November 28, 2020
There has been no update here for over a month, and the world of finance seems to have smoothed out. The world has exhaled, in what seems to be a sigh of relief after the US election and the markets are presenting us with a ‘risk on’ scenario.
At the risk of sounding silly, the world probably shouldn’t fall for it.
Markets continue to rise because money continues to be flooding into the system. This is money produced by increases in government debt. While riding the tsunami higher is exciting, the difficulty is always knowing when the tide will turn. That can be difficult to ascertain.
This year, the US Federal Reserve has grown their balance sheet by over $3 trillion which is exceptional from any perspective. Consider that before the 2008 Great Recession, their balance sheet was < $1 trillion. At the start of the COVID collapse they had begun working it down again and it was under $4 trillion. It is currently $7.2 trillion.
Meanwhile, the US federal debt has climbed by $3.2 trillion in 2020. A clear review shows that before 2008, the US federal debt was under $10 trillion. To prime the economy over the past decade or so, an additional $13 trillion of debt was added. That in itself is exceptional, but when COVID hit, it climbed from $23.2 trillion to the current reading of about $27 trillion. That’s another staggering number.
Since my last post, the money supply (M2) in the US has increased by about $300 billion. In the last two months, it has gone up by a half a trillion dollars. In the twelve years before Covid, the money supply (M2) went up by 7 trillion dollars or or about $500 billion a year. This year alone, the money supply has grown by $4 trillion dollars. It’s phenomenal.
Of course when markets melted down in the spring a lot of value was destroyed, but the money management business is kinda hooked on convincing everyone to stay invested and the best way to do that is to make sure that asset prices rise. The best way to do that is to make sure that everyone has enough money to cover their responsibilities and flooding the economy with money is the easiest way to do that.
So the stock markets have come right back up to where they were in February (well, it did take eight months) and have now surpassed those highs. It must all be good, right? (It’s not all good!). All of the warnings and prognostications here are proving incorrect but I will stick to my knitting and say that it can’t continue. Because, it can’t continue. Without further injections of massive capital into the system, individuals and companies will be forced to reduce spending, perhaps sell assets, perhaps even pay more in taxes, any of which will reduce profitability.
To generate the snapback that has supported the markets, governments from around the world, not just those in the US or Canada, have had to borrow (or create by expanding central bank balance sheets) more money in 12 months than was borrowed in entire decades in the past. Again, the total value of the US Federal Debt and the Federal Reserve balance sheet before COVID will end the year more than $6.2 trillion higher than at the start.
The total value of the debt and federal reserve balance sheet at the beginning of the year were about $27.4 billion in total. The additional $6.2 trillion (22% more) sustained the US stock and bond markets.
In the bad news column, all of this didn’t return employment to where it was prior to the collapse. Of course there is hope that it will, but below is the chart of continuing claims for unemployment. To be sure, things are not getting worse, but they are about the same level as the peak of the last economic collapse, the Great Recession of 2008.
The pain from this collapse isn’t being felt because of all that money governments have poured into the US economy (and elsewhere too), but it has only pushed off the pain for many.
Clearly the rise in asset prices is significant and another chart that I highlight frequently is the value of the Wilshire 5,000 vs. GDP and it continues to show that stock markets are vastly over priced by historical standards.
Now to be sure, there is an argument that justifies this overvaluation and it is interest rates. With interest rates near zero for anybody with a lot of assets (that’s the top 10% of the population, the rest are paying ridiculously high rates), there is a lot of money to be had to invest or spend. Below is a chart of 10 year treasury rates. That uptick over the past 20 weeks is something to be concerned with. It suggests that bond investors are expecting a rise in prices (inflation). Of course that is what the Federal Reserve wants to avoid a collapse in asset prices, but it brings its own set of issues.
This whole problem can be viewed from another perspective and that is the value of currency. In a rational world, a country with increasing debt and low interest rates would suggest that risk is not being properly accounted for. So in sympathy, the currency should decline as external participants sell assets to reduce risk. If that were happening, then the dollar should be declining. Wait, there it is.
Clearly, the dollar is not doing as badly as it was during the Bush administration, and its even better now than it was early in the Trump presidency, but the weakening that is currently occurring is worrisome because all of the traditional ‘positive’ levers have been pulled.
A declining dollar is good for exports, because goods priced in US dollars look cheaper vs. other currencies. The other side of that is that it increases prices for things that are imported. Given that many consumer goods are now imported, inflation is likely to pick up.
Overall, the markets have significantly outperformed most expectations and with a new president (still presumptive) expected to stabilize politics, but implement policies that are less business friendly, the probability of the markets staying this over valued are pretty low. Do remember, extremes in markets can last for a long, long time.