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Episode 30

Equities are not the Economy

Published on: May 28, 2020 • Duration: 18 minutes

This week we look at how the move in US equity prices is shaping our view of the economic recovery, which is not going to be following the same trajectory as the Nasdaq. In The Chatter, we look at the EU’s proposal for a rescue fund and ask if this is a game-changer. In The Whisper, we look at a few assets to follow for signs that the risk-on momentum is going to change.

  • Fears about a deep recession in the second quarter of 2020 are being offset by the anticipation of a sharp recovery off those lows. The performance of the U.S. equity market has also created a heightened sense of expectation that the worst is now behind us. But what sort of trajectory would be realistic for a recovery? That's The Big Conversation. 

    The S&P500 had another good start to the week and has now broken above the 62 percent retracement. A level which capped most of the initial rebounds of major bear markets throughout history, such as the Dow in 1929 and Japan in 1989. We have noted in previous episodes that the stock market is not the economy and the U.S. equity market is not representative of global equities. The biggest five U.S. stocks now account for a larger portion of the S&P 500 market cap than even during the dot com bubble of 2000. And as everyone knows, the response of central banks has been dramatic, plugging that liquidity gap and helping the shadow banks and brokers to re-lever. Moreover, the fiscal stimulus and the 'buy the dip' mentality that had prevailed for much of the last decade has encouraged a surge of interest in retail investors who've been opening new accounts at zero cost brokers such as RobinHood at a record pace, also helping fuel the rally. Much of this outlook is therefore informed by the effects of a few stocks and the actions of the Fed who are heavily distorting prices in the Treasury and the Corporate Bond markets. But this remains a liquidity fix, not an economic fix. The Fed can lend, but they can't spend. They are unable to target specific sectors or specific companies. Larger corperations who have relationships with the big banks will experience the benefits of central bank liquidity. But this could lead to the zombification of large and inefficient companies. It may lead to fewer bankruptcies amongst the larger cap corporates, but it will also crowd out the smaller companies and family businesses. And based upon this historical relationship that we saw last week of Chapter 11 bankruptcy filings and the U.S unemployment rate, we can expect bankruptcies within this group to rise. The recovery is going to be highly differentiated by geography, by sector and by age group. We can see that the expectations for second quarter GDP varies quite considerably from region to region. A recent Reuters poll forecasts a decline in Eurozone GDP of between 10 and 15 percent. For the UK, the expectation is for a decline between 17 and 24 percent, whilst for the U.S. the expectation is for GDP to decline as much as 40 percent in a worst case scenario, (which is the red bar on this chart). Whilst the decline in GDP forecast is greatest for the US, it's a fair bet to say that most people expect the U.S. to recover faster than Europe. And in many regions, talk of any form of recovery is still premature. Total global Covid cases have been on the rise due to surge in places like South America and India. World supply chains remain heavily entwined, such that different speeds of recovery will continue to create points of friction in the global economy. Within the U.S, we can see how the distribution of job losses has been heavily skewed into one sector: that's leisure. This is a pattern that has been repeated across developed markets, where services are a very significant part of the economy. Economies dominated by the service sector have therefore been hardest hit. And even in Asia, we can see that the consumer discretionary sector has also been heavily impacted, along with energy, which was hit by the double whammy of declining demand and the price war. Staples and communication services were, not surprisingly, the only winners in the region during the first quarter of this year. And not only has the impact been highly differentiated by geography and sector, but also by age and education. U.S. payrolls data shows that although all age groups are affected, the 25 to 54 age group, depicted by the lightest blue line on the chart, were by far the hardest hit - though that is the biggest cohort - losing over 10 million jobs was the over 55 cohort (in grey) lost five million jobs. Differentiating for education, we can see that the largest job losses were for those with high school education, but no degree. That's the mid-blue line. Although there have been significant losses for those with bachelor degrees or above (which is the grey line) perhaps what's most notable is the increase in employment for this group over the preceding 10 years. It should be clear from these charts that if we do get a recovery, then the experience will differ for different ages, different countries, different sectors. Indeed, some sectors have already experienced a recovery due to the concentration effects, which a few years worth of change have been compressed into a few weeks, generally benefiting the online segments of the economy. So whilst we can establish that there'll be different speeds of recovery, investors will need to differentiate between a recovery in the liquidity conditions versus a recovery in the economic conditions, including the likelihood of a solvency crisis over the coming months and years. Now, the crisis of liquidity has been solved by central banks. If people had their cash tied up in illiquid investments and couldn't get their hands on, let's say, dollars to pay bills, then the Fed and other central banks have bailed them out. But that does not solve the crisis of solvency, where a person needs more income or even just any income in order to pay back debts over the long term. For corporate, that would be a revenue stream that covers costs - though some companies - the zombies mentioned earlier, will be able to continue borrowing debt and rolling over their obligations. And today, total global debts are acute to the household, the corporate and at the government level. So, again, this is highly differentiated by geography, sector and age. So the speed of the recovery will matter. We will see a V shaped recovery in many data points, but what will matter is the terminal point of that recovery. We can illustrate this with China - again, accepting the Chinese data may not be the most reliable, but China PMI's have rebounded. Remember, these are sentiment indicators rather than hard data. So on the surface, it looks like the economy is getting back onto a stable footing. Whilst we can see that China's retail sales are also rebounding, they are doing so at a significantly slower pace. And the key question is, where will the recovery settle? Will it rebound to the previous levels or to somewhere below? Traffic data suggest that China's car usage has increased during the weeks because commuters are avoiding public transport. But then it tails off dramatically at weekends because of a reluctance to return to shopping malls and leisure facilities. Revenues from gambling hotspots of Macao have fallen nearly 100 percent year on year. And the speed with which these recover will be a decent indication of whether animal spirits have returned to the economy. So far, it looks like the worst hit sectors are also going to be the ones that take the longest to recover. The terminal growth rate could be significantly below the preceding levels for some time to come. For instance, whilst the U.S. Energy Information Administration, the EIA, is forecasting a relatively rapid recovery in energy consumption, it expects that the level of demand for 2020 will settle below the pre-virus levels. None of these are a true V shaped recovery. They might eventually look like a V because of the depth of the demand destruction, but it will take months and in many cases years to return to previous levels. The ability of the monetary and fiscal authorities to target growth will also vary by region. The ECB may already have reached the limits of its powers within the Eurozone. This may be one of the contributing factors behind the Macron-Merkel plan for a European Union funded rescue to supplement the existing EU budget, which we discuss in the next section. The Bank of Japan has announced another package this week that is close to one trillion U.S. dollars in size, but this is more of the same. We can expect low velocity and low productivity, i.e. the same path that Japan has been treading for three decades. The U.S. Federal Reserve has been prodigious in its monetary accommodation, but the main beneficiaries would again appear to be the wealthy one percent, rather than the hollowed out middle class, who should be the engine of growth. And in the U.K., the Bank of England, the monetary authority and the government, the fiscal authority, are clubbing together to kickstart the economy. Public sector borrowing has exploded higher well beyond the initial forecasts and dwarfing the borrowing during the great financial crisis of 2008 to 2009. Despite all the borrowing, U.K yields remain under pressure, with yields on the U.K two year and five year gilts going into negative territory for the first time in history as the deflationary pressure mounts. Less than a week ago, expectations for U.K rates going negative were very low, according to 78 percent of people surveyed in a Reuters poll. And having recently said there was no chance of negative rates, the Bank of England now say they are looking at that possibility. If the U.K can embark on an aggressive combination of fiscal and monetary accommodation, then this should put pressure on the British pound. Parity with the U.S. dollar looks possible despite the risk on rally in Sterling that we've seen in recent sessions. But the current global risk on price action is factoring in the outlook for liquidity, not solvency. Many fiscal schemes supporting wages will start to roll off in June, or will require supplements from employers who will then start to cut jobs further or push down wages in order to protect weaker margins. And while some economic activity has started to beat expectations, there are still sufficient signs that the impact we are seeing will be more persistent than expected. The April Chicago Fed National Activity Index, which aggregates a number of countrywide data points, was expected at minus three point five, but came out at minus sixteen point seventy four. These data points suggests that a recovery will be far harder to win than a simple second half rebound. 

    On May the 18th, French President Emmanuel Macron and German Chancellor Angela Merkel unveiled a proposal for a European Union recovery fund. Now, some people think that this could be a significant turning point for the European movement, even calling it Europe's 'Hamilton' moment after Alexander Hamilton, who helped found the financial system of post-independence America. Others, however, remain skeptical that this European recovery fund will fail to bring together Europe's diverse interests. Like so many other attempts to integrate Europe's financial framework. So what is this recovery fund and what makes it a potential game changer for Europe? The fund size is 500 billion euros, and the funds will be raised as common debt of the European Union. In the proposal unveiled by Macron and Merkel, the fund will be dispersed as nonrefundable grants rather than as loans, so basically given away. And this fund is in addition to the already agreed 2021 to 2027 fiscal budget of one trillion euros. This facility already redistributes funding with the transfer generally traveling from North to South and from West to East. Germany's deputy finance minister said that the rescue fund would "pool revenue collection powers and autonomous borrowing powers at the level of the central government". The immediate response was that the spread between German and Italian 10 year bond yields narrowed. Perhaps the most striking elements of the proposal is that it is at the European Union level not at the eurozone level, and it was endorsed by Angela Merkel, who has so far resisted the idea of debt mutualization. Merkel's agreement came out of the blue, though it probably had its origins in both the size of the economic slowdown facing Europe and the recent ruling by the German Constitutional Court against the European Central Bank's unfettered bond buying program. A ruling which had roiled the European Court of Justice and could potentially curtail the ECB's ability to shore up the Eurozone's shaky finances. What is clear, however, is that many European countries were already struggling before the Corona Crisis, which could now easily push some countries over the edge. There are fears that the European idea could collapse without a fund that helped member states based on their current predicament rather than their economic size. This is one of the concerns that eventually galvanized Angela Merkel into action. And the economic pain was widespread. Consumer spending in France had seen a record decline. German GDP, which had been struggling for a couple of years after the global slowdown in manufacturing, particularly the global auto sector, plunged two point two percent in Q1, with worse expected to come for Q2. The Eurozone composite PMI collapsed to its lowest level ever. Whilst the Eurozone banks have recently made a new all-time low, Europe's STOXX 600 is still below the highs made in 2000. The EURO STOXX 50 has never come close to approaching those levels made in that year. And even those countries outside the Eurozone, but within the European Union, have experienced sharp declines. Sweden's household consumption has dropped to a 20 year low. Macron and Merkel still have to work hard in order to convince other member states to sign up to the proposal. The 'frugal four' of Sweden, Denmark, the Netherlands and Austria have already rejected the scheme. They would prefer further cash to be handed out only in the form of repayable loans rather than given away as grants. Their worry is that the recipients failed to make the structural changes that are required, therefore, the rescue fund could effectively become a bottomless pit. This was always one of the major concerns about debt mutualization without a fiscal union. Furthermore, 500 billion euros, which is the size of the fund, is a drop in the ocean. The European economy is around 20 trillion euros in size. Rescue fund will hardly touch the sides, but the frugal four will be concerned that once the door has been opened, then the trickle becomes a flood. Although Merkel and Macron will both have to battle to bring the frugal four onside, there is broad based support within the 27 nation bloc. Even the former German finance minister, Wolfgang Schauble, who was a fiscal hawk during the eurozone debt crisis of 2012, is backing this plan. So will this rescue package be a step nearer to true EU integration? EU policymakers generally need their backs against the wall in order to commit to real change. The Corona virus landscape is certainly one of extreme uncertainty, adding additional pressure to a region that it's failed to generate lasting EU wide growth due to its structural problems. But if this package is passed, then the EU will have crossed at least one more of its many Rubicons. 

    [00:14:24] If we're looking for signs that global risk assets are reaching a turning point after the big rallies, what are some of the assets that we should have on our radar? U.S. equities, especially the Nasdaq and to a lesser extent, the S&P500 are only really reflecting the concentration effect of a small handful of stocks. Plus, the implied bid from the central banks, even if that bid has not yet materialized in many parts of the market. But because of these distortions there is only a small amount of informational value within the U.S. equity space. Similarly, corporate bonds offer very little by way of price discovery - though that doesn't mean they are necessarily a bad investment. If however, there was a genuine widespread belief that the medium to longer term risk profile had materially changed, we would expect emerging market equities to outperform the S&P500. Although we had a bout EM outperformance on Tuesday, the ratio between the S&P500 and the MSCI Emerging Market Index was coming off a new 10 year high in favor of the S&P. Considering the recent weak performance of the U.S. dollar, EM equities should be outperforming. The fact that they are not as an indication that this is still a U.S. centric rebounding risk rather than a global sea change in sentiment. Emerging market currencies have recently been breaking marginally higher, but they should be one of the first areas to roll back over if real global weakness persists. This would happen if the market moves from a narrative in which the liquidity shock has been resolved, to one in which insolvency is beginning to rear its head. The emerging market currency index is currently bouncing off recent lows, but many emerging markets are sitting on significant U.S. dollar denominated debts in the private and government sectors. So far, the sectors with debt concerns have been heavily punished compared to, for instance, stocks in the upper end of the Nasdaq, who generally have a healthier cash positions, and those have outperformed. European banks are also carrying significant levels of debt, and they, too, have been bouncing off their recent lows. In fact, it's remarkable how similar the chart of the JP Morgan emerging market currency index and the chart of the Eurozone bank's index looks over the last five years. They are both currently extending their bounces, but if these start rolling back over, then this would be a good indicator that risk tolerances are changing again. And it's taken weeks of risk on activity for these two indices to break out of their consolidation lows. Although there are many other assets we could watch for clues, the Chinese Yuan, the CNY is crucial. With tensions again rising over the influence of China within Hong Kong, threats of a re-escalation of the trade war between the US and China could lead to the Chinese letting the US dollar drift higher versus the Yuan. If this breaks the recent highs, it could lead to a surge, though the Chinese policy continues to be one of small rather than large steps. And a key factor will be the willingness of the U.S. administration to suffer weakness in the equity market because a weaker Yuan would mean a stronger U.S. dollar, and a stronger US dollar would be a tightening of global financial conditions, akin to a rate hike hurting global risk assets. Now, clearly, that's not what this fragile recovery wants, and it may be one reason why the U.S holds back from a dramatic response. But I will be watching the ratio of the S&P500 versus EM equities, emerging market currencies, European banks and Chinese currency in particular, for signs that the framework is beginning to shift again.