June 30, 2020
One of the most important qualities to good analysis is the ability to discern the parts of the analysis that are correct and the parts that are not. Or perhaps the whole thing is rubbish, or you get it all right and are a total genius.
This blog has been focused on the train that is barrelling down the track toward the stacked house of cards built over the tracks, but those geniuses who manage the financial levers of the economy keep adding track between the two. It makes these prognostications look silly. But there is still a house of cards and a train and they are converging.
To stay with the analogy, how much more track is there? That is the question.
After much distraction over the past couple of weeks, the data has piled up while the writing has taken a breather. Catching up is nearly impossible, but here are a few highlights.
- Production – Industrial production is way (way) down. Back to areas last seen in the slump of 2001 and 2009. Back when the S&P 500 bottomed around 800 (it’s at 3,000 now).
- Orders – Orders for durable goods are down, but not sharply. This isn’t unusual early in an economic downturn. The decline in orders for autos during the 2008/2009 ‘Great Recession’ took two years to bottom out, for fabricated metal, just one year, the variations are robust. The two key items to understand are that durable goods orders are typically a lagging indicator and overall, the drop has been swift and significant. Food on the other hand . . . it never changes much (see 2001/2002 and 2007-2009 in the chart below). Except this time. Food/beverages tanked, although that is likely due to the closing of restaurants and bars (and the extra cost/service margins).
- Revenue – The easiest measure of revenue in the economy is GDP. This is measured quarterly, and the advanced estimate for Q2 GDP won’t be released until July 30. The current estimate from the Atlanta Fed is for a decline in Q2 of 39.5%. That is up substantially from the last estimate, in the -55% range. Given the sharp bounce back in some aspects of consumption (and the significant increase in savings rate), there is a good chance that Q2 GDP comes in at -10%, in line with estimates made here two months ago. More timely but less robust data is available. The latest data suggested that retail sales (excluding food services) have bounced back nicely to within breathing distance of last year. Here is the chart and it looks impressive. There are plenty of caveats here (building and garden equipment took a 12% jump, food inflation probably accounted for a big bump, sampling errors, etc.), but it looks pretty good.
For most people focused on the now, the data appears to be good. The headlines over the past month are showing a ‘dramatic snap back’ in spending. Along the lines of the dire view of the economy propagated here, these headlines are continuing an illusion that happens frequently by non-math people. A decline of 50% met with an increase of 50% is still a 25% decline from the original measure. (If you have 100, reduce it by 50% to 50, and then increase the 50 by 50% you have 50+(50*0.5) = 75. You still are down 25% from the original value).
Other than the monthly retail data, much of the data is showing a sharp snap back from drastic declines in sales. These are aligned with the sharp snap back in market prices, however the underlying difficulties are not even close to being resolved.
Fitch, a global bond rating company offers a lot of research regarding financial metrics and this week they lowered Canada’s bond rating from AAA to AA+. There are only ten other countries with AAA ratings and all have arguably stellar financial metrics. The impact of this is that a lower credit rating makes borrowing funds more expensive. If this were to happen to the US, one of the other ten triple-A countries, it will be more difficult to sustain their ultra low interest rates. The same will be true for Canada over the coming years.
Another reason for mentioning Fitch is that they produce a Global Economic Outlook and that data paints a modestly rosy picture for the economy going forward. The ‘snap-back’ in activity is surprising to many, but it shouldn’t be. We didn’t stop living forever, just until the virus was under control. In similar fashion, many are mistaking that early plunge for the starting point of the ‘L’ based recovery. It shouldn’t be, the starting point should be sometime near to the ‘re-opening’ of the economy.
It would be foolish to think that consumption was going to tank by 50% (the GDPNow metric mentioned many times here bottomed around -55%), but that was with an almost complete shutdown of the economy. That was never going to happen. The real risk is what economic activity looks like when things re-open. That time will be different depending on where you are in the world. Sweden has never really shut down; China, New Zealand and Italy completely shut down and eliminated or virtually eliminated the virus; the US thought the whole thing was a hoax and now is the epicentre of the virus. The re-opening outcome will be different in different parts of the world.
A key feature will be how safe people feel. Some are aching to get back to normal, while others are reluctant to leave the safety of their homes. This behavioural shift will continue for some time and there are many metrics for the behavioural aspects. (US TSA activity measures airport traffic; OpenTable measures restaurant reservations; fuel consumption measures automotive activity; google analytics and apple maps show human movement . . . all examples of metrics that are available in near real time.)
This data all looks pretty robust, things are returning to normal (even if it is a new normal) and activity is rising again. Ignoring the US which is returning to shutdowns at least in some hotspots, the new normal appears to be somewhat less than the old normal. The supply chain has been stressed and there are many data points where goods and services are hard to find. Major retailers like Amazon, Ikea, Home Depot are having trouble delivering goods in time frames even close to normal. This is likely to continue for some time.
There are reports that ships are waiting to be loaded in China, and this may be similar in other parts of the world. It also may help to explain the dramatic rise in shipping costs as noted by one of those arcane metrics described here about two weeks ago, the Baltic Dry Index (see chart below). The price to ship goods has risen over 400% in six weeks and that is not completely unusual after the Chinese New Year, but pretty unlikely in the summer.
Returning to the analogy at the beginning, financial engineering has added railroad track between the oncoming train and the house of cards sitting on the tracks. The house of cards is made up of economies that are heavily indebted and the oncoming train is the cost of servicing those debts.
There has been much written here and elsewhere about the size of the debt and how unsustainable it all is. Anyone who is invested in the stock market is benefitting now from that debt despite the fact that it is unlikely to continue. One thing that was learned through the study of prior economic calamities is that recessions are not caused by the drop in demand, but by the lack of access to capital. As investors seek to protect their interests, capital availability is constrained.
During this downturn, central banks have taken this lesson to heart and pushed massive amounts of capital into the system to ensure that financial institutions are able to lend, that investors are not worried about the value of their investment and employees are getting paid. It all seems great.
Another item mentioned here ad nauseam is Moral Hazard, that action or activity that is undertaken without consideration of the risk, or when the risk is not borne by those undertaking the activity. All of the financial risk is being undertaken by the taxpayers en masse, allowing risk takers to ignore those risks.
The effect is just as it seems, risky assets continue to attract capital and prices are being bid up, even on assets with limited quality.
It may not be clear, but the vast majority of that stimulus has not gone to items that traditionally benefitted from similar (and always substantially smaller) stimulus. Historically a stimulus bill would encourage building of bridges or a railway, housing construction, highways, electrical grids and more. An approach that invested public money into employment and the provision of fixed assets with long term value. The COVID crash has seen much of the money provided going to assist companies and individuals with staying liquid. Put into other words, it allowed people to put food on the table and pay rent and other fixed costs. In other words, it is not productive capital.
This has been seen before. During the Great Recession, China built cities without residents, shopping malls where no customers came. In the end some of this worked out, despite the apparent silliness at the time. It is possible that this ‘unproductive capital’ will indeed prevent the train wreck envisioned.
There is little chance that this works out well. A dramatic and historic change is coming but the clarity of what it looks like is still absent. The chairman of the US Federal Reserve made two striking comments today to highlight the points being made here:
- “the economy is still far from healthy and a full recovery will likely take years to achieve,”
- the outlook for the US economy is “extraordinarily uncertain” and dependent on government responses
Yet the stock market has returned to pre-pandemic highs and assets of all kinds remain vastly over-priced. This doesn’t even include geo-political risks, governance risk (note the Wirecard fraud in Germany), political risks (elections and activism in many countries around the world) and various other financial risks.
The historic change coming will be caused by COVID-19, but the path is uncertain (will it be a monetary issue, a revolution, a war, a debt collapse, spiralling inflation or deflation), but it will come. Perhaps another blow-off top in the markets is necessary first, but the outcome is not likely to be pleasant for the vast majority.
In the end, the market calls made here have been wrong, but the reasons remain in place. The long term outcome may well play out along the lines described here, but those buying stock in Tesla (an outstanding run, if you aren’t familiar) or one of the bankrupt/zombie companies (Hertz, Chesapeake Energy (finally declared bankruptcy this weekend), AMC theatres (not yet bankrupt)) for now are really happy.
Perhaps in future capitalism will go back to delivering consequences to the poorly run companies rather than pushing those consequences onto taxpayers. Until then the delusions will persist.
P.S. Great to see that advertisers are holding Facebook accountable for allowing lies and hate on their platform. If the world is going to change, it is apparent that government has abdicated from responsibility and is not going to make it happen. The forces of change may be gathering steam for the greater good.