@theMarket: Markets Celebrate Fourth of July
The continuing gain in jobs cheered equity markets on Thursday, just before the holiday weekend. Given the surge in virus cases in more than half of the United States at the same time, some investors were dumbfounded. They just don't get it.
The nation added 4.8 million jobs in June, which was better than expected. It was the second month in a row that the employment data surprised investors by beating expectations. Remember, however, that this data is backward looking. The bounce back in the economy as a result of re-opening businesses resulted in these upside labor surprises. Readers should expect those employment gains to moderate next month for some obvious reasons.
Topping the list is the massive upsurge in virus cases in those states that chose politics over lives. The pandemic has slowed many state plans to re-open their economies and will impact future growth as well as further employment. I suspect this three-day weekend will damage the American comeback even further, unless the nation actually listens to the advice of medical experts.
In the meantime, I've spent most of the week explaining to clients and readers why I have maintained my bullish stance throughout the last several months. It comes down to my view on the future of the economy and the stock market. There are three main schools of thought on how the economy will weather this pandemic.
There are those who believe a "V" shaped recovery is in the offing. These are mostly politicians and investors with their eye on November's elections. Then there are those who think we will see a "U" shaped gradual pickup that will take longer to accomplish. Finally, there is a group who believe we will see a "W" type recovery, where the big decline in March is followed by a sharp recovery (like what we are experiencing now), only to fall back again before finally rising out of the chaos.
If you look at all three cases, what do you see? In every case, the direction of the right side of each of these letters is going up. From my perspective, that is all you need to know. Will the restoration of jobs and the economy require six months, 12 months, or even 18 months? No one really knows, because no one can game the virus without a vaccine. Whether the economy takes a longer or shorter time period to get there, it will still recover, and so will your investments.
There are several promising vaccines in the works worldwide. In some cases, such as one Chinese version (that is already being administered to their army), the chances of success should be known sooner than later. Several drug companies are expected to provide further information on their vaccines in the fall. A successful drug would be a gamechanger, not only here in the U.S. but for the economies worldwide. In which case, the "V" might be the preferred choice.
Thanks to the massive stimulus provided by the government, the last quarter in the stock market was one of the best since 1998. And the stimulus is expected to continue fueling further gains in the financial markets. While I still expect markets to have their ups and downs, hang in there, because better days are coming if we all use our common sense.
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The Retired Investor: Big Banks & Big Brother
It is an interesting time for bank stocks. In the aftermath of two federal regulatory actions last week, the money-center banks are becoming more public than private institutions.
First the good news. Federal banking regulators announced that they are relaxing provisions of the Volcker Rule, which was an important part of the Dodd-Frank Act of 2010. Readers might recall that act was passed in the aftermath of the financial crisis. It was meant to prevent another "too big to fail" scenario within the nation's banking system.
A key provision of the act prevented banks from using their own funds to invest in risky assets such as derivatives, options, private equity, and hedge funds. Those rules have been essentially relaxed, allowing large banks a wider latitude in what they can invest in. Margin requirements (at least in some areas) such as in swap trades, have also been eased.
The long and short of it is that banks have been allowed to once again travel the road of riskier investments. The lowering of margin requirements will also free up $40 billion in capital that banks can now use in proprietary trading. This turn of events might be troubling to those of us who remember the worst crisis since the Great Depression in this country.
But what Big Brother giveth, he can also take away. Last Thursday, the Federal Reserve Bank released the results of its annual stress test of the 34 largest banks in the U.S. Stress tests are another regulatory change that was implemented by the federal government as a result of the financial crisis. They are meant to ensure that the United States banking system can withstand shocks to its capital base.
The COVID-19 pandemic and its impact was the focal point of the regulatory authorities test this year. All 34 banks passed the minimum capital requirements necessary under these circumstances, although in the worst-case scenario regulators said "several would approach minimum capital levels."
That's the good news. The bad news was the Fed also ordered the banks to limit shareholder payouts and suspend repurchases of their stocks during the third quarter. Dividend distributions will be limited to the levels banks paid out in the second quarter.
While the news initially surprised investors, banking stocks have gained ground since the announcements. That should not surprise you, given the steady encroachment by the Federal Reserve Bank and the U.S. Treasury into the private sector since the beginning of the pandemic. The fact that banks have increasingly operated under the thumb of government has been going on for the last decade. It is one explanation for why the sector as a whole has consistently underperformed other areas of the stock market.
One might question where and when will this creeping nationalization of the private sector economy come to an end. The Fed is already purchasing bonds from companies such as Verizon on the open market as well as bond funds and exchange traded funds. Will stocks be next?
Today, the government announced a $700 million loan to a major trucking company, YRC Worldwide Inc., in exchange for an equity stake of 29.6 percent. In the name of the great pandemic, as companies become increasingly distressed, I believe more and more of the economy will come under the control of the government. The question to ask is then what?
As I have maintained, I fear we are fast transforming from a quasi-capitalistic economy into something that resembles Europe's economic socialism, or even China's centralized economy. It appears we have no say in the matter. Is it that our free market system has become an antiquated idea and has no place in today's global economy? That is for you to decide.
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@theMarket: The Virus Versus the Fed
Bulls and bears are in a tussle. Market averages reflect the battle that is moving stocks down, up, and then sideways throughout the week. It is a phase where investors are in a data-dependent mood and the data isn't all that good.
The bears are watching the COVID-19 cases climb higher every day, which threatens to trash their expectations for a "V" shaped recovery. The bulls, meanwhile, aren't too worried. They are banking on the Federal Reserve Bank's promises to keep pouring added stimulus support into the financial markets just in case the virus pushes the economy further toward the brink.
It did not have to be this way.
A few months ago, America had a chance to beat this pandemic. That was before the president decided to politicize the virus, pretend it wasn't serious, and then fumble the response when he realized it was. Now, with the number of new virus cases hitting the highest level since the onset of the pandemic in America, he chooses to simply ignore it.
We are left holding the bag. However, readers are also aware that the American people are not blameless. For weeks I have been warning that the general disregard for following medical guidelines among the public was likely to produce the present results. When our politicians encourage this behavior, and even support gun-toting radical groups to storm state houses, this is what you get.
Twenty-seven states (and counting) have witnessed an increase in COVID-19 cases. The worst hit among them followed the president's urgings to re-open, downplay the risks, and get the economy moving again before the election. New York Gov. Andrew Cuomo, who has paid his dues combatting the worst outbreak in any American state, said it best. "You played politics with this virus, and you lost."
So, what happens now? Most likely, we get a few more rounds of positive economic data points, such as stronger retail sales, higher manufacturing numbers, etc., but those are "rebound" numbers from a low, low base. After that, the data will look less rosy and may even decline, if the virus numbers increase and begin to spread outward from hotspots in the West and Southeast.
The economy, as we know by now, is not the stock market. The stratospheric levels of the indexes are all about Fed stimulus. The thinking here is that as long as the helicopter money is still raining down from a central bank sky, buy stocks. Fundamental news, such as the results of yesterday's stress test by the nation's large banks, which at one time would have been important, has little to do with what happens to their stock prices.
Speculation in the markets by new retail investors, stuck at home, and trying to make money day trading, adds another unpredictable element. It is their buying, for example, that is bidding up the stocks of bankrupt companies, like Hertz and GNC, or chasing unproven "story" stocks at a few cents a share to see them double or quadruple in a day, or a week. My advice is buyer beware if you are trying to play that game, because they almost always end badly.
June is almost over, and I expect there will likely be more turbulence early next week. There is some talk of a large end-of-quarter rebalancing among institutions from stocks to bonds, after the strong equity gains this past quarter. That could cause some additional selling, maybe another 100-point risk to the downside in the S&P 500 Index.
However, contrarian indicators, such as bearish investor sentiment, and high short interest on the S&P 500 Index, plus expectations of another massive fiscal stimulus bill next month, would indicate that stocks are still in a bullish phase. Last week's advice, therefore, to "buy the dips" remains in place.
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The Retired Investor: Corporate Debt & the U.S. government
The pandemic and its impact on the American economy required a drastic response from both the federal government and the Federal Reserve Bank. One of the most controversial, but necessary, steps taken by the Fed was to not only purchase private-sector debt, but implicitly guarantee that debt.
In addition, both fiscal and monetary stimulus has been pouring into the economy in an effort to defend jobs and stave off bankruptcy for thousands of small businesses. While some worry about the inflationary effects this may have down the road, the attitude of most economists is that we will worry about that later, if it becomes a problem.
In my last column, I explained that as far as Fed stimulus is concerned, central bank money is not necessarily inflationary, it simply swaps assets for central bank reserves within the financial system's balance sheet. Inflation rarely occurs, unless banks take some of their money and decide to lend it to you and me. That's called private money. The faster it circulates (called velocity) from one person or entity to the next, the higher the chances that inflation will rise.
Over the last decade, lending institutions, generally, have been loath to lend to the private sector because they feared that borrowers would not be able to pay back their loans. But what happens if that lending risk were to disappear? That is what may be happening in today's markets under the government's new loan programs. By purchasing or promising to purchase, corporate debt, bad or otherwise, within the U.S. financial system, banks are now presented with a no-risk, win/win proposition of lending.
Why not lend as long as the government is willing to pick up the tab if things go bad? So, what if a company can't repay its loans? It wouldn't necessarily need to declare bankruptcy. The government could simply extend payments, lower interest rates, or do whatever it takes to keep the debtor in business. Right now, for example, much of the payroll protection loans will be forgiven if the guidelines are followed. Why not extend the same terms for other causes?
Would that ultimately mean the amount of private and public debt grows even larger than it already is in this country? Well, yes, but according to Modern Monetary Theory (MMT) that's OK, too. MMT argues that as long as a country can continue to control and print its own currency, there is no chance that a country can go bankrupt.
In fact, the more a country spends, the better off it will be, according to MMT theorists. If inflation were to result, all the central bank would need to do is hike interest rates. Therefore, there would be no need to adhere to traditional economic theory.
Think of it — politicians would have a field day. All their political popular causes would suddenly be possible — refinancing, reconstruction, environmental, even equality loans — all guaranteed by the government. A version of this concept (another $1 trillion in fiscal stimulus) is expected to be passed by Congress next month.
Traditional economic theory would argue that all that borrowing would create a ballooning deficit and out of control deficits would require a reduction in spending and/or an increase in taxes. Otherwise, inflation would explode, interest rates would skyrocket, the economy would tank, and the government's debt payments would go through the roof.
Both theories, however, have an Achilles heel when it comes to inflation. The last four years have revealed to us just how much influence politics have on what we thought was our independent central bank. Imagine the outrage from every political corner if the Fed were to raise rates, no matter the reason.
In addition, the government's announced plans to provide a backstop to corporate debt, should result in an uptick in bank lending. It won't be much at first, since banks will need to feel their way into renewed lending before expanding on the practice. But there is a lot of cash just looking for a home right now. Between $4 and $5 trillion is sitting in money market funds, according to Refinitiv Lipper, as of last month. There is also another $2 trillion in cash parked within the banking system.
If I am right, over the remainder of this year, and into next, I expect to see loans increase substantially, unleashing first a trickle and then an avalanche of money, which should flow into the real economy. That is what the central bank, the federal government and everyone else is hoping for. My concern is that we may see the velocity of money take off as well. If it does, and inflation does begin to rise, will we be prepared for the outcome?
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The Retired Investor: Inflation, a Factor to Forget?
It has been a long time since we have seen a rise in the inflation rate of any magnitude. As a result, most investors have largely dismissed inflation as a near-term concern. But that doesn't mean we have vanquished this troublesome variable from the financial equation forever.
There is a reason that inflation fears have subsided. Ever since the Financial Crisis, when central banks and governments dumped trillions of dollars into the world's economies, investors feared that all this money would re-ignite the inflation fire. It didn't happen. Instead, the inflation rate moderated, and in some countries began to drop. Rather than worry about inflation, investors and central bankers began to worry about the opposite — deflation.
You see, inflation, as any economists will tell you, is caused by an increase in the velocity of money. Simply put, velocity is a measurement of the rate that money is exchanged. It is the number of times that money moves from one entity to another.
Let's say I borrow $100 from my local bank. I spend $10 of it at McDonald's, another $20 at the movies, and spend the rest taking my wife out to dinner. If any of these three use that money to pay their suppliers, workers, or whatever, the money I spent is passed on to others. If they, in turn, take that money and buy items of their own with it, then the velocity of money continues higher. Over time, if this continues, the velocity of that same $100 will be so great that too much of this money will be chasing too few goods. In which case, inflation takes off.
One of the principles of economic theory is that in order for inflation to catch hold, all the money that central banks dumped into the global economic system over the last decade had to somehow find its way into the hands of consumers, who will spend it and pass it on. That didn't happen either. Instead, the world's banks and other financial institutions, stashed all that central bank cash in their electronic vaults, but didn't lend it out. There were two reasons for this.
The first one was fear. Banks were not about to lend this money to consumers, or corporations, given the aftermath of the crisis. Lending (in the form of mortgage money), was a big risk for banks, given what happened to the housing markets during 2008-2009. At the same time, unless you were one of the bluest of blue-chip companies, banks were charging an arm and a leg for corporate borrowers. Besides, the corporate appetite to borrow money was tepid at best. Given that the economy was sluggish, and the future uncertain, who really wanted to invest?
The growth rate of the economy continued to justify that attitude. The economy remained anemic throughout the Obama years and beyond. Companies argued that there just wasn't enough incentive to invest. Taxes were too high and regulations too onerous.
The Trump administration, as we know, thought they had provided the solution. They cut regulations and gave businesses a massive tax cut, expecting that at long last corporations would hire workers, raise wages, and grow the economy. Instead, all companies did was buy back their stock, pay out larger dividends, or acquire other companies with the money. The only inflation we experienced was in the stock market as prices of financial assets soared.
Fast-forward to today, worldwide, both governments and their central banks have upped the ante on additional monetary and fiscal stimulus, thanks to the pandemic. They feel they can do so with impunity, knowing consumers worldwide will not be spending much of that money until the all-clear is sounded on the pandemic side. They are confident that despite the fact that while monetary and fiscal stimulus is at historical highs and still growing, inflation will remain subdued.
As long as all that new stimulus money remains in the banks and does not fall into the hands of the consumer or into business investment, the velocity of money should remain tame. However, in my next column, I will point out that in this new round of stimulus, the Federal Reserve Bank has changed the rules of the game dramatically.
At the same time, more and more politicians, and some economists, are arguing that Modern Monetary Theory (MMT), by necessity, should be the natural direction the world takes in combating the fallout from the pandemic. Why is that important?
I believe by force of circumstances, both the Fed and proponents of MMT may be rubbing a lamp that could lead over time to releasing that genie of inflation back into the world once again. I'll explain why in my next column.
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