My British colleague Roger, now in lockdown in the UK, is the one who came up with the title phrase. He said, from an economic, policy and market standpoint, this is the key question to ask. In terms of the policy apparatus now in place, as he phrased it:
I think we should discuss the risks of bringing a demand side bazooka to a party where there’s no supply. Will this lift assets as before or will it merely drive up temporary inflation in a deflationary bust, therefore helping no one? Is QE infinity going to cap the yield curve whilst inflation rises, creating negative real yields and driving gold’s next leg higher? Also, shouldn’t the dollar be holding onto its losses if this is such a big deal or does that tell us something about the real state of the worlds economy?
There’s a lot to unpack in that. But I am going to try to do it in today’s post.
Present monetary policy situation
Let me frame where we are from a policy perspective given that the two main parties in the US have now agreed to a stimulus bill.
Monetary policy always comes first because central banks can act quickly. Their first port of call is always going to be a combination of rate policy and forward guidance. This serves to anchor the yield curve on the short end, while managing expectations for future policy on the long end of the risk-free asset curve. What we’ve seen there is a collapse of base rates on the short end and a curve flattening over time as expectation for future policy tightening has evaporated. For me, any curve steepening is a proxy for optimism about the potential for a future economic rebound and the effectiveness of economic and monetary policy.
But, they have done that and it wasn’t enough to stem the tide. Thus, central banks have been forced into more aggressive policy positions. Look at the Federal Reserve’s press releases, for example. There has been a flurry of activity since March 15 when the Fed cut to zero.
Central banks recognize that we are now in a global liquidity crisis with multiple vectors. And so, they are attempting to provide blanket support for solvent but illiquid financial institutions. More than that though, in the Fed’s press release from Monday morning, they signaled that the situation was so dire that the “effective transmission of monetary policy” no longer stopped at blanket liquidity support for the financial sector. The Fed now needs to provide direct credit support for the private sector with the aim of “[s]upporting the flow of credit to employers, consumers, and businesses by establishing new programs”.
Again, all of this is under the auspices of ensuring the proper functioning of the financial system and the effective transmission of monetary policy.
Present fiscal policy situation
Monetary policy can only get you so far. It works mainly through interest rate channels and by shoring up liquidity in the financial system. So, its transmission is mostly financial in nature. And so, via the financial system, it has only an indirect impact on output and income. Fiscal policy, particularly through deficit spending, actually directly puts money in people’s pockets.
When the government deficit spends, it is effectively transferring net financial assets to the private sector. Every pound, every dollar of additional deficit spending is a pound or dollar of additional money that the private sector holds.
And in a downturn, you want to see the deficit spending increase because countercyclical public sector support via deficit spending counteracts private sector retrenchment. In a recession or a crisis, individuals, families and private sector businesses are cash flow poor. And those that have cash flow are fearful. So spending dries up. And when spending dries up, private sector incomes plummet because they are dependent on that spending. Deficit spending replaces some of that lost spending and income.
The big question is what’s the most effective way of providing that cash flow support to the private sector. And note, it can happen via tax cuts or spending as it always has, but also by simply crediting private sector bank accounts.
This crediting of accounts is effectively what we’re seeing now with governments around the world simply putting money in people’s bank accounts. Sure, the central banks facilitate the action by buying government securities issued as this deficit spending ramps up. But the right way to look at this is as a consolidated government balance sheet, for a nation’s Treasury and central bank, with the two working hand in glove. In exigent circumstances, that’s how it always works. The central bank is an agent of the government. And the independence of central banks always, always evaporates in times of crisis.
The bazooka question
The biggest question for me is how effective is fiscal policy going to be. It’s both a timing issue and a sizing issue. That’s inherent in the question Roger posed. What Roger was saying is this: even if the government gets the sizing right, it’s not clear it can get the timing issue right when the economy is in lockdown. If there’s no supply, you can create all the demand you want. It won’t increase output.
It could increase inflation though. Constrained supply with more euros or yen chasing a finite set of goods and services is a recipe for higher prices. It reminds me of inflationistas predicting hyperinflation after the last recession because of quantitative easing. Quantitative easing is just an asset swap of central bank reserves for financial assets like government bonds or mortgage-backed securities. For the private sector as a whole, it simply replaces an interest-bearing asset with a non-interest bearing one when rates are zero or negative. QE sucks interest income out of the private sector, making it deflationary, not inflationary, when kept in place for long periods.
Inflation is not “always and everywhere a monetary phenomenon” as Milton Friedman argued. Inflation is “always and everywhere a constrained supply phenomenon”. It’s about too much money chasing a constrained supply of goods and services and bidding up the price of those goods in services in the price of that (increasing) supply of money.
So, here’s my answer to Roger’s bazooka question. The money that governments are creating out of thin air and with which they then credit accounts increases GDP only to the degree it replaces demand that’s evaporated because of lost income. Put more simply, crediting accounts is really only about keeping the wheels turning. It’s about making sure people can pay their rents and mortgages and put food on the table. And that’s important, not just for the individuals and families who get the money, but also for the businesses where those people spend.
But crediting accounts is not going to make up for all of the lost incomes. We’re talking about millions of people going unemployed. Do the math; if 10% of people are unemployed in an economy where the private sector accounts for two thirds of GDP, you’re losing 6 2/3% of GDP. The government, which is only a third of the economy, then, has to supply 20% more deficit spending to completely make up for that loss. That’s a lot of deficit spending. And, in the US at least, those are not the kind of numbers I am hearing.
What happens to asset prices?
I think bond yields go lower here. The UK ten-year is trading at 0.459% right now. The Canadian is at 0.891%, the Aussie at 0.976%, The Kiwi at 1.463%. And the US ten-year at 0.853%. I focus on the Anglo-American countries because they are the principal ones converging to zero where the Europeans and Japanese already are. And the question is how long zero remains in place. The longer it remains in place, the flatter the curve gets, with short rates remaining relatively unchanged and long rates converging downward toward zero. The New Zealand 10-year is the outlier here then, and long rates present more relative value than short ones.
Implicit in all that is my view that there is no V-shaped recovery coming – not even a U-shaped one, but an L-shaped rebound. The more L-like the rebound, the more relative value long duration risk-free assets have. The great bond bull market is not over yet in my view.
I haven’t mentioned the eurozone here simply because there’s another level of assumptions you have to embed. Since national governments aren’t currency issuers and can default, you have to assume the European Central Bank will backstop the debt in order to benefit from convergence. The German 10-year is trading at -0.300% right now, with Spain having traded up to 0.837%. Will Spain get a backstop from the ECB that allows it to converge with Germany? You’re at 113 basis points spread now. Can you get down to 70 or 80? And if so, is that a bet worth taking? I don’t think it is. And Spain is much better positioned than Portugal, Italy or Greece to get a backstop. While Greece gets you 2.417%, the risk there is default.
On the equities side of the ledger, shares look expensive to me in a world where there is no buyback bid in the US. Exxon Mobil, for example, trades at 19x estimated 2021 earnings and 22x 2022’s. Do you want to pay 22x Exxon in a world of extreme uncertainty? What’s the upside on that? Not a lot in my view.
At least with a company like JPMorgan Chase, you get forward multiples for 2021 and 2022 of 7.8x and 7.4x earnings. That looks like a better relative value play to me. But, most S&P500 companies aren’t priced like that. Microsoft has the same profile as ExxonMobil with 23x and 21x forward earnings multiples for 2021 and 2022. Expensive
I don’t know if the bazooka can lift those prices then. Liquidity support from the Fed will certainly help underpin investment-grade bonds. But, shares and high yield look like places where bombs will explode in the cash flow poor environment we’re in right now.
Delta Airlines was cut to junk by S&P yesterday. And this was a company Moody’s was rating A3 just a year ago. How many of the BBB names will fall into the high yield bin, where there is no Fed backstop? That’s akin to Greece failing to make the grade for an ECB backstop during the European sovereign debt crisis. The risk of default is elevated for high yield names. And overall, that’s also a drag on equities, since shares are the residuals on leveraged corporate balance sheets after debt-holders are made whole.
My view
Overall, then, I don’t see government stimulus measures as enough to arrest the fall in the real economy. The downdraft in GDP will be severe. And it will be global.
The central banks’ blanket liquidity safety net is not designed to support rickety, leveraged and insolvent companies. That necessarily means a torrent of defaults and bankruptcies is coming. This environment is not good for risk assets in the least. Fiscal, monetary and liquidity support are not going to end the business cycle. Therefore, expect more downside to come despite yesterday’s rally in shares and the future rallies to come.