sell any security, and is for informational purposes only. Past performance does not ensure future returns and all investing involves risk. Individuals should consult with a professional advisor before making investment decisions.
O'Brien Greene & Co. may have positions in the securities mentioned in the commentary provided on this site. Investment decisions should be made in light of each investor's complete financial situation. Many investments are unsuitable for certain individuals, and investors should consult a professional before acting.
June 5, 2020
Summary: the stock market’s rise since its extreme sell-off in March isn’t surprising, given the degree of government support that has been provided by the Federal Reserve and Treasury. But this support may have unintended consequences, and it could induce inflation, which most investors are unprepared for.
About two months ago the United States enjoyed its lowest rate of unemployment in the past fifty years. Since that time nearly 40 million people have lost their jobs and the US has reached its highest rate of unemployment in eight decades. Air travel, hotel stays, and most brick-and-mortar retail shopping virtually ceased, threatening sector-wide bankruptcies that have begun with some familiar household names, including Nieman Marcus, J.C. Penney, J.Crew, Hertz, Gold’s Gym, and Pier 1. Even as the coronavirus has swept across the US, multiple hospitals have closed and countless medical practices are threatened with insolvency for a lack of patients. Global supply chains have been thrown into disarray, farmers have been destroying unharvested crops and culling herds, and a glut of oil supply briefly drove the price to buy a barrel in the US below zero, meaning that traders would pay you to take this essential commodity that it took some $50 per barrel of input costs to produce.
The commercial mortgage market has been teetering on collapse, as many business tenants have ceased making rental payments to their landlords. Prices for residential real estate, meanwhile, have risen due to a dearth of supply, with the median price of an existing home in the US rising to a record high in April. In mid-May the Mortgage Bankers Association reported that 4.1 million homeowners were in mortgage forbearance plans and overall 8.16% of all mortgages in the US were past due.
In the midst of all this, financial markets are witnessing a strong bull rally in bonds and stocks, with the S&P 500 Index (SPX) up +43% and the Russell 2000 Index (IWM) up +52% from their lows in late March. The S&P sits at about -5% below its all-time highs reached before the coronavirus pandemic, and above where we were at this time last year.
In our email of March 15, written in the midst of the sell-off, we wrote: “There is some reason therefore to think that after the virus is contained the economy and financial markets could come roaring back with a quickness that rivals its recent decline. This possibility means that investors cannot reasonably ‘go to cash’ with the bulk of their portfolio.” This assessment seems to have been borne out thus far, although it’s premature to say that the virus is “contained.”
What’s going on? Our answer, which may be surprising, is that everything is more or less proceeding according to plan. This suggestion may sound absurd at first hearing, but consider: as the gravity of COVID-19 became widely appreciated in March, state and Federal governments set about a coordinated plan to fight the virus. This fight (the war analogies were explicit) involved intentionally separating the real economy from financial markets, not just in the United States, but across the world. Everything may be proceeding more or less according to governments’ plan, but the plan is still fraught with enormous execution risk and the possibility of longer-term unintended consequences.
It’s dangerous to try to float financial markets on government stimulus while shutting down economic production, and it can only go on for so long—how long, nobody knows. But the advent of rioting and looting across American cities in the aftermath of the George Floyd tragedy suggests not much longer. Would legitimate protests have morphed into violence if the lockdown hadn’t been in place? This is a question worth pondering. Given what we knew about the virus in February and March, the economic shut down was defensible, and perhaps the most reasonable course of action available.
Travel and industry were forcibly closed and over 90% of the US population put under “stay at home” orders to slow the spread of the virus, even as financial markets remained open. More importantly, financial markets weren’t left to themselves, but immediately received trillions of dollars of subsidy from the Federal Reserve, which already dwarfs the entire monetary response to the 2008-2009 financial crisis. The European Central Bank, Bank of England, and other central banks deployed subsidies that are even larger than the US’s, relative to the frequency of their currencies’ use. Japan, which has the third-largest economy in the world, recently doubled its COVID stimulus package to $2.2 trillion or 40% of the country’s entire annual economic output. The total amount of US government stimulus deployed in 2019 is estimated to be equivalent to a full five years’ worth of Federal tax receipts.
This Response is Different
Unlike the government response to the 2008-2009 financial crisis, the present bout of government stimulus packages from central banks and treasuries has three important features: first, it has come very quickly, in a few weeks instead of many months. Second, financial authorities across the world have responded uniformly, with more or less coordination. Also unlike ’08-’09 is a widespread determination by governments to push money into the entire economy and into the hands of ordinary businesses, individuals and families, and not just to provide financial liquidity that remains trapped inside the banking system.
The US Treasury began mailing $1,200 checks to home-bound workers and paying supercharged unemployment benefits to those already furloughed or laid-off. According to a University of Chicago study, over 60% of unemployed workers are currently receiving considerably more in unemployment benefits than they did in income when they were working full-time. In the United Kingdom, the central government directly assumed responsibility for most companies’ employee payrolls and the Bank of England began printing money directly into the government’s checking account in order to fund its pandemic response measures. Thus far the Bank of England has created half a trillion pounds using this “temporary” policy of direct monetary financing, which is historically associated with failed banana republics, and not the founding country of modern capitalism.
In the United States the Federal Reserve has hired BlackRock, the largest investment manager in the world, to oversee a portfolio of corporate paper, bonds, junk bonds, and municipal bonds on its behalf, funded by new money that the Fed creates. The Fed even has a Main Street Business Lending Program (MSBLP) that will make loans directly to small businesses. The only asset class that the Federal Reserve has yet to buy directly is equity, and this will surely come when the next crisis hits. (The Swiss National Bank and the Bank of Japan have been buying stock exchange-traded funds for years in order to manipulate their currencies and stimulate their economies.) Thus the pandemic has prompted the gradual nationalization of financial markets by the central banks and government treasuries across the developed world.
Nothing in the Federal Reserve’s legal charter empowers it to take these extraordinary measures. The Fed’s gotten around this inconvenience by having the Treasury make the actual purchases, while it provides the financing. This workaround has the effect of fusing the Treasury with the Fed, in spite of the fact that the former is meant to be a creature of the sitting presidential administration, and the latter is meant to be politically “independent.” The Fed is now committed—in a presidential election year, no less—to provide unlimited financing to the Treasury to boost the stock and bond markets. President Trump hasn’t been shy about trying to influence Fed policy via Twitter.
But now he needn’t take such an indirect route, since the Treasury secretary serves at his pleasure. If the stock market falters before the November election, Trump’s appointee will have a new and powerful tool to do something about it.
Taking full view of the size and scope of the government response to the pandemic, it shouldn’t be surprising that financial markets have rallied since the sharp sell-off in March. Large public companies and the wealthy have generally avoided the harshest effects of the lockdown measures, which have fallen disproportionately on the poor and on independent, small businesses. According to the Federal Reserve, 63% of workers with a college degree can fully work from home, while only 20% of workers with a high school degree can do so. The Fed also estimates that a full 40% of households that earn less than $40,000 per year and had a job in February lost that job in March. The recent rioting and looting across the United States only serves to aggravate the collateral damage from the pandemic response: outside perhaps of corporate commercial real estate, the unrest will disproportionately harm small business owners and the urban poor.
Assessing the Virus
Markets price in known risks. As the COVID-19 pandemic has unfolded, it has increasingly become a “known unknown,” and to that extent the market can adjust to the risks it presents. We don’t know whether a vaccine will be developed or if so, how long it will take, and we don’t know how many or how severe follow-on waves of infection will be in the future. But we do know a lot more now that we did in late February and early March, when the market began to crash. We now know that the US hospital system had enough capacity to meet the initial surge in acute infections and that for most people under 65 and without certain underlying conditions, COVID-19 appears to be less life-threatening than the ordinary flu. In our home state of Pennsylvania, the median reported age of death from COVID-19 is 84, while general life-expectancy in the state is just 78. The majority of reported deaths have occurred in nursing homes.
Compare the economic significance of a virus that does not seriously threaten the working-age population, like COVID-19, with the Spanish Flu epidemic of 1918, in which half of all deaths occurred among otherwise young, healthy people aged 20-40. Now that government lockdowns are easing, and evidence is emerging that some lockdowns may have been too broad or long-lasting, we may witness an additional relief rally in financial assets, as investors get further clarity about how extensive the longer-term impact of COVID-19 will be. The great challenge in the coming months will be the re-coupling of financial markets with the real economy, which will be made harder by the civil unrest. Everything may be proceeding more or less according to plan so far, but “the plan” is still fraught with enormous execution risk and longer-term unintended consequences.
Recommendations
We draw several investing lessons from the experience of the past two months:
The recommendation of gold deserves some comment. In the context of financial history, we believe that gold may now serve as a better store of value than many segments of the bond market. In previous periods when bond yields fluctuated within their historic range, the argument against gold was simple: it wasn’t a productive or earning asset like an ownership interest in a business, and it didn’t generate a stream of income like a bond, even as it had a cost of ownership due to storage and security. Furthermore, some forms of gold ownership had unfavorable tax treatment.
Persistently low interest rates have dissolved most of this argument’s force. The attraction of gold lies in its resilience as a store of value: unlike bonds or fiat currency, gold isn’t a promise to pay that is contingent upon the faithfulness of counterparties, but gold is payment in and of itself. The extraordinary monetary policies of central banks around the world have destroyed large swaths of the bond market by making it suitable only for short-term speculators. The US dollar may be the reserve currency of the world, but this status creates perverse incentives for US policy makers, who in the short term are insulated from the bad effects of policies ultimately undermine the dollar’s value. There are now some twelve trillion dollars’ worth of negative yielding bonds across global markets. Even many bonds that aren’t negative in nominal terms produce a nearly guaranteed loss after inflation is taken into account. In the aggregate, the bond market has become extraordinarily exposed to real losses if interest rates rise to levels that are modest by historical standards, and new catalysts for inflation’s return are appearing by the day.
At present there is still comparative value in segments of the US municipal bond and corporate bond market, but low rates and negative yields have made gold a uniquely attractive asset for risk management within a diversified portfolio. Before the adoption of extreme quantitative easing programs by central banks, bond yields would function as indicators of market expectations about future inflation. Quantitative easing has destroyed the information value of bond yields; they no longer reflect investors’ expectations and indicate risk, but they express improvisational policy targets of central bankers.
One consequence of this situation is that investors will have little warning about a pick-up in inflation before it is upon us. It’s possible that inflation never returns and the US and the rest of the world gradually slide into Japan-style price deflation for decades. But it’s also possible that inflation does return, as COVID-related supply chain disruptions, a politically induced reversal of globalization, and government stimulus programs combine to drive up costs across the economy. In either scenario, pronounced deflation or inflation, a modest allocation to gold will likely be a more resilient store of value than near-zero yielding bonds or even cash, because deflation will increase the burden of debt and insolvency risk for companies and states alike.
At the end of June we will send our regular portfolio accounting and appraisal letter. In the meantime we will post some economic and investment commentary on our website www.obriengreene.com. These shorter posts will try to share some of our thinking about these extraordinary times in which we find ourselves.
Sincerely,
Matthew B. O’Brien
matthew.obrien@obriengreene.com
610-891-7880
DISCLAIMER: Please note that this letter does not constitution the recommendation to buy or sell any security, and is for informational purposes only. Past performance does not ensure future returns and all investing involves risk. Individuals should consult with a professional advisor before making investment decisions.