The gap between Main Street and Wall Street
has never been more acute.
Many financial assets are soaring, whilst
the average consumer is struggling with debt
that has been brought into sharp focus by
a loss of income.
But is the current mix of monetary accommodation
once again distorting the long term outlook
for the economy?
That's The Big Conversation.
In March, Spain experienced a 9.4 percent
surge in bankruptcy rates amongst its small
businesses, that was according to a report
by Thomson Reuters.
And considering that the crisis was probably
at its deepest in April, we should expect
these numbers to rise dramatically.
And this won't be an isolated experience either,
other regions have been hit equally hard,
although measures in UK and Germany plus the
difficulty of entering filings during a period
of lockdown, have meant that bankruptcies
in these regions have actually fallen.
In Japan, on the other hand, Reuters reports
that coronavirus has pushed 141 companies
into bankruptcy since February, mainly in
the travel and leisure sector.
Now the sort of level of balance sheet impairment
to the household, corporate and government
level will be one of the key drivers of economic
growth over the next few months.
So far, risk assets have already experienced
two of the three classic phases of a major
economic bust.
The deleveraging phase and then the hope phase.
But as the reality phase kicks in, a key concern
will not be about the monetary inflation of
central banks, which is all this money printing
which we discuss further in The Whisper, but
it's about the potential for monetary deceleration
i.e. the velocity, not the amount of money.
According to the St. Louis Fed velocity is,
"the number of times one dollar is spent to
buy goods and services per unit of time.
If the velocity of money is increasing, then
more transactions are occurring between individuals
in an economy".
Or simplified even further - when there is
an increasing amount of economic activity
taking place, velocity will be rising.
I prefer not to use equations, but a simple
formula for the velocity of money is that
V is equal to the price of goods multiplied
by the quantity of goods.
And then all that's divided by the money supply.
So velocity = price x real expenditure divided
by money supply.
And what's money supply?
Well, the M2 money supply is often used, which
is checking, savings and deposit accounts,
plus money markets and mutual funds.
Therefore, an even more simplified version
of velocity would be to divide gross national
product GNP by money supply such as the M2
just outlined earlier.
In this chart showing the central bank balance
sheet versus the velocity of money, we can
see the economic fragility that has persisted
before the coronavirus.
Velocity had been in a sharp decline because
money supply was increasing at a faster rate
than GNP growth.
What that means is that each new unit of so-called
stimulus was having a lower and lower return
on growth.
So if we now roll onto today's environment,
we know that the numerator of GNP or GDP,
i.e. the economy is collapsing whilst the
denominator of M2 money supply is accelerating.
Therefore, velocity will fall much further
because corporates will offset lost revenues
and start to hoard cash in anticipation that
their future revenues will fall.
Households will start to plug their own shortfall
in savings and try to offset the debts that
they had built up over the preceding years.
And all this is going to be deflationary.
In this chart, we can see the relationship
between the year on year change in CPI and
the year on year changes in the velocity of
money.
It implies that US CPI is going significantly
lower, perhaps even as low as we saw in 2008.
Even if peak economic contraction is now behind
us.
Now to avoid deflation, governments need to
stimulate aggregate demand to levels that
are above and beyond where they were prior
to the virus.
Raising asset prices is not the same thing
as raising economic activity, and we saw that
for the last 10 years.
Cash flows from governments to the private
sector, that's corporates and households,
are merely filling the void, helping to stabilize,
but not to stimulate the economy.
Because that real economy of businesses and
households is preoccupied with firstly plugging
the immediate liquidity crisis, such as paying
today's mortgages or rent, and then secondly,
hoarding cash in anticipation of future solvency
issues such as a decline in income revenues.
Meanwhile, the outlook for U.S. bankruptcies
looks shocking.
Expectations for a V-shaped recovery appear
increasingly unlikely simply because the lockdowns
have dragged on from Spring and into Summer.
And even as economies edged towards normality,
it's going to be via a series of baby steps
rather than a straight line release.
This following chart shows the potential magnitude
of the risks.
Here we plot the US unemployment rate against
Chapter 11 bankruptcy filings.
Even if we adjust the size and speed of the
rise in unemployment with an expectation that
jobs will return much faster than expected,
we should expect bankruptcies to rise dramatically.
In reality, I think it's fair to assume that
within the leisure and hospitality industries,
the return to work will be a drawn out affair
with restrictions of some sort in place throughout
the Northern Hemisphere's Summer.
The hope is always that the US consumer will
come good.
And over the last 40 years, the consumer has
proven remarkably resilient.
The consumer is therefore key.
But it's the consumption part of the economy
that has been taking the hit from coronavirus
this time around.
And what is the likelihood that the consumer
behavior will return to normal afterwards?
U.S. consumers were not in a robust position
prior to the crisis.
Despite the recovery in the aftermath of the
great financial crisis in 2008, 45 percent
of Americans have close to zero cash in their
savings account.
And that's according to a survey by GoBanking
Rates in December 2019.
Auto and student loans are also at record
levels.
We can see in this chart how auto loans have
soared past the previous peak prior to the
great financial crash of 2008.
Credit card financing costs have also risen,
despite Fed funds that are close to zero,
pushing credit card delinquency rates to a
20 year high.
And that was before Covid struck.
It's clear that many US and many European
consumers have been teetering on the edge
for years, living paycheck to paycheck.
Now, with paychecks abruptly postponed and
in some cases canceled, many households will
be missing rental, mortgage and credit card
payments and also skipping on health care,
setting in motion the dominoes in which their
credit scores will be impaired.
And banks who are already hoarding cash will
be reluctant to lend.
Government handouts will be used to plug the
holes in today's cash flows, or they will
be hoarded in order to offset a decline in
future revenue or wages.
And in many cases, it will be used to pay
down debt.
We can already see that the US savings rate
is now at the highest level since the early
1980s, and that creates a vicious spiral.
If households are hoarding, then corporate
cash flows will be impaired.
Corporates will therefore also hoard against
a drop in future revenues and they will cut
jobs and cut wages.
Household balance sheets will therefore be
impacted further, forcing more retrenchment
in cash hoarding by companies that are fearful
of future revenue losses.
And then the banks will hoard.
Their capital will be kept aside and they
will only lend to the less risky corporates
because consumers are exacerbating that dynamic.
Now, let's be clear, we're not talking about
a complete collapse in consumption.
In fact, the next set of headlines will probably
be about how economies are returning to something
like normality.
But it's what happens at the margin that matters.
It only takes a small percentage of consumers
to stay away from restaurants and leisure
facilities to push a profit into a loss.
If fixed costs are inelastic, it only takes
a few weeks of the new normality with slightly
smaller customer bases to push companies into
insolvency.
Many industries have wafer thin margins and
consumption patterns aren't likely to return
to pre-Covid levels, even if economies rapidly
reopen, because the crisis has revealed the
underlying balance sheet fragility and may
now trigger a desire to de-lever.
And that would be deflationary.
The question is then if consumers retrench,
can central banks print at a fast enough pace
to offset the decline in demand?
Now, Jerome Powell is backing the Fed as he
should.
But the experience over the last 10 years
of unorthodox accommodation is that central
bank's efforts actually make matters worse.
In the 1970s, they didn't try and create inflation,
but they got it.
Over the last decade, they didn't try to create
disinflation, but they got it.
Today they are trying to create inflation
and history suggests that they won't get it.
But they might get an even greater disconnect
between the equity market and the underlying
economy between Wall Street and Main Street.
There's a lot of chatter about the performance
of the U.S. equity market when compared to
the outlook for the broader economy, in particular
the consumer, as we've just discussed.
The Nasdaq 100 has rallied back to within
about 4 percent of its all time highs with
both it and the S&P making new recovery highs
on Monday.
So although the NASDAQ is signaling what appears
to be a healthy recovery, there are many other
signals from the market that are indicating
a less robust outcome.
So how should we interpret these mixed signals?
Firstly, as mentioned in the main section,
it's key to understand that the equity market
is not necessarily representative of the economy,
and that the US equity market is not representative
of global equities.
Arguably, the US equity market, which has
been outperforming most other major global
benchmarks for the last decade, has not been
trading on fundamentals for some time, but
has been trading on flows.
These flows would be buyback flows, 401K pension
flows, and even inflows from foreign capital.
Assets had already migrated from active managers
to passive managers who have a concentration
bias into the largest names by market capitalization
such as those in the S&P 500.
And this has helped keep valuations on the
S&P 500 at elevated levels for a very long
time, even prior to the Corona crisis.
Since the crisis, these flows have been concentrated
into an even smaller handful of tech names,
mainly those with a significant global online
presence.
And this has helped elevate the Nasdaq to
its highs.
The S&P 500 has also benefited from these
flows, although the rally in the S&P is still
very much in line with the other bear market
rallies, at least at this stage it is.
So far the S&P has recouped 62 percent of
its initial decline and that's a classic Fibonacci
retracement level.
And it mirrors numerous historical examples
in which we first see an aggressive liquidation
phase or deleveraging, followed by a significant
rebound.
And this is what happened in 1929.
A liquidation phase followed by a big rally
of around about 50 to 60 percent before the
market rolled over.
The same pattern was true the Japanese Nikkei
225 after its equity bubble peaked at the
end of the 1980s, followed by a sudden decline
before bouncing to recoup 50 percent of its
losses and then rolling over again as reality
kicked in.
And then more recently, the sell off at the
end of 2018 also saw a 62 percent rally before
the index rolled over to make new lows.
Clearly, the S&P, like the Nasdaq, could break
above the 62 percent retracement level, which
has been testing this week.
But at this stage, it is still perfectly in
line with numerous historical examples of
how a market might perform through a classic
equity bust.
The Nasdaq itself is not a play on the macro
economics, but on the performance of only
a handful of stocks.
But when we look around the rest of the world,
the dominant performance of large cap US markets
is clear.
Ignoring the volatility in March, the S&P
500 has continued to move higher versus the
German DAX, the UK's FTSE 100 and Europe's
EuroStoxx50 index.
Many of these markets, such as the UK's FTSE100,
have struggled to hold the 38 percent retracement
level versus the S&P at 62 percent, and the
Nasdaq having almost recouped all of its losses.
Many global equities remain entrenched in
long term bear markets.
The Japanese Nikkei 225 has failed to regain
the highs made in 1989 and the EuroStoxx 50
has failed to regain the highs made in early
2000.
The U.S. market reflects the dominant flows
of corporate buybacks in the years preceding
Covid-19, followed by the concentration of
flows into the winners such as Amazon over
the last couple of months, plus both the explicit
support of the US Federal Reserve for certain
asset classes such as investment grade corporate
bonds, as well as the implicit support for
equities by the threat of further intervention,
such as we saw over the weekend from Fed Chairman
Powell.
However, there are still areas within the
US equity market that are a closer reflection
of the underlying economic malaise.
The small-cap Russell, 2000, has retraced
50 percent of the initial de-leveraging, but
remains 20 percent off the highs, even after
Monday's huge rally.
And even within the S&P 500, which is around
12 percent off the all time highs when we
filmed this piece, if we excluded the top
five or six performing tech names, then the
rest of the index would be down closer to
25 percent.
The market cap of the top five or six stocks
is equivalent to the bottom three hundred
and twenty five or so names, which is one
of the greatest concentrations that the index
has seen.
Digging deeper still, we can see the performance
of the banks has massively lagged the performance
of the broader equity market.
Although the role of banks in the economy
has diminished since the financial crisis
of 2008, partly due to regulation and the
need to rebuild their working capital, they
are still integral to the performance of the
real economy - and that's the economy of businesses
and households rather than the financial assets
such as equities and bonds.
The BKX, the bank index, managed only a 38
percent retracement of the initial selloff,
and has again been within a whisker of the
recent lows.
The ratio of the bank index vs. the S&P 500
last week made a new all time low.
Banks are clearly indicating that the economy
remains in limbo, even as we contemplate a
reversal of lockdowns and another rally in
the Nasdaq 100.
In Europe, the picture is even worse.
The eurozone banks made a new intraday all
time low last week, hobbled by a backdrop
in which the eurozone and EU leaders are again
showing during times of crisis that there
is no union, even though there has been a
rescue package announced this week.
And this performance in banks is repeated
across the world.
The Australian Bank Index only managed a rebound
of 23 per cent of the original decline that
happened in March.
So whilst the Nasdaq and to a lesser extent
the S&P 500, are highlighting the strength
of a handful of stocks, the banks are reflecting
the reality that the rest of the economy is
experiencing.
For smaller businesses lacking the technology
or the clout, insolvency is an issue which
is on the immediate horizon.
Lower or negative interest rates were already
a challenge for banks.
The potential wave of global insolvency is
clearly being reflected in both their relative
and absolute prices, even whilst a handful
of stocks, at least in the US, give the impression
that the economy appears to be anticipating
a rapid rebound in activity.
Between Friday of last week and Monday of
this week, at one point, silver had gained
10 percent.
But silver still remains a laggard versus
gold.
Monday's squeeze higher in precious metals
was in response to US Federal Reserve Chairman
Powell's weekend comments on the US show 60
Minutes, in which he outlined the policy tools
at his disposal.
In many ways, we shouldn't be surprised that
his enthusiasm for printing, this has become
enshrined in many central banks emergency
rule books.
The interview also came hot on the heels of
an address earlier last week in which he outlined
the headwinds for the U.S. economy.
Basically playing good cop/bad cop.
When the presenter of 60 Minutes Scott Pelley,
asked him if he had flooded the system with
money during the crisis period, he said, "Yes,
we did, that's another way to think about
it."
And when asked "Where does it come from?
" He answered, "We print it digitally.
We have the ability to create money digitally."
When pressed further, the key passage was
"Has the Fed done all it can do?"
And he replied, "There is a lot more we can
do.
We're not out of ammunition by a long shot.
No, there's really no limit to what we can
do with these lending programs."
Many risk assets, particularly those pricing
inflation, sprinted higher on Monday.
So after money printing in 2020 was at a rate
that dwarfs 2008, especially when we look
at the growth on a year on year basis, the
Fed is prepared to do yet more.
Precious metals took a leg higher in anticipation
of the bigger bailout that Powell was suggesting,
although gold did retreat off its highs when
real yields started rising.
But for silver, there is still some considerable
catching up to do.
Silver has many industrial uses, and when
liquidations impacted all risk assets in March,
the precious metals with industrial uses were
particularly badly hit.
And even gold was impacted by margin calls.
But when we look at the price action, we can
see that silver's performance has also lagged
gold over the last five years.
And with that underperformance being particularly
acute over the last few months.
And when we look at the longer term chart,
we can see how extended the current period
of underperformance has become.
And yet on those other occasions when precious
metals rallied, silver eventually outperformed
gold, as it did in 2011 and also in 1980.
The Corona crisis has added a further dimension
by impacting a large number of silver miners
who've temporarily had to mothball their operations,
thus creating some of the supply chain bottlenecks
that will put upward pressure on prices.
And given the small size of the market, and
the potential size of interest from institutional
investors, prices could move quite quickly.
And if we think that this period of money
printing is going to be far in excess of other
periods - and Chairman Powell has implied
that they have a lot more ammo, then that
environment should be excellent for the precious
metals complex.
Precious metals perform well in a period of
deflation.
And in order to avoid deflation, central banks
will print more money in order to try and
create inflation.
That should also be good for precious metals,
so therefore the path to inflation, If we
can ever get there is paved with both silver
and gold.
Silver is coming off a very slow start, but
history suggests that once it gets going,
this is a supercharged precious metal that
everyone begins
to chase.
