I saw this on LinkedIn today...
'Barring any severe shocks, 2021 is likely to be a year of reaccelerating growth.'
Let's take this quote into a different context.
Imagine it's January 14th, 2020.
'Barring any severe shocks, 2020 is likely to be a year of reaccelerating growth.'
Do we see how dumb that sounds?
This will begin our chat today on why the market has amnesia in our view, clearly with the first point being that people have forgotten about tail risk...
Y'know, those events that you think have an impossible chance of happening when you model them, but in reality, they actually do happen and have a bigger effect than you think?
A decade forgotten
Let's take a look at some markets economic indicators to see the state of play at the moment...
Above is the 10 year yield with a 20 year linear regression added.
Note where the market is approaching now.
That's the mean of the last 20 years - in other words, it is mean reverting.
When that happens, you tend to see one of two things occur.
Either the market changes completely and we totally break through it (see just before the crisis last year happened) or we touch it and push back to where we came from.
And right now, the 10 year yield is facing a touch of resistance.
I'll join the dots together at the end, so for now, let's just focus on these charts.
Next up is the big one...
This chart can really just tell us about the extent of the rebound in Q3...
But doesn't necessarily paint a broad enough picture, because on first glance, you might be thinking, 'oh, that looks OK.'
But if growth falls by such a large margin, then there is always more work to do to regain the prior growth.
We have not really seen that, and recent data doesn't suggest that.
Take a look at the most recent NFP data.
-140k jobs were added in the US in December...
And now, the most recent Initial Claims...
This shows the amount of US workers that filed for unemployment for the first time in the prior week.
Estimations were set at 795,000, with the previous figure sitting at 784,000...
But the figure came in at a whopping 965,000, the most since August.
Why is the market forgetting the past decade?
From Sam Boughedda, analyst at Macrodesiac (he has a full title now)...
Sure, we have seen an escalation in vaccinations since then, but we have also seen cases and fatalities rise over the Christmas period, while there has also been new lockdowns and restrictions in Europe and China.
So is the current (slight) upturn going to cause a great deal of change? Again, I doubt it.
And the change he is referring to here is with Fed policy.
Last week, Powell spoke at Princeton via webchat (because that's how things are done now in the New Paradigm™), and it was actually damn good because the questions asked were punchy, for once.
The main takeaway was that the Fed are unlikely to change course any time soon, and backed up his Jackson Hole policy of Average Inflation Targeting by also referring to what Clarida had said in the week too...
We are not going to lift off until we get inflation at 2% for a year
The Fed have the foot on the gas of asset purchases.
This will not let up any time soon, especially when the rest of the world are doing the same.
But again, we need to reference market amnesia again...
The year of complacency, and an entirely fickle market.
Those two words go hand in hand with the current environment too.
Check out what happened in Q4 of 2018.
This period was known as a 'taper tantrum'...
The Fed announced that it would be slowing the pace of its asset purchases.
This led to a broad sell off in US equities - who wants to be holding risk when the Fed is no longer there to support the market by suppressing treasury yields?!
Well risk did come off, as you can see in the chart.
Let's do a quick comparison of the two periods.
We don't need to go into anything too broad because the overriding factor here is that in 2018, we weren't in the midst of a pandemic.
We didn't have mass business closures, the largest stimulus ever required to keep a semblance of a normal economy, nor did we have the largest labour market shock ever.
Y-axes broken forever.
Could you imagine the Fed raising in an environment like this?
I can't, and I would argue that they are extremely cautious about tightening policy to pre-empt anything.
Now, they are focusing on data.
In 2018, they were pre-empting.
There's a big narrative shift.
Why go data focused now?
You know after you've been winded and you deliberate whether you want to engage in that activity again?
The Fed are probably very wary about further tail risks down the line, whereas the market seems unconcerned.
'Alright, we've got vaccines coming now. Everything is fine, inflation will tick up and growth will come back with it.'
But I do not see it that way, for some reasons described above.
Powell made a direct comparison with 2008 in the Princeton webinar.
He referred to the problems with 2008 being with the consumer and issues with bank liquidity.
My take now - the real problems are with corporates and the overhang from 2008, both the effects of, and the policies after.
Take a look at this chart...
What we are seeing here is that corporate debt has the lowest yield since just after WW2 ended.
This is pretty much all Fed driven in my eyes.
This is important from Moody's themselves to back up the above info.
For example, the Moody’s Analytics long-term Baa industrial company bond yield averaged 8.28% when the U.S. stock market peaked at 135% of GDP in 2000’s first quarter.
The average long-term Baa industrial bond yield of 2000’s first quarter even topped its 7.60% average of 1997-1999.
In stark contrast, the recent 3.27% long-term Baa industrial bond yield was not only well under its 4.43% average of 2018-2020, it also was less than each of its prior month-long averages going back to the 3.25% of October 1952.
The Fed’s suppression of Treasury bond yields and willingness to extend extraordinary support to corporate credit has helped to rein-in both corporate bond yields and their spreads over Treasury yields.
January 13’s 145 basis-point spread over the long Treasury yield for the long-term Baa industrial yield was the narrowest since the 143 bp of February 9, 2018.
The long-term Baa industrial yield spread of 2000’s first quarter averaged a wider 181 bp, which was above its 174 bp median of the 30-years-ended 2020.
And the real kicker from Bloomberg...
The P/E of the Russell 2000 topped at above 10,000 last month. For the last three weeks, the index hasn’t had a P/E because on aggregate it has had no E; the losses of its constituent companies have more than counterbalanced the profits.
That is a situation that is untenable.
And yet, the Russell has kept hitting highs.
Powell references financial stability constantly, and as I have mentioned before, this is certainly the Fed's main mandate if we were to look at evidence.
A little bit tangential to this perhaps is why I do not believe that the full employment part of the dual mandate is something they really care about is because of the below chart.
With the labour force participation rate dropping pretty much consistently over the past decade or so (funnily enough, barring half of Trump's presidency where it increased a little YoY), it's 'easy' to have full employment since the unemployment rate doesn't count those who have permanently taken themselves out of employment according to the measure.
This also gives rise to the faults of the Philips curve which, admittedly, the Fed hasn't used in years to be a good gauge of where inflation is headed (kinda).
So why does the Fed have to be data focused?
Well, ideally they want to continue easing in my view.
It's the path of least resistance.
They do not want to shock an already shocked market; a market which is currently experiencing base rate neglect - that amnesia of the past decade which is creating complacency.
So the current state of US smaller corporates is largely one of the reasons as to why this has to happen.
If we take a look at the data above on the profits of small cap firms and then look at this story by the WSJ, then something doesn't add up...
The Main Street Lending Facility has hardly had any take up.
To me, this might show some despondency in the market and a stark issue.
If these firms are just surviving, what would it mean if the Fed were to turn hawkish?
Would these firms simply go under?
Yes, they would.
Here's where the programme failed...
The root failure, say banks and borrowers, was that if the loan a borrower wanted was attractive to a bank, the lender didn’t want to sell most of it to the Fed. But if a loan looked to be a dud, the bank was reluctant to hold any of it.
But to look at it more broadly, it's not just a failure on the part of the facility's mechanism...
The firm being in too poor a condition pre virus came out top - so again, I find the market's amnesia right now astonishing.
The pandemic was certainly a tail risk, but a tail risk that had exacerbated long run structural issues.
And these are issues that couldn't be mended by 10 years of stimulus, so how can they be mended by even more?
I believe I have mentioned before that the real downfall of western economies is not if everything fails, but if we have an environment of 'economic melancholy'.
Where we just trudge along, with productivity heading ever lower, innovation subsides and depression is our natural state.
It is scary to think of a future of permanent depression, but I guess all is OK because we can bid markets to constant all time highs, right?