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It’s all good.  Highest unemployment rate since the Great Depression?  Record breaking quarterly loss in GDP on the way?  Looming deflation and debt defaults?  Pffftt!  Down markets are for losers.  The Fed’s got your back!

Wall St is already flirting with 3000 again only a few weeks after bottoming at 2200.  The ruling narrative is that traders are “seeing past -covid-19”.  They are, but they are also assuming this will be a V shaped recovery for Wall St, whether it is or not for everything else.  The party line is that this is investors being far sighted but let’s get real here. Its all about trader’s believe that whatever bad stuff happens, the Fed can fix it with the sufficient application of money.

Truth is, the Fed CAN fix a lot of things, at least in the short term.  Not everything though. It can’t directly bail out all the smaller companies that will need it or all the employees that lose their jobs or gig workers that lose their gigs.  I do not think they will be around to literally underwrite the trouble that will work its way down the supply chain or to business-to-business suppliers like owners of office buildings.

We are lucky in the gold sector. I think it will be a clear winner. There’s still lots of pain coming elsewhere in the economy though, and I don’t think that’s anywhere near priced in. New Lows on Wall St? Maybe not, but a long grinding pullback is coming.   
 .  Eric Coffin

“Investors don’t like uncertainty.”
Kenneth Lay 

If you don’t know Kenneth Lay, you might miss that I’m being a bit ironic with the quote.  Lay was the chairman of Enron Corp, one of the most famous accounting frauds in history.   Clearly, he put other’s money where his mouth was.  He was so convinced Enron’s investors hated uncertainly that he cooked the books for years to ensure they would not have to experience it. 

It’s clear from their actions in the past month or so that the US Federal Reserve also believes investors can’t handle uncertainty. It too is doing everything it can to ensure they don’t have to experience it. Before you ask; No, I do not think it’s fraudulent, though it does ramp up the level of moral hazard we’ll face in future.

So far it’s working.  Check out the chart below which compares S&P forward PE and the size of the Fed balance sheet.  Traders have been willing to pay much higher multiples for future earning streams as the Fed underwrote an ever-larger portion of the markets.  Yes, falling interest rates account for some of the change, but only some.  The real reason seems to be high optimism on the part of traders.  Yes, the rallying SPX index obviously generates its own optimism, but its still mind boggling to me that the forward PE is now higher than it was before covid-19 came along.

Some of this is passive investing.  Continued buying by passive funds is indicated by how concentrated, within the index, the buying has been. I think that helps explain the recent pattern of FAANG stocks becoming even more dominant within the SPX.   Those five stocks now account for over 20% of the S&P by value.  That’s higher than at any time in the history of the index and 50% higher than the long-term average. 

I can understand Amazon and Netflix.  It’s obvious why both of those would gain during lockdown.  But Apple must be having supply chain issues and Google and Facebook, when you strip away the tech lustre, are basically advertising channels. I don’t doubt they’ll maintain their dominance, but advertising spending tends to be very cyclical.  How many companies will increase ad spending when so many are in the midst of existential struggles?

Only passive investing, and confident retail traders explains the level of both forward PE and FAANG stock valuations to me. Ironically, retail investors that sat out 10 years of Wall St gains are now entering the market in droves.  They got the pullback they were hoping for.  And they look smart so far. But anyone who has traded through a couple of cycles knows that seeing retail arrive en masse is rarely a good long-term sign.

And, again, recent data bears that out. The chart below shows the most recent US consumer sentiment surveys.  I think the dichotomy is very telling. 

The “current situation” readings absolutely cratered.  Exactly what you’d expect in the midst of a lockdown so not surprising.  The surprising reading for me was “expectations” which not only didn’t crater but actually bounced last month.  Granted, survey questions about expectation usually cover 12 months into the future, but its still impressive those did not decline at all.  The only explanation for that reading is that consumers expect a “V” shaped recovery from covid-19, and a steep sided V at that.

Some of this is just natural optimism but the main cause for that optimism lies in the (latest) central bank experiment we find ourselves in.  Central banks everywhere have been rewriting the rules since the pandemic surfaced. The US Fed has been especially active, working in concert with the Treasury Department to create workarounds that allow it to underpin markets its not legally allowed to.

The chart below is an updated view (but already out of date) showing growth in the size of balance sheets for the major central banks.

Impressive as that growth is, it does not take fiscal spending into account.  The US has been a leader there too, in terms of deficit expansion at least.  Last year’s federal deficit was $1 trillion.  It’s unlikely this years will come in much under $4 trillion, if it does in fact come in lower at all.

All that spending is the reason for the optimism and the reason for a 35% rally off the March bottom.  It’s not virus news, though that’s getting better, and its certainly not current economic metrics.  Those are bad and likely to get worse before they get better.  This is pure “don’t fight the Fed” FOMO.  

Fair enough, but I remain as skeptical about a V shaped Wall St recovery as I am about a V shaped economic one.

It’s fashionable to hate on the Fed among financial and market commentators.  I don’t indulge in that because I think they’ve done a good job so far during this crisis.  Should they have normalized rates a few years ago? Yes.  And they should have shrugged off whatever market weakness that spawned.  I think the die was cast even then, though. Western economies are too overleveraged to handle high interest rates. That is bad but its hypocrisy to just “blame the Fed”. We’re not children and we all made choices. Central bank did not force companies to lever up balance sheets.

The Fed has done a good job of underpinning markets, even if I don’t think they should have underwritten some of them. Washington has stepped up on the fiscal side, though they may have to do more before this is over. That saved the markets from collapse but we’re not out of the woods yet.

In the US, 30 million people have filed for unemployment. Many of those jobs will return but definitely not all of them.  And the unemployment system doesn’t cover a lot of the “gig” workers or self employed. There is an unknown, but not small, number of workers on top of that 30 million that have also seen their incomes vaporize.

As I’ve noted in the past couple of issues, the lockdown slowdown is baked in the cake already. The more trenchant question is how fast things return to normal, and what normal even looks like now.

The charts below, an updated version of Chinese activity indicators and electricity usage for parts of Europe helps answer the first part of the question.  Housing sales and transit passenger usage have both bounced in China but are still far below pre-covid levels. The transit reading is probably an underestimate of true activity levels. I think a lot of workers don’t want to be on packed subways and buses. They are finding alternate means.

Power usage in Italy and Spain has bounced, though France hasn’t yet.  They are a long way from pre-covid normal but it’s still early days. The fact those readings have been presented as a big positive tells you just how unique the current situation is.  In any “normal” recession, a 20-25% drop in power consumption would be considered catastrophic.

Just before this issue went out, Flash PMI readings started to come in from Europe. Calling them awful doesn’t begin to do them justice.  Flash service PMI from Europe for April are in the single digits.  We have never seen readings even close to that low, ever.  It’s the equivalent to saying “the factory lights are turned off, everything’s got a dust cover on it and we’ve padlocked the doors”.  Which is pretty much the actual situation.

Ok, granted, that was April. Everyone knew it would be awful.  I would not expect markets to react much to those numbers.  Likewise, I do not really expect a big negative reaction to the next US non-farm payroll number in a few days. Everyone knows it will be terrible. Even if it is a negative surprise (whatever that means in this situation) traders will probably just shrug.

The important question, and it will not weigh on markets for a few weeks, is how fast we bounce back. We already know it’s a recession, the worst we’ve ever seen.  But is it a Depression as macroeconomists might define it—more than four quarters of negative growth? The definition is a bit more nebulous than that, classified as a “sustained” downturn but I think it would have to be at least four quarters of negative.

While it may be too early to use the “D” word, it bears thinking about. A lot of the furloughed workers will come back to work, but certainly not all of them.  And the current job loss numbers are so large that even if, say, 75% come back, we’ll have a huge unemployment rate.  Then we must look at knock on effects.

How many small business or early stage ones that have not built up a loyal clientele are going to just throw in the towel?  I do not know, but the number won’t be small. 

How many companies that have been under work at home rules will decide they don’t actually need all those back office staff?  How many companies will decide, for that matter, that they don’t need most of that back-office space.  How many people will decide they don’t want to be on a plane, or a cruise ship or in a crowded restaurant, hotel or social event?   Again, no one knows the answers yet but I’m willing to bet, am betting in fact, that the numbers won’t be small for any of the above.

In the short term, central banks and large dollops of fiscal spending can paper over just about anything, but that has a limited shelf life.  You can already see political push back to more fiscal spending in the US, though I imagine we see at lest one more broad based program. 

So far at least, the US Fed has succeeded in calming the market and retaining control of the bond market, more or less.  The charts above and below show the large decrease in VIX and 10-year bond yields.  While still high by longer term standards, volatility has been cut in half in the past month. That is impressive given the economic backdrop. Decreased Vol means rules based institutional traders can take on more leverage under Value-at-Risk models, and the Fed’s been flooding the market with liquidity, partially for that purpose.

Bond yields have been trending down, in part due to Fed buying or at least the promise of it.  Promised buying has been even mor successful in secondary bond markets like LQD and HYG.  Bond funds and hedge funds have been buying boatloads of bonds in these markets. Not because they got religion on lower bond risk. They have been front running the Fed, which apparently hasn’t started buying itself yet.  Pre-announced front running to keep hedge funds sweet.  Is it any wonder the one percent is so reviled in the US these days?

Low yields, and lots of swap lines, have also kept the US Dollar from running away.  There are a lot o smart traders expecting a run in the order of 30-50% un the USD Index.  I am not sold on that theory yet, but I can see the power of the argument. There are trillions in offshore US denominated loans and a scarcity of dollars to pay them off.  Some think there is no way the Fed can keep the Dollar from running.

I think the risk is real, but don’t underestimate the ability of the Fed and other central banks to come up with work arounds.  The swap lines are helping a lot and foreign central banks may find ways to funnel Dollars directly to their home USD borrowers. Yeah, there may not be a legal mechanism for that, right now. But who cares?  We are talking about governments. They get to rewrite the rules.

While the dollar might run, I suspect a combination of swaps and sale of US based assets could generate enough greenbacks to keep it from getting out of hand. It will take a lot of Dollar creation to make it happen, but the Fed’s already made it plain there is no top end to their balance sheet until they think this crisis has passed.

Would a possible USD run cap the gold price?  It would create a big headwind, for sure, and could lead to occasional pullbacks.  But gold is not just trading against the Dollar.  I think there are two things driving most of the gold demand: fear of a reset and fear of (longer term) inflation.

Federal debt and central bank balance sheet sizes, not to mention private leverage, have reached the point where there is no obvious way out. At the private level, some of this will be “solved” through bankruptcies and debt write offs.

I do not see any of the G8 countries literally going bankrupt. I do not see them balancing the books through tax increases and spending cuts either, though. The scale of tax and spending changes required make this concept a political “third rail”, career suicide for the politician that grabs it. Maybe we do see a debt jubilee, though inflating debt away would be the preferred route.

If there is enough supply chain disruption and onshoring after demand starts to return, we could see some inflation-later. We will not see in the short term.  It already looks like CPI will go negative in the next few weeks and stay that way for an unknown period.  That will drive real interest rates higher unless central banks can force rates lower with repeated bouts of QE.  And yes, though they swear it will not happen, even the Fed might go to negative rates. That would be a disaster or the banking sector, but it could be hard to stop if the market is pricing in a deflationary environment.

No one knows how they will play out.  But the high odds of some sort of reset, and the certainty it will directly impact financial assets somehow, has many more turning to gold. Gold is an asset with no creditor, outside the financial system. That’s an extremely attractive attribute, on top of gold’s ability to be a hedge against inflation and government/central bank stupidity.

Its that protection that I think will keep gold strong. It will have pullbacks during USD surges or periods of extreme “risk on” on Wall St, but the trend is higher.

As most of us own juniors I’ll leave you with the charts below.  We can see how well gold has done.  After a big drop and much hand wringing by gold stock investors, we’ve seen GDX follow gold.  It’s has a clear breakout and is trading at  seven year highs. Not where it should be, perhaps, but doing well enough to make us feel smart.

GDXJ has made a comeback too, though it has not broken out yet. I think that is coming, perhaps after a bit of backfilling.  The point of the three charts laid out in this order is to show that money is, indeed, moving down the food chain.  And it is happening fairly quickly, all things considered.

We are seeing higher share prices and trading volumes starting with the more advance companies on the HRA list but spreading to earlier stage ones now. Things are looking up. And if gold can advance a bit more above $1700 in the next few weeks, this may not be the usual “sell in May and go away year”.

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