The world is now reopening from the coronavirus shutdown and starting to pick up the pieces of abruptly shuttered lives and businesses. The landscape presents a grim view indeed, as the economic toll of the virus is tallied. Mass unemployment, a rising wave of bankruptcies, and a future that looks more uncertain than any since the 1930s is greeting the efforts to get back to “normal.”
In contrast, Wall Street has hardly missed a beat over the last 90 days. The plunge in stock prices in March quickly reversed, and large-cap indexes are now approaching their highs of February as if nothing happened. Ignoring the ongoing data from the economy, some of the biggest rallies have occurred on days of the direst economic reports. If you looked only at the stock market, you’d be blissfully unaware of the depression stalking Main Street.
Investors now face a dilemma unique to our times: should they believe Wall Street or Main Street? Can the profound economic negatives befalling families and businesses in America, and indeed globally, be safely ignored as Wall Street would have us believe? Should we expect a rapid rebound in economic activity, and for consumers, long touted as the U.S. growth engine, to return to their free-spending ways? And ultimately, as we scan the wreckage wrought by COVID-19, can we confidently say, as Wall Street seems to be doing, that fundamentals no longer matter?
It is no mystery why stocks are advancing by leaps and bounds—it’s money. Plentiful and nearly free money. While many pundits trot out trite clichés about the market “looking forward,” “seeing across the valley” of the recession, or “fully discounting the bad news,” the reality is the financial markets have again been bailed out by the Federal Reserve and other global central banks.
When the impact of coronavirus dawned on Fed policymakers, they quickly ramped up their money printing machine, known as quantitative easing (QE), and flooded the system with bank reserves. The Fed can do little else to stem the economic tide as it washes over the country, as they have squandered the opportunity to bring monetary policy and interest rates back to some semblance of pre-2008 normality. It is hard to believe that over the last ten years, after the longest economic expansion on record and an unemployment rate under 4%, interest rates in January 2020 were still in the low single digits. Faced with the pandemic and its resulting wave of closures, layoffs and bankruptcies, the only monetary tools available to them were the reengagement of QE programs.
The resultant surge in the Fed’s “balance sheet” is nothing short of breathtaking. In three months, the Fed has created over $3 trillion of new money, and the balance sheet stands at just over $7 trillion. The scale of this monetary expansion is without precedent in modern finance and is a clear indication that the policies of old (a.k.a. “sound money”) have been tossed out the window. This is dollar debasement on an epic scale.
Wall Street, of course, knows what to do with the odd trillion dollars that falls in its lap. Buying and speculation have resumed in earnest as if the pandemic were nothing but a mild cold. Moreover, many of the riskiest companies have been able to readily borrow (at junk bond rates) in a market starved for yield, underscoring the appetite for risk. Airlines, cruise ship operators, and retailers have been able to tap the credit markets in hopes that they can get themselves through the worst of the coronavirus depression they are in. (Interestingly, hard-hit oil and gas companies have not been nearly as welcome by bond investors.) This has led to a rising cycle of nearly free money begetting higher prices and reinvigorating the speculative bubble.
The contrast with Main Street could not be greater. Record recoveries in stock prices have been matched by record job losses. Industrial production, retail sales, and regional Fed activity indexes recorded April and May declines that were heretofore unimaginable. Unemployment may reach 20% in the months ahead and Gross Domestic Product (GDP) is forecast to drop at a 40% (annualized) rate in the second quarter. Expectations among business owners are still quite depressed, with many expressing doubts about the return of customers. Consumers, too, have expressed an unwillingness to take chances on travel, restaurants, and other social gatherings for the time being.
An economic recovery is not solely a function of reopening the economy. Reopening in no way guarantees demand. The U.S. Chamber of Commerce reports that 25% of small businesses have already shut down, and 40% have only enough working capital to last through May. The AARP claims that 53% of U.S. households have no emergency savings, underscoring how close to the razor’s edge of poverty many Americans live. It’s unlikely these consumers are going to engage in a post-shutdown spending spree.
Thus, it is hard to imagine the economy getting back to 100% of its January level any time soon. But would 90% be enough? Investors are riding a wave of euphoria proclaiming any increase in economic activity as a good sign. To put a 90% recovery into context, remember that GDP fell a seemingly miniscule 4% in the 2008 recession, enough to create 10% unemployment and a 50% drop in the stock market, along with social unrest, Brexit, and Trump’s rise to power. A 10% drop in GDP, more than twice as bad, would likely lead to lasting unemployment and large-scale bankruptcies.
Two things are worth remembering about today’s dismal economic statistics. First, these are not small variations around a gently rising trend line. These are major drops in activity and income. Second, we are only three months into this, with the prospects of more bad news to come. This kind of damage does not get repaired quickly. Given that we have now lost more jobs in 2020 than were created in the entire previous decade, it is naïve to expect a rapid bounce back this year.
“Trickle up economics” is about to unfold, as the drop in incomes of the bottom 90% of workers will create a negative feedback loop of lower spending, higher savings, and diminished demand. Can billionaires alone hold up the consumer sector? Probably not. Moreover, the Fed can create conditions conducive to borrowing, but they cannot create customers or force households to spend. And when the prospect of borrowing becomes moot because a household has maxed out their credit, or their lower incomes preclude them from getting a loan, or they’ve found they can live without more “stuff,” the Fed’s policies will be found to be moot also.
Like Pavlov’s dogs, Wall Street has been conditioned to the Federal Reserve riding to its rescue with buckets of money, and today is no different. This raises the question of whether fundamental financial data matter to the markets anymore, or whether asset prices will be driven solely by QE from now on. This has major implications for investment strategy from here forward. If QE-fueled liquidity is going to be the driver of asset prices, then we are truly entering a new paradigm in the world of investing. We can dispense with the expensive MBA educations and toss out our finance books, because the only thing left to analyze will be the ebb and flow of the Fed’s liquidity operations. Bear markets will last only a few weeks, and companies that historically would have gone bankrupt will be “zombified” by their ability to perpetually borrow no matter how poor their business prospects may be.
But if fundamentals DO still matter, then markets have gotten way ahead of themselves. Pity poor Warren Buffett, sitting atop his $130 billion pile of cash. He has been noticeably absent from the Wall Street feeding frenzy, and has come under withering criticism for it, with some high-profile funds now dumping his stock, Berkshire Hathaway. But perhaps he sees something that Wall Street has become blind to—today’s market offers poor value on a fundamental basis. A glance at the “market capitalization-to-GDP” measure makes his reticence understandable. This measure is now back up to the rarified levels it reached in 2000, the most overvalued market in history. Should we take Buffett’s silence as a loud and clear message?
We believe fundamentals still matter because income matters. We cannot pin economic or investment strategy on the hope for perpetual borrowing. Debt is nothing more than bringing future consumption into the present, and depends on a stream of income to pay it back. The key economic negative of the pandemic is the widespread loss of income among households, businesses, and municipalities alike. Policymakers seem to believe that encouraging even more debt is the solution to our dilemma, and that artificially inflating asset prices will bail out borrowers. But income is key; when high leverage runs headlong into a drop in income, trouble usually ensues.
If fundamentals still matter, then we must be alert to reaching a tipping point in the markets, when the effect of falling incomes (salary, revenues, earnings) finally overwhelms the tsunami of debt encouraged by QE. It may not be soon, as the Fed has demonstrated QE is here to stay. Conversely, the profound economic damage the pandemic has delivered may be enough to tip the scales back in favor of fundamental financial factors. When QE ultimately fails to “save” the economy from its excesses, investors will finally realize the central bank emperors are wearing no clothes. At that point, the common sense reality of Main Street will finally prick the bubble in which Wall Street is currently living.