As the pandemic drives markets to the 2018 lows, certain
relationships in trends between the markets and the COVID-19 virus are evident. As social distancing increases, markets
continue to fall. So, by looking at the expected breakout levels of the
virus, we can assess possible market reactions. The chart below shows the
inverse correlation between the expected peaks of the virus and potential lows
in the markets:
Source: FIPhysician – & Patrick Hill – 3/18/20
In the COVID-19 – SPX model above, the steep red line is a
forecast of new cases if social distancing were not in place. The green line shows how social distancing
will flatten the curve of new cases. The blue curve shows how growth in the
pandemic may unfold doubling every 4 – 7 days.
The lower chart shows how social distancing correlates to movements in
the SPX. As the number of cases peak, there is a related trough in the SPX.
Looking at present levels, we are likely to see more selling as the number of
cases increases to a possible low of 2000 in the May-June time frame.
Epidemiologists currently forecast the COVID -19 pandemic will unfold
in two waves, with the current breakout and remission during the summer
followed by a possible second breakout in the fall and winter of this
year. Researchers think the closest
analog to the COVID -19 pandemic is the Spanish Flu in 1918, which came roaring
back the following winter resulting in a second wave of even greater infections
The first blue dot shows where the SPX is today at this early
stage in the pandemic. The SPX index may
continue to fall as the economic damage increases and GDP declines in the first
and second quarters. Two consecutive declines will officially put the economy in
The SPX may fall to 2030 in this first wave, which represents a
Fibonacci retracement of 50 % from the 2008 low to the 2020 peak. From there, markets may rebound back up to
2350, a Fibonacci retracement of 61% as the virus breakout fades, relief rally emerges,
and economic activity picks up. However,
as this occurs, higher interest rates from massive stimulus spending may weigh on
financial markets, as seen in the spike of bond yields, the decline in gold
prices and other safe haven assets.
Consumers who are already financially stretched are being
furloughed or laid off, which will trigger loan defaults. Finally, corporations are now at the highest
level of debt since 2008 and are experiencing a steep decline in sales, causing
a cash squeeze leading to layoffs. The
most important consideration is that the
virus is exposing the heavy reliance on debt on major institutions and
consumers in our economic system.
The slide into a recession is evident in announced layoffs by significant
corporations. Marriott and other hotels have announced thousands of layoffs. Other
hospitality industry companies will follow. Harley-Davidson, GM, Ford, Fiat
Chrysler, Nissan, and Tesla have all suspended manufacturing for several weeks
in the U.S. Thousands of workers are on furlough until manufacturing resumes. There is a growing risk consumer demand may
not return to pre coronavirus levels forcing permanent layoffs.
While manufacturing is 30% of GDP, services contribute 70% of
GDP. Many services can be offered online
or via web conferencing. The present social
distancing experiment will provide significant insights into how well the
economy can perform when many knowledge workers are working from home. If working from home is successful, we expect
to see more companies permanently move employees to their homes to reduce
office space and cut expenses. This has grave implications for the commercial
real estate industry and investors of those properties.
The diverse U.S. economy is likely to recover quicker than the
world economy. However, an earnings
recovery may stall due to the fact most S&P 100 companies derive 55% of
their sales from overseas and 60% of their profits from international markets.
Looking at a possible second virus wave in the fall, it is likely that
economic damage will grow worse due to increasing unemployment, declining
corporate spending, falling consumer spending, and a resumption of social
distancing. The second wave fits a decline model seen in 2000 from the Y2K software
bug scare. That crisis was an external
event, causing a demand shock, though little supply shock. The bottom for the NDX did not happen until
18 months after the market peak. The virus seems to be compressing the market
drop period as there have been three trading halts of 7% in the markets in just
eight days of trading. SPX support is
near 1810 – 1867 in 2016, just above the Fibonacci 38% level of 1708.
In our post
of February 14th about the coronavirus triggering a
downturn, we saw the strong possibility of the economy sliding into a recession. In the post we noted that Allianz Chief Economic
Advisor, Mohammed El-Arian observed that we are likely headed into a U or L shaped
“…analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Hope is not a strategy. Of course, we hope the virus is contained, lives saved, and the economy can weather the stress on corporations and consumers. However, as long term investors, we need to look at the reality of what may happen based on research and plan our strategic investments accordingly. Plan for the worst, and hope for the best.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Will The Corona Virus Trigger A Recession?
As if waking up to an economic nightmare, investors see
headlines like these and many others flashing across their Bloomberg terminals:
Facebook says Oculus headphone production will be delayed due to virus
Apple extends country wide store closing for another week
Foxconn delays iPhone production
Qualcomm cuts production forecast due to virus uncertainty
Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
US Steel flashes a warning of a cut in demand
Nike shoe production halted
Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
IEA forecasts drop in oil demand this quarter- first time in a decade
never ending list of delays, disruptions, and cuts rolls on from retail to high
technology. Even services are impacted as flights and train trips are canceled
within and to and from China. While some
technology-based services are provided over the Internet service, restaurants,
training, and consulting, as examples, must be performed in person. Manufacturing operations require workers to be
at the factory to produce products. Thus, manufacturing is much more acutely
affected by quarantines, shutdowns, transportation disruption, and other government
It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019. For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year. Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.
Source: The Wall
Street Journal – 2/7/20
Prior to the epidemic,
world trade had begun to slow as a result of the China – U.S. trade war and
other tariffs. World trade for the first
time since the last recession has turned negative.
Analytics, The Wall Street Journal, The Daily Shot – 1/19/20
Based on severity
estimates, analysts have forecasted the impact on first-quarter China GDP
growth. In the chart below from Fitch Ratings, growth for first quarter drops
almost in half and for year growth drops to 5.2 % if containment is delayed:
Sources: The Wall
Street Journal, The Daily Shot – 2/6/20
When news of the
virus first was announced, the market sustained a quick modest decline. The
next day, investors were reassured by official news from China and the World
Health Organization that the virus could be contained. Market valuations
bounced on optimism that the world economy would see little to no damage in the
first quarter of 2020. Yet, there is growing
skepticism that the official tolls of the virus are short of reality. Doctors
report that at the epicenter of Wuhan that officials are grossly underestimating
the number of people infected and dead. The London School of Hygiene and
Tropical Medicine has an epidemic model indicating there will be at least
500,000 infections at the peak in a few weeks far greater than the present 45,000
The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain. U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities. The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %. President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily. It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.
chaos in the supply chain operations is creating great uncertainty. Workers are
being told to work from home and stay away from factories for at least for another
week beyond the Lunar New Year and now well into late-February. Foxconn and Tesla announced plant openings on
February 10th, yet ramping up output is still an issue. It will be a
challenge to staff factories as many workers are in quarantined cities and train
schedules have been curtailed or canceled.
Many factories are dependent on parts from other cities around the
country that may have more severe restrictions on transportation and/or workers
reporting to work. Thus, even when a plant is open, it is likely to be operating
at limited capacity.
On February 7th,
the Federal Reserve announced that while the trade war pause has improved the global
economy, it cautioned that the coronavirus posed a ‘new threat to the world
economy.’ The Fed is monitoring the
situation. The central bank of China infused CNY 2 trillion in the last four
weeks to provide fresh liquidity. The
liquidity will help financially stretched Chinese companies survive for a
while, but they are unlikely to be able to continue operations unless
production and sales return to pre epidemic levels quickly.
Will the Federal
Reserve really be able to buffer the supply chain disruption and sales declines
in the first quarter of 2020? The Fed already
seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control
and providing billions in repo financing to banks and hedge funds causing soaring
prices in risk assets. While the Fed may
be able to assist U.S. corporations with liquidity through a tough stretch of
declining sales and supply chain disruptions, it cannot create sales or build
Prior to the
virus crisis, CEO Confidence was at a ten year low. Then, CEO confidence levels improved a little
with the Phase One trade deal driving brighter business prospects for the
coming year. Now, a possible black swan epidemic has entered the world economic
stage creating extreme levels of sales and operational uncertainty. Marc Benioff, CEO of Salesforce, expresses
the anxiety many CEOs feel about trade:
“Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”
Adding to the uncertainty
is a deteriorating political environment in China. During the first few weeks of December, local
Wuhan officials denounced a doctor that was calling for recognition of the new
virus. He later died of the disease, triggering a social media uproar over the
circumstances of his treatment. Many Chinese people have posted on social media
strident criticisms of the delayed government response. Academics have posted petitions for freedom
of speech, laying the blame on government censors for making the virus outbreak
worse. The wave of freedom calls is
rising as Hong Kong protester’s messages seem to be spreading to the mainland. The
calls for freedom of speech and democracy are posing a major challenge to
President Xi. Food prices skyrocketed by
20 % in January with pork prices rising 116 % adding to consumer concerns. Political
observers see this challenge to government policies on par with the Tiananmen
Square protests in 1989. The ensuing massacre of protestors is still in the
minds of many mainland people. As seems to be true of many of these events that
it is not the crisis itself, but the
reaction and ensuing waves of social disorder which drive a major economic
has forecast a slowdown in US GDP growth in the first quarter of 2020 to just
Economics, The Wall Street Journal, The Daily Shot – 2/6/20
Will U.S. GDP
growth really be shaved by just .4 %? If
we consider the compounding effect of the epidemic to disrupt both demand and
supply, the social chaos in China challenging government authority (i.e., Hong
Kong), and a lingering trade war – these factors all make a decline into a
recession a real and growing possibility.
We hope the epidemic can be contained quickly and lives saved with a
return to a more certain world economy.
Yet, 1930s historical records show rising world nationalism, trade wars,
and the fracturing of the world order does not bode well for a positive
outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg
opinion warns of a U shaped recession or worse an L :
“I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Patrick Hill is the Editor of The Progressive
Ensign, https://theprogressiveensign.com/ writes
from the heart of Silicon Valley, leveraging 20 years of experience as an
executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide
investment and economic insights. Twitter: @PatrickHill1677.
Can Six Myths Keep The Market Going?
Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600? The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?
Patrick Hill – 12-31-19
reason for the disconnect is investment analysts and the media lead investors
to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released
a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed
policy shift) begun 30 years ago low-interest rates, low volatility,
sustainable growth and muted inflation are still in place and were only
interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash.
GS concluded that the economy ‘was nearly recession-proof.’
mainstream financial media also feed the Mania Phase with stories like Goldman
Sachs declaring the Great Moderation is working with our economy in a ‘new
paradigm’. We are to believe there will not be a recession because our
policymakers have the economy under control.
Really? With over $17 trillion of
negative debt worldwide to keep the world economy going, central banks have
succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For
the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:
Phase of the Economic Cycle is Continuing
Will Bailout the Economy
The Fed Will
Keep the Economy Humming
If the Fed
Fails Then the Federal Government Will Provide Stimulus
The Trade War
Won’t Hurt Global Growth
and Markets Are Insulated from World Politics
Let’s look at each myth that is likely to affect portfolio and market performance in the next year. This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.
Myth 1. The Growth Phase of the Economic Cycle is Continuing
The Fed has reported that the economy is still in ‘mid-cycle’ phase. We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers. The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.
Sources: The Conference Board, The
Wall Street Journal, The Daily Shot – 6/14/19
In the chart below, consumers are stretched as
loan default rates are rising despite a 50-year low unemployment rate. Rising
delinquencies tend to signal rising unemployment and economic decline is likely
in the near future.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19
Of major concern is that the manufacturing
sector is now in a recession based on five months of ISM reports below the 50 %
economic expansion benchmark. The overall contraction is validated as 70 % of
manufacturing sub-sectors are contracting as noted in the report below. While the US economy is primarily driven by
services, the manufacturing sector has a multiplier effect on productivity,
support services, and employment with high paying jobs. Note the contraction in
sub-sectors is reaching levels last seen before recessions.
Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19
There are other indicators pointing to the end of the growth phase. For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.
Myth 2. Consumers Will Bailout the Economy
Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates. Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt. The Bloomberg Personal Finance Index dropped significantly in October:
Source: Bloomberg, The Wall Street
Journal, The Daily Shot – 11/10/19
Car loans now span seven years on average
versus five years a few years ago. Further, the new loans ‘roll in’ debt from
previous car purchases due to negative equity in the owner’s trade-in vehicle. Vehicle price increases up to 10 % over the
last year for both cars and trucks add to the debt burden. Car debt is beginning to weigh on consumers
as delinquencies are climbing:
Sources: NY Federal Reserve, The
Wall Street Journal, The Daily Shot – 10/29/19
Today, credit card rates are running at a ten-year
peak of 17 – 22 % have seen no relief despite the Fed cutting rates. There is a record spread between the Federal
Funds rate and credit card rates as banks seek new revenue sources beyond
making loans. Many consumers are turning to credit cards to pay bills to
sustain their lifestyle as their wages are not keeping up with rising living
In addition, consumers are increasingly working
at more than one job to be sure they can pay their bills.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19
Workers need to take on multiple jobs in the
gig economy. McKinsey & Company estimates that 52
million people are gig workers or a third of the 156 million person workforce.
Contractors have no job security. Gig workers often receive hourly wages
with no health, retirement or other benefits. The lack of benefits
means they have limited or no financial safety net in the event of an economic
There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year. Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years. Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?
Myth 3. The Fed Will Keep the Economy Humming
The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.
Sources: The Wall Street Journal, The Daily
Shot – 12-30-19
We agree with their perspective that the Fed is entering an economic space where
no central bank has gone before. In
the past, the Fed lowered rates when an economic downturn was evident. Just
prior to earlier recession’s interest rates were at a higher starting level of
at least 4 – 5 %. Plus, today the Fed has
returned to pumping liquidity into the economy via its repo operation and QE as
Sources: The Federal Reserve of St. Louis, The
Wall Street Journal, The Daily Shot – 12/30/19
The International Bureau of Settlements (BIS)
disclosed in their analysis of recent Fed repo operations that funding
supported not only banks but hedge funds. A key concern is the nature of the
hedge fund bailout. How steep is the loss being mitigated? Is there a possibility
of contagion? Is more than one hedge fund involved? Should the Fed be bailing out hedge funds
that are overextended due to speculation? The
Fed is already using its tools at the height of the current economic growth
cycle. The Fed financial tools are too stretched to turnaround an economy in a recession
from multiple financial bubbles bursting.
The Fed continues to declare that inflation is
at 2.1 %, missing the reality of what
consumers are actually paying for goods and services. We find from industry research that finds inflation
is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and
services that consumers buy, not inflation defined by a formula to suit
political needs. Using inflation lifestyle ‘cost of living’ data, which is not
transparent or available for audit does not meet the foundational data needs of
investors. Gordon Haskett Research Advisors conducted a study by
purchasing a basket of 76 typical items consumers frequently buy at Walmart and
Target. Their study showed that from June 2018 to June 2019, prices
increased by about 5.5%.
industry research supports inflation running at a much higher level than
government figures. On a city by city basis, Chapwood has developed an index
for 500 items in major metropolitan areas of the US. Chapwood reports the average national
inflation level to be about 10 %. Note
inflation is compounded; for example, in San Jose a five year average price
increase of 13% is for each year. An item costing $1.00 would cost $1.13 the
next year and then $1.28 the third year and so forth. It islikely workers caught
in a squeeze between stagnant wages and 10 % inflation will not be able to
continue to sustain present levels of economic growth.
inflation at 6 – 10 % has major policy, portfolio, and social
implications. For example, with the ten
year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’
economy of – 4.10 %. Higher inflation levels fit the financial
reality of what workers, portfolio managers, and retirees are facing in
managing their finances. Many
workers must take multiple jobs and develop a ‘side hustle’ to just keep up
with inflation much less get ahead. For portfolio managers, they must grow
their portfolio at much higher rates than was previously thought just to
maintain portfolio value. Finally, for
retirees on a fixed income portfolio it is imperative they have additional
growth income sources or part-time work to keep up with inflation eating away
at their portfolio. For more details on our analysis of a variety of inflation,
categories see our post: Is
Inflation Really Under Control?
One additional assumption about Fed
intervention repeated by many analysts is the Fed liquidity injections mean
that corporate sales and profits will bounce back. For some financially sensitive industries
this argument may be true. For other firms with excellent credit ratings, they
may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and
sell products based on demand. If demand falls, low-interest loans will not
increase sales. Only new products, new
channels, reduced pricing, marketing and other initiatives will revive sales.
Myth 4. If the Fed Fails Then the Federal Government Will Provide Stimulus
European Central Bank leaders have called on European governments to provide economic stimulus for their markets. Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector. For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.
Source: World Inequality Lab, Thomas Piketty,
Gabriel Zucman et al. – 2018
Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth. The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions. Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.
Myth 5. The Trade War Won’t Hurt Global Growth
By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track. Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term. The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.
China has quietly raised the exchange rate of
their currency to offset some of the impact of still in place tariffs on the
U.S. economy. The government made a
major move to block US and foreign companies from providing key technical
infrastructure. The technology ministry has told government agencies that all IT
hardware and software from foreign firms are to be replaced by Chinese systems within
three years. If the Chinese government decides to establish ‘China only’
network standards it may be difficult for US firms to even work with state-sponsored
companies or private businesses that must meet China’s only standards. Apple
and Microsoft would have to build two versions of their products. One version
for the Chinese economy and one for the world.
A critical change is taking place
in world trade which is the establishment of a two-block trading world. China is a key growth market at a 20 % – 30 %
increase in sales annually for US multinational companies. For these
corporations navigating the trade war will be problematic even with the Phase
One agreement. Our post characterizing
this major change in world trade can be found at: Navigating
a Two Block Trading World.
The U.S. has placed sanctions on Chinese
sponsored network provider Huawei, effectively limiting the network vendor from
US government and private networks. The
Phase One agreement includes the US canceling planned tariffs for December 15th
in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on
September 1st of last year. Yet, tariffs of 25 % remain in place on
$250 billion of Chinese goods. The
Chinese have canceled retaliatory tariffs planned for December 15th
and plan to increase purchases of US goods and services by $200 billion over
two years. In addition, China will purchase US agriculture products at a $40
billion rate per year from a baseline of $24 billion in 2017. If the
Chinese follow through on their purchase commitments US companies should see
increased sales. However, history on
Chinese purchases shows they forecast large purchases but small purchases are
A major trade issue has been created when the
US decided not to appoint any new judges to the World Trade Organization court
for disputes. The court cannot hear or make decisions on any disputes any
longer; meaning countries will resort to free-for-all negotiations on trade
disputes. We expect as economies falter, nationalist policies on trade will gain
more popularity and world trade will continue to decline after a slight
blip up from the U.S.-China Phase One deal.
Sources: BCOT Research, The Wall Street
Journal, The Daily Shot – 12/16/19
Finally, prior to the trade war global trade
has been facing major headwinds. Since 2008, global firms have looked to open
more international markets to sell their goods, but have met sales resistance
causing revenue and profits to be flat or decline. We expect the flattening of global
sales to output to continue and eventually decline as overall world trade falls.
CEOs in a Conference Board survey rate trade as
a major concern as they look at a highly uncertain economic picture. Marc Benioff, CEO of Salesforce, described
his concerns at a company all hands meeting last November:
“Because that issue (trade) is on the table,
then everybody has a question mark around in some part of their business,” he
said. “I mean, we’re in this strange economic time, we all know that.”
Myth 6. The Economy and Markets Are Insulated from World Politics
Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb. Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02. The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf. An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.
saw during the negotiations for the Phase One trade deal how rumors both in
China and the U.S. would send the S & P futures market up or down by 10 –
15 points depending upon whether the news was positive or negative. Algo
traders would drop 30k contracts in a matter of seconds to make huge moves in
SPX price, while the VIX was at 12.50, supposedly a calm market. The chart
below shows how positive and negative news whipsawed the market.
Liz Ann Sonders – Schwab – 12-7-19
news not only moves markets but the economy as well. When the president tweets a tariff threat,
consumers and industry move swiftly to buy those goods before their prices go
up. Businesses have to build the product
quickly, sell it and they are left with falling sales as future purchases are
pulled forward. Business to business
deals are caught up in this constant flip flop on trade policies as well. CEOs
must make investment decisions to build a plant in a particular country 1 – 3
years in advance. They must calculate their allocation plans based on
inadequate information and in a highly uncertain policy environment. Often, rather
than make an investment decision, executives will wait for the economic clouds
The current bull market run has set record highs continuously. Yet, as the saying goes: markets go up in stair steps and down in an elevator. As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.
The prudent investor will recognize the end of
the business cycle is likely underway. It is time to prepare for an economic
slowdown and a resulting equity market reversion to the mean. A reversion to
the mean quite often requires that markets swing beyond the mean.
The wary investor will ask hard questions of
their financial advisor and review corporate reports with an eye on fundamentals.
Financial success is likely to result from good risk management and
implementation combined with agility to make mid-course corrections. Investors should test their assumptions based
on breaking trends that may impact portfolio performance. At the same time, constantly flipping
investments will lead to poor performance. Allocate funds to different
portfolio groups based on long, medium and short term goals to keep from being
emotionally swept up in temporary market swings. The key is to be prepared for
the unknown, or a black swan event. Expect
the unexpected and consider the advice of market legends like Bernard Baruch:
“Some people boast of selling at the top of
the market and buying at the bottom – I don’t believe this can be done. I had
bought when things seemed low enough and sold when they seemed high enough. In
that way, I have managed to avoid being swept along to those wild extremes
of market fluctuations which prove so disastrous.”
Patrick Hill is
the Editor of The Progressive Ensign, https://theprogressiveensign.com/
writes from the heart of Silicon Valley, leveraging 20 years of experience as
an executive at firms like HP, Genentech, Verigy, Informatica and Okta to
provide investment and economic insights. Twitter: @PatrickHill1677.
Is Inflation Really Under Control
analysts have been discussing the pros and cons of using negative interest
rates to keep the U.S. economy growing. Despite
this, Fed Chairman Jerome Powell has said that he does not anticipate the
Federal Reserve will implement a policy of negative interest rates as it may be
detrimental to the economy. One argument
against negative interest rates is that they would squeeze bank margins and
create more financial uncertainty. However, upon examining the actual rate of
inflation we are likely already in a ‘de facto’ negative interest
rate environment. Multiple inflation data sources show that actual inflation maybe
5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data
points to understand why there is such a divergence
between the Fed assumptions that inflation is under control versus the much
higher rate of price hikes consumers experience.
October, the Bureau of Labor Statistics (BLS) reported that the core consumer
price index (CPI) grew by 2.2% year over year.
The core CPI rate is the change in the price of goods and services minus
energy and food. Energy and food are not
included because they are commodities and trade with a high level of
volatility. However, the Median CPI
shows a ten year high at 2.96% and upward trend as we would expect, though it
starts at a lower level than other inflation indicators. The Median CPI
excludes items with small and large price changes.
Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19
key items that have small and large price changes is not what a consumer buying
experience is like. Consumers buy based
on immediate needs. When a consumer drives up to a gas pump, they buy at the
price listed on the pump that day. Consumers
buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the
food. Recent consumer purchase research shows that prices of many goods and
services continue to increase at a rate much higher than 2.2%.
Haskett Research Advisors conducted a study by purchasing a basket of 76 typical
items consumers buy at Walmart and Target.
The study showed that from June 2018 to June 2019, prices increased
Gordon Haskett Research Advisors, Bloomberg – 8/10/19
and Target are good proxies for consumer buying experiences. Walmart is the
largest retailer in the U.S. with over 3,000 locations marketing to price-conscious
consumers. Target has 1,800 locations in the U.S. and is focused on a similar
consumer buyer profile, though a bit less price sensitive. Importantly, both
Walmart and Target have discount food sections in their stories.
has been rapidly increasing in cost as well.
Rental costs have soared in 2019 as the following chart shows a month
over month shift to .45%, which is an annualized rate of 5.4%.
Bureau of Labor Statistics, Nomura – 5/13/19
of other services like health care and education have increased dramatically as
well. Service sectors, which make up 70% of the U.S. economy, are where wages
are generally higher than in manufacturing sectors. Techniques to increase
service productivity have been slow to implement due to service complexity. Without
productivity gains, prices have continued to rise in most services sectors.
Deutsche Bank – 11/14/19
care costs have increased by 5.2% per year, and education costs have risen 6.8
% per year. Wages of non-supervisory and production workers have fallen behind
at 3.15 % increase per year. Note that the overall CPI rate significantly
underestimates the rate of costs in these basic consumer services, likely due
to underweighting of services in the cost of living calculation.
consumers, housing, utilities, health care, debt payments, clothing, and
transportation comprise their major expenses. Utility and clothing costs have
generally declined. While transportation, housing, and health care costs have
increased. The rate of new car annual inflation
was as low as 1 percent in 2018. Yet, according
to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing
Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019.
The soaring price of vehicles has caused auto loans to be extended out to 7 or
8 years, in some cases beyond the useful life of the car.
are financing 25% of new car purchases with ‘negative equity deals’ where the
debt from a previous vehicle purchase is rolled into the new loan. The October consumer spending report shows
consumer spending up by .3% yet durable goods purchases falling by .7%
primarily due to a decline in vehicle purchases. A 4.2%
increase in vehicle prices year over year is unsustainable for most buyers and
indicates likely buyer price resistance resulting in falling sales.The October durables sales decline could have
been anticipated if inflation reporting was based on actual consumer purchasing
wars with China, Europe, and other countries are contributing to significant price
increases for consumer goods. Tariffs
have driven consumer prices higher for a variety of product groups, including:
appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports
vehicles, housekeeping supplies, and sewing equipment.
Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot
chart above, prices increased by about 3.5% over 16 months before mid-May 2019.
As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices
will likely continue to rise. The President has announced new tariffs of 15% on
$160 billion of Chinese consumer goods for December 15th if a Phase
One deal is not signed. On December 2nd, he announced resuming
tariffs on steel and aluminum imports from Argentina and Brazil and 100 %
tariffs on $2.4 billion of French goods. The implementation of all these
tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying
inflationary trend that is being under-reported by government agencies.
Evidently, the prices for goods and
services that consumers experience are vastly different from what the federal
government reports and uses to establish cost of living increases for programs
like Social Security. So, why is there a disconnect between the government CPI rate
of 2.2% and consumer reality of inflation at approximately 5%? The raw data that the Bureau of Labor
Statistics (BLS) uses to calculate the CPI rate is not available to the
public. When a Forbes reporter asked the
BLS why the data was not available to the public the BLS response was companies
could ‘compare prices’. This assumption does not make sense as companies can compare
prices on the Internet, in stores, or find out from suppliers. The ‘basket of
consumer items’ approach was discontinued in the 1980s for a ‘cost of living’
index based on consumer buying behaviors. There was political pressure to keep
the inflation rate low. If real inflation figures were reported the government
would have to increase payments to Social Security beneficiaries, food stamp
recipients, military and Federal Civil Service retirees and survivors, and
children on school lunch programs. Over
the past 30 years the BLS has changed the
calculation at least 20 times, but due to data secrecy there is no way to audit
the results. The BLS tracks prices on 80,000 goods and services based on
consumer spending patterns, not price changes on goods and services per
se. For example, if consumers substitute
another item for a higher-priced one it is discontinued in the
Williams has calculated inflation rates based upon the pre-1980s basket
approach versus the cost of living formula used by BLS today. His findings show a dramatically higher rate
of inflation using the 1980s formula.
Government – 10/2019
using the earlier basket formula sets the present inflation rate at nearly
10%. Based on our research on various
price reporting services, we think the real consumer inflation rate is probably
about 5 to 6%.
of this gap between real inflation and reported inflation rates are profound
and far-reaching. Federal Reserve
complacency about a low inflation rate to justify a low Fed Funds rates is
called into question. In fact the
economic reality of today is we are living in a 3.25% ‘de facto’ negative interest rate environment where
the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity
pumping into the economy, based in part on low inflation, is overheating risk
assets while providing support for corporate executives to take on debt at decade
economic framework on erroneous inflation data versus the reality for consumers
and businesses lead to massive financial dislocations. This economic bubble is
unsustainable and will require a brutal recession to rebalance the
economy. As part of a possible soft
‘landing’ policy, the BLS could make price data available to all economists.
Full data access will provide an opportunity for objective comments and
feedback based on other consumer price research.
The Fed actually
focuses on the even lower Personal Consumption Expenditure rate of 1.6%
reported by the Bureau of Economic Analysis for October. The Fed prefers the
PCE rate because a consumer survey technique is used, while economists prefer
the CPI, which is more granular so it is easier to identify goods and services categories
that are driving inflation. Using
unrealistically low inflation assumptions leads to misguided policy decisions
and perpetuation of the myth that inflation is under control. Yet, in fact
inflation it is out of control due to extremely low Fed interest rates,
liquidity injections, and trade war tariffs.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
The Market Soars As Corporate Profits Slump!
The SPX recorded
new highs this week. Investors appear to
be excited about the U.S. – China Phase 1 trade agreement, which only goes so
far in ending the trade war. Plus, the
Fed is cutting interest rates, injecting $100 billion in repo financing over
the next month, and embarking on a new round of QE. So, is it clear sailing for
corporate America? Maybe companies are not as financially viable as record SPX
levels would indicate.
at the lifeblood of a company, cash flow.
Goldman Sachs analysis of corporate cash flows shows that SPX companies
are actually running, in aggregate, negative cash flow at 103.8% while keeping
stock buybacks and dividends flowing to shareholders. Debt is up 8% squeezing
corporate cash flow to the point where aggregate cash flows are down 15% versus
the prior year.
Source: Goldman Sachs – 7/25/19
Cash is the lifeblood of a company,
but a company can’t borrow money forever without being a viable profitable
entity able to pay back debt.
corporations have taken on record debt at 47% to GDP. The last time corporations approached this level
of debt was during the Great Recession.
Yet, default rates have not gone up.
Sources: Federal Reserve Bank of St. Louis, Edward Altman – 8/5/19
time for debt payment defaults different? It would seem this is a ‘benign credit cycle’
when defaults don’t rise. However, a
more likely cause is that corporate cash flows are being pumped up by low
interest rate loans. This corporate financial cliff maybe one reason the Fed is
moving quickly to keep overnight and interest rates low. The Fed has said it is concerned about high
levels of corporate debt. What is wrong
with corporate debt at 47% of GDP?
is when profits sink due to the trade war or as consumer spending slows,
companies will no longer qualify for low interest loans. Banks and investors will
hesitate to take on risky loans to companies raking up continuous losses. Without low cost loans to provide needed cash
flows, sales decline will result in a freeze on hiring, the layoff of full time
workers, and a closure of offices and plants. Management will take these
measures to try to keep the company open until sales turnaround.
margin squeeze has been happening over the past 4 ½ years, well before the
trade war started. Profits were flat for
the past nine years, supported by a huge corporate tax cut from the Tax Cut
Bill of 2018. The contraction in profit margins has been the longest one on
record since WWII. Note how recessions usually follow steep declines in profit
margins at 1 to 4 years.
Source: Oxford Economics, The Wall Street Journal, The Daily Shot – 10/28/19
margins been contracting? Margins can be
increased by investing in automation, lowering material costs, deploying productivity
enhancements, and other efficiencies. Instead of investing in margin increasing
activities, corporate executives have been spending available cash from profits
and debt on stock buybacks totaling $1.15 trillion in 2018. Stock buybacks are a way to boost corporate
stock prices thereby increasing the income of shareholders and executives. Executives
have squandered over the past ten years the opportunity to use profits for investments
in research, productivity enhancements, raising wages, or cutting costs. Management has focused on short term stock
gains at the cost of long term corporate viability. The chickens are finally
coming home to roost.
addition, profit margins are declining due to declining international sales. It is difficult to maintain healthy margins
when sales are falling due to base spending for sales, support, and
transportation to reach a certain sales threshold of profitability. Major
corporations face increasing trade headwinds.
For most S & P 100 corporations 50 to 60% of their sales come from
overseas with prior growth rates from 15 – 25% per year in emerging
markets. The Asia – Pacific region is
the fastest growing sales region for many companies. Yet, the accumulating tax
of trade tariffs and trade uncertainty is stifling sales growth.
Sources: U.S. Census Bureau, Tariffs Hurt the Heartland, USTR Office, The Wall Street Journal, The Daily Shot – 10/28/19
January of 2018, U.S. companies have paid about $34 billion in tariffs. To hold
price levels and market share, companies largely paid tariff costs themselves rather
than passing them onto customers. Taking tariff costs onto corporate ledgers
has squeezed profit margins. The loss of decent margins in high growth markets
is creating a huge profit challenge for companies.
Phase 1 agreement with China may provide a pause to the trade war, breaking up
into two major trade blocks.
Corporations will have to navigate selling into two opposing markets
with focused sales, support, and product features and pricing. For more details, see our post Navigating
A Two Block Trade World to see how companies plan on changing supply
chains, and the implications for investors.
executives see a loss of profits and margin tightening in the future. A recent
CEO survey showed confidence levels of SPX CEOs at recession levels. The survey results indicate a possible SPX
decline beginning as soon as four months from now.
Sources: USA CEO Confidence Survey, Macrobond, The Wall Street Journal, The Daily Shot – 10/18/19
concerns that CEOs see in revenue and profitability were borne out in 3rd
quarter reports of 40% of S &P companies.
Companies with more than 50% of sales in international markets report a
9.1% decline in profits and a 2.0% decline in revenue. All S &P companies report a 3.7% slip in
earnings thus far for 3rd quarter of 2019.
Source: Factset – 10/25/19
markets recognizing the decline in profits for corporations? The chart below shows the SPX rising despite flat
national corporate profits since 2013, with a huge divergence emerging in the
past four years. The SPX soaring to new heights tells us that stock marketcomplacency is at record levels in appraising stock valuations
versus actual corporate profits. The chart below shows how wide the gap has
become which is about twice the gap size just before the Dotcom decline into
2002 from a peak in 2000.
Source: Soc Gen – Albert Edwards – Marketwatch – 10-28-19
The economic storm corporate executives see on the horizon is likely to be a future economic reality, and not liquidity fueled soaring valuations. Executives are closest to economic reality because they have to make the economic system work for their company day in and day out.A reversion of equity valuations to the reality of falling corporate profits is coming. The only question remaining is: when will the SPX reversion happen?
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Will Monetary or Fiscal Stimulus Turnaround the Next Recession?
recession is emerging with interest rate curves inverted, the end of the
business cycle at hand, world trade falling, and consumers and businesses
beginning to pull back on spending. The question is: will monetary or fiscal stimulus
turn around a recession?
post, we find both stimulus alternatives likely to be too weak to have the
necessary economic impact to lift the economy out of a recession. Finally, we
will identify the key characteristics of a coming recession and the
implications for investors.
economy is at the nexus of several major economic trends formed over decades
that are limiting monetary and fiscal options. The monetary policy of central
banks has caused world economies to be abundant in liquidity, yet producing limited
growth. Central bankers in Japan and Europe have been trying to revive growth
with $17 trillion injections using negative interest rates. Japan can barely keep its economy growing with
an estimate of GDP at .5 % through 2019. The Japanese central bank holds 200 %
of GDP in government debt. The European
Central Bank holds 85 % of GDP in debt and uses negative interest rates as
well. Germany is in a manufacturing recession with the most recent PMI in
manufacturing activity at 47.3 and other European economies contracting toward near-zero
Roberts notes that the world economy is not running on a solid economic
foundation if there is $17 trillion in negative-yielding debt in his blog, Powell
Fails, Trump Rails, The Failure of Negative Rates. He questions the
ability of negative interest policies to stabilize world economies,
“You don’t have $17 Trillion in negative-yielding sovereign debt if there is economic and fiscal stability.”
Negative interest rates and extreme monetary stimulus
policies have distorted financial relationships between debt and risk assets. This
financial distortion has created a significantly wider gap between the 90 % and
the top 1 % in wealth.
outlines in the six panel chart below how personal income, employment,
industrial production, real consumer spending, real wages, and real GDP are all
weakening in the U.S.:
RIA – 8/23/19
of dollars of monetary stimulus have not created prosperity for all. The chart
below shows how liquidity fueled a dramatic increase in asset prices while the
amount of world GDP per money supply declined by about 25 %:
The Wall Street Journal, The Daily Shot – 9/23/19
interest rates have not driven real growth in wages, productivity, innovation,
and services development that create real wealth for the working class. Instead,
wealth and income are concentrated in the top 1 %. The concentration of wealth in the top one percent is at the highest level
since 1929. The World Inequality Report notes inequality has squeezed the
middle class between emerging countries and the U.S. and Europe. The top 1 % has
received twice the financial growth benefits as the bottom 50 % since 1980:
World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018
There are several
reasons monetary stimulus by itself has not lifted the incomes of the middle
class. One of the big causes is that stimulus money has not translated into wage
increases for most workers. U.S. real
earnings for men have essentially been flat since 1975, while earnings for
women have increased though basically flat since 2000:
U.S. Census Bureau – 9/10/19
policy is not working, then fiscal investment from private and public sectors is
necessary to drive an economic reversal.
But, will the private and public sector sectors have the necessary tools
to bring new life to an economy in decline?
Wealth Creation Has Gone to the
The last 40 years have seen the
rise of private capital worldwide while public capital has declined. In 2015,
the value of net public wealth (or public capital) in the US was negative -17%
of net national income, while the value of net private wealth (or private capital)
was 500% of national income. In comparison to 1970, net public wealth amounted
to 36% of national income, while net private wealth was at 326 %.
World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018
Essentially, world banks and
governments have built monetary and fiscal economic systems that increased
private wealth at the expense of public wealth.
The lack of public capital makes
the creation of public goods and services nearly impossible. The development of
public goods and services like basic research and development, education and
health services are necessary for an economic rebound. The economy will need a
huge stimulus ‘lifting’ program and yet the capital necessary to do the job
is in the private sector where private individuals make investment allocation
building high levels of private capital a problem? Because, as we have discussed, private wealth
is now concentrated in the top 1 %, while 70 % of U.S GDP is dependent on
consumer spending. The 90 % have been working
for stagnant wages for decades, right along with diminishing GDP growth. There is a direct correlation between wealth
creation for all the people and GDP growth.
Corporations Are Not In A Position
corporations certainly have invested in their businesses, people, and
technology. The issue is the majority of
corporations are now financially strapped.
Many corporate executives have made profit allocation decisions to pay
themselves and their stockholders well at the expense of workers, their
communities and the economy.
S & P
500 corporations are paying out more cash than they are taking in, creating a
cash flow crunch at a – 15 % rate (that’s right they are burning cash) to
maintain stock buyback and dividend levels:
In 2018 stock
buybacks at $1.01 trillion were at the highest level they have ever been since
buybacks were allowed under the 1982 SEC safe harbor provision decision. It is
interesting to consider where our economy would be today if corporations spent
the money they were wasting on boosting stock prices and instead invested in
long term value creation. One trillion
dollars invested in raising wages, research, and development, cutting prices,
employee education, and reducing health care premiums would have made a
significant impact lifting the financial position of millions. This year stock
buybacks have fallen back slightly as debt loads increase and sales fall:
Dow Jones – 7/2019
corporations with tight cash flows have borrowed to purchase shares, pay
dividends and keep their stock price elevated causing corporate debt to hit new
highs as a percentage of GDP (note recessions followed three peaks):
Federal Reserve Bank of Dallas – 3/6/2019
debt has ballooned to 46 % of GDP totaling $5.7 trillion in 2018 versus $2.2
trillion in 2008. While the bulk of
these nonfinancial corporate bonds have been investment grade, many bond
covenants have become weaker as corporations seek more funding. Some bondholders
may find their investment not as secure as they thought resulting in significantly
less than 100 % return of principal at maturity.
recession, corporate sales fall, cash flow goes negative, high debt payments
become hard to make, employees are laid off and management tries to hold
on. Only a select set of major corporations
have cash hoards to ride out a recession, and others may be able obtain loans
at steep interest rates, if at all. Other
companies may try going to the stock market which will be problematic with low
valuations. Plus, investors will be
reluctant to buy stock in negative cash flow companies.
corporations will be hard pressed to invest the billions of dollars necessary
to turnaround a recession. Instead, they will be just trying to keep the doors
open, the lights on, and maintain staffing levels to hold on until the day
sales stop falling and finally turn up.
Public Sector is Also Tapped Out
recessions, federal policy makers have turned to fiscal policy – public
spending on infrastructure projects, research development, training, corporate
partnerships, and public services to revive the economy. When the 2008 financial crisis was at its peak
the Bush administration, followed by the Obama government pumped fiscal stimulus of $983 billion in spending
over four years on roads, bridges, airports, and other projects. The Fed funds
interest rate before the recession was at 5.25 % at the peak allowing lower
rates to have plenty of impact. Today, with rates at 1.75-2.00 %, the impact
will be negligible. In 2008, it was the combined
massive injection of monetary and fiscal stimulus that created a V-shaped
recession with the economy back on a path to recovery in 18 months. It was not monetary
policy alone that moved the economy forward. However, the recession caused lasting
financial damage to wealth of millions. Many retirement portfolios lost 40 – 60
% of their value, millions of homeowners lost their homes, thousands of workers
were laid off late in their careers and unable to find comparable jobs. The Great Recession changed many people’s
lives permanently, yet it was relatively short-lived compared to the Great
in the chart above, public sector wealth has actually moved to negative levels
in the U.S. at – 17 % of national income.
Our federal government is running a $1 trillion deficit per year. In 2007, the federal government debt level was
at 39 % of GDP. The Congressional Budget Office projects that by 2028 the
Federal deficit will be at 100 % of GDP
CBO – 4/9/19
We are at
a different time economically than 2008. Today with Federal debt is over 100%
of GDP and expected to grow rapidly. The Feds balance sheet is still excessive
and they formally stopped reducing the size (QT). In a recession federal policymakers will
likely make spending cuts to keep the deficit from going exponential. Policy
makers will be limited by the twin deficits of $22.0 trillion national debt and
ongoing deficits of $1+ trillion a year, eroding investor confidence in U.S. bonds.
The problem is the political consensus for fiscal stimulus in 2008 – 2009 does
not exist today, and it will probably be even worse after the 2020 election. Our
cultural, social and political fabric is so frayed as a result of decades of
divisive politics it is likely to take years to sort out during a recession. Our political leaders will be fixing the
politics of our country while searching for intelligent stimulus solutions to
be developed, agreed upon and implemented.
What Will the Next Recession Look
We don’t know
when the next recession will come. Yet, present trends do tell us what the
structure of a recession might look like, as a deep U- shaped, slow recovery measured
in years not months:
Corporations Short of Cash – Corporations already strapped are short on cash, will lay off workers, pull back spending, and are stuck paying off huge debts instead of investing.
Federal Government Spending Cuts – The federal government caught with falling revenues from corporations and individuals, is forced to make deep cuts first in discretionary spending and then social services and transfer funding programs. The reduction of transfer programs will drive slower consumer spending.
Consumers Pull Back Spending – Consumers will be forced to tighten budgets, pay off expensive car loans and student debt, and for those laid off seeking work anywhere they can find a job.
World Trade Declines – World trade will not be a source of rebuilding sales growth as a result of the China – US trade war, and tariffs with Europe and Japan. We expect no trade deal or a small deal with the majority of tariffs to stay in place. In other words, just reversing some tariffs will not be enough to restart sales. New buyer – seller relationships are already set, closing sales channels to US companies. New country alliances are already in place, leaving the US closed out of emerging high growth markets. A successor Trans Pacific Partnership (TPP) agreement with Japan and eleven other countries was signed in March, 2018 without the US. China is negotiating a new agreement with the EU. EU and China trade totals 365 billion euros per year. China is working with a federation of African countries to gain favorable trade access to their markets.
Pension Payments in Jeopardy – Workers dependent on corporate and public pensions may see their benefits cut from pensions, which are poorly funded today with markets at all-time highs. GE just announced freezing pensions for 20,000 employees, the harbinger of a possible trend that will reduce consumer spending
Investment Environment Uncertain – Uncertainty in investments will be extremely high, ‘get rich quick’ schemes will flourish as they did in 2008 – 2009 and 2000.
Fed Implements Low Rates & QE – The Fed is likely to implement very low interest rates (though not negative rates), and QE with liquidity in abundance but the economy will have low inflation, and declining GDP feeling like the Japanese economic stasis – ‘locked in irons’.
Implications for Investors
following recommendations are intended for consideration just prior or during a
recession with a sharp decline in the markets, not necessarily for today’s
Cash – It is crucial to maintain a
significant cash hoard so you can purchase corporate stocks when they cheapen. The
SPX could decline by 40 – 50 % or more when the economy is in recession. Yet, good values in some stocks will be
available. At the 1500 level, there is
an excellent opportunity to make good long term growth and value investments
based on sound research.
CDs – as Will Rogers noted during the
Depression, “I’m more interested in Return of
my Capital than Return on my
Capital”, a prudent investor should be too.
CDs are FDIC insured while offering lower interest rates than other
investments. Importantly, they provide return of capital and allow you to sleep
Bonds – U.S. Treasuries certainly provide
safety, return of principal, and during a recession will provide better overall
returns than high-risk equity investments. Corporate bonds may come under
greater scrutiny by investors even for so-called ‘blue chips’ like General
Electric. The firm is falling on hard times with $156 billion in debt. GE is seeking
business direction and selling off assets. The major conglomerate’s bonds have
declined in value by 2.5 % last year with their rating dropped to BBB. Now with
new management the price of GE bonds is climbing up slightly.
Utilities – are regulated to have a
profit. While they may see declining
revenues due to less energy use by corporations and individuals, they still
will pay dividends to shareholders as they did in 2008. Consumer staple companies are likely to be
cash flow strained; most did not pay dividends to investors during the 2008 –
2009 recession. REITs need to be evaluated on a company by company basis to
determine how secure their cash streams are from leases. During the 2008 – 2009
downturn, some REITs stopped paying dividends due to declining revenues from lease
Growth & ValueEquities– invest in
new sectors that have government support or emerging demand based on social
trends like climate change: renewables, water, carbon emission recovery,
environmental cleanup. From our Navigating
A Two Block Trade World – US and China post, we noted possible
investments in bridge companies between the two trade blocks; services, and
countries that act as bridges like Australia. Look for firms with good cash
positions to ride out the recession, companies in new markets with sales
generated by innovations, or problem solving products that require spending by
customers. For example, seniors will
have to spend money on health services. Companies serving an increasingly aging
population with innovative low cost health solutions are likely to see good
demand and sales growth.
intelligent investor will do well to ‘hope for the best, but plan for the
worst’ in terms of portfolio management in a coming recession. Asking hard questions of financial product executives
and doing your own research will likely be keys to survival.
In the end, Americans have always pulled together, solved problems, and moved ahead
toward an even better future. After a reversion to the mean in the capital
markets and an economic recession things will improve. A reversion in social and culture values is
likely to happen in parallel to the financial reversion. The complacency, greed,
and selfishness that drove the present economic extremes will give way to a new
appreciation of values like self-sacrifice, service, fairness, fair wages and
benefits for workers, and creation of a renewed economy that creates financial opportunities
for all, not just the few.
Patrick Hill is the Editor of The Progressive Ensign, https://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Today’s Melt Up Triggers Tomorrow’s Melt Down
Since November of 2016, the NDX has soared by 72% and is poised to
break the recent all-time high of 8027. Today, it seems that sentiment is
shifting back to selling bonds and buying riskier equities with hyped
estimates. FAANG stocks have fueled an ongoing rally, via stock buybacks, non –
GAAP financial gimmicky, and promises of eventual profitability for many
Source: Stockcharts.com – 9/12/19
has moved prices up as the market has suspended its disbelief of key
fundamentals like future earnings, declining sales, job layoffs, contracting
world trade, and negative cash flow.
First, let’s look at downward revised earnings forecasts for the rest of the year indicating a decline almost to a contraction level in the U.S.:
Sources: Bloomberg, IIF – 9/10/19
Analysts expect lower earnings and profitability due to declining
sales. The pivotal function of any business is sales. The inventory to sales
ratio is now at 2008 levels indicating that sales are declining while
production is continuing, which is typical of the later stages in the business
Sources: The Wall Street Journal, The Daily Shot – 9/12/19
Continuing present production levels with flat to declining sales
is unsustainable. Executives are faced
with declining sales overseas in part due to tariffs. As such, the number of production
shifts must be reduced, as the highest cost for most businesses is
payroll. A key indicator of executives
beginning to reduce staff is indicated by an increase in jobless claims in five
key manufacturing states starting about when tariffs were first enacted in November
Sources: B of A Merrill, Haver, The Wall Street Journal, The Daily
Shot – 8/30/19
Markets are underestimating the devasting impact that broad tariffs are having on U.S. corporate sales. S & P 100 corporations generally recognize from 50 – 60 % of total sales from overseas, and profits of 15 – 25 % or more from emerging markets like China and India. When tariffs hit U.S. products, there is a cascading effect on small businesses, and throughout the worldwide supply chain. Even if a product is produced domestically, many of the sourced parts come from several emerging markets which now face tariffs. China’s tariffs on U.S. farm products like soybeans have reduced sales by 90 %. Soybean farmers are looking for new markets, but are having a difficult time replacing the massive purchases that China makes each year. Tariffs are culminating sales headwinds and investment uncertainty at the fastest rate since 2008.
Sources: CPB World Monitor, The Wall Street Journal, The Daily Shot – 9/11/19
In the midst of all these economic and business headwinds,
executives should be running tight finances, right? Well, not exactly. Due to a surge in debt
issuance, corporations now have the highest debt to GDP ratio in history. However, they may not have learned about how
to keep out of financial trouble. S
& P 500 corporations are paying out more cash than they are taking in,
creating a cash flow crunch at a – 15 % rate (that’s right they are burning
cash) to maintain stock buyback and dividend levels:
Source: RIA PRO (www.riapro.net) Chart of the Day -9/10/2019
Unicorn IPO valuations are off the chart, many with unproven
business models and large losses. 2019 has seen the highest value of IPOs since
2000, an indicator of high interest in risky investments and soaring investor sentiment.
Not surprising, 2019 has the highest number of negative earnings per share IPO
companies since 2000 as well.
Sources: Dealogic, The Wall Street Journal, The Daily Shot –
Sources: Jay Ritter, University of Florida, The Wall Street
Journal – 3/16/18
The lack of profitability and the number of IPOs ‘to cash out
before it’s too late’ evokes memories of the 2000 Dotcom Crash. Then, investors were looking for ‘high tech
growth’ stocks, and as it was assumed that companies would figure out their
business model later.
When? As an example, Uber just recorded a $5.24 billion loss for the 2nd quarter of 2019. Lyft lost $644 million in the same quarter. Despite the popularity of their services, the business models for both ride-sharing companies has yet to be proven. Making profitability even harder for these companies, the State of California legislature just passed a bill recognizing ride-sharing drivers as employees and not contractors. Gov. Gavin Newsom is expected to sign the legislation. If Uber and Lyft have to pay salaries, benefits and other costs for full-time employees they will incur staggering costs, and may likely never be profitable. Uber says it is building a ‘transportation platform’ where drivers are delivering food and packages not transporting passengers so they can avoid being labeled a passenger transportation company. Both firms are planning to put an initiative on the ballot to declare their drivers as contractors to save their business models. It is still unclear, even with drivers being recognized as contractors, that they have viable business models. Yet investors just didn’t care at IPO time, though both stocks have since dropped in price dramatically since their IPO dates. Ride sharing is just one small industry and one example. There are many other unicorns with questionable businesses that are flourishing in the markets.
The suspended disbelief we see today is similar to the sentiment
that sent the NDX up nearly 400% just before the Y2K crash. We can learn from what happened beginning 20
months before the Y2K crash. The NDX
started in October of 1998 at 1063 and peaked at 4816 in May of 2000:
That astounding move up was followed by a roller coaster ride down
to 2897 for a 38 % decline by May of 2000, followed further by a two year decline
to 795, or 84 % decline from the 2000 peak.
The NDX would not reach the 4816 level again for another 16 years! Investors had to wait a long time just to break
One similarity to the Y2K related drop in sales we see today is from
tariffs. Companies have pulled purchases forward to avoid tariffs. Similar
activity occurred in 1999 as IT departments bought new software and hardware to
solve a possible year 2000 (Y2K) software bug. Software and hardware purchases
were pulled forward into 1999, then as one IT manufacturer CEO put it ‘the
lights went out on sales.’ The hard dates for tariff increases a year
ago forced corporations to pull up purchases that would otherwise be made later
in the year, resulting in an unnatural boost followed by a contraction of
Consumer products will be hit with 15 % tariffs in October and 25
% in December, so consumer, like businesses, are likely moving up their
purchases. We expect consumer spending to show increases in August, and
September, and decline after that. A contraction in consumer business
operations is likely to follow pulled up consumer purchases.
Plus, investors need to be cognizant of the huge transformation of
the world trade infrastructure into two competing trade blocks triggered by the
trade war by the U.S. and China as discussed in my post: Navigating
A Two Block Trading World. The forming of two trade blocks will
change the character of world trade, and therefore create uncertainty in international
sales for all businesses dependent on overseas customers to maintain growth and
Today, sentiment is set in suspended
disbelief that ‘the Fed will cut rates’ and make the economy grow. Corporations are swimming in low-cost debt,
with negative cash flows and flat to falling sales. If the Fed governors pick up an attaché case
with a sales pitch and get sales going again then the Fed might have an impact
on corporate profitability. Yes, cheap money may help stave off layoffs or cost
reductions, but in the end businesses
will have to cut costs to match new lower sales levels.
The market ‘hopes’ that a trade deal will revive the economy as
well. An ‘interim’ trade deal where
China gives up very little except a commitment to purchase agriculture and
livestock products in return for a suspension of increased tariffs won’t change
the broad-based tariff damage to the economy.
Unless broad-based tariffs are
ended, as 1,100 economists recommended in a letter to the Trump administration
18 months ago, the hemorrhaging of sales will continue.
So what can we learn from today’s investor sentiment compared to
sentiment observed during the Dotcom crash?
When the market finally ends its
disbelief and is hit with the reality of business fundamentals, the decline
will be fast and deep. The melt up, or
whatever is left of it, will trigger a melt down. The 4:1 return difference
in the 2000 melt up versus today’s melt up today is likely due to the 4.7 % GDP
rate in 1999 versus the forecasted 1.7 % GDP forecasted for 2nd
quarter this year. In 2000, the economy
was simply growing a lot faster than today, and productivity was rapidly
growly. This helped sentiment and provided some basis for the melt up. Further the melt up in 1999 was fueled by the
Fed providing excessive liquidity to help ensure that Y2K did not shut down the
The current melt up is occurring at a much lower level of economic
activity. Yet, both instances are based on a disconnect between what is
happening in the economy and the valuations of stocks. The longer the
disconnect with fundamentals, the longer it will take for the reversion to the
mean to rebalance the economy. Plus, the further the disconnect the larger
reversion to the mean or even an overshoot and it will take longer to get back
to ‘even’ – maybe 16 years from the peak as we saw in Dotcom Crash in 2000.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Navigating A Two Block Trade World
“Investors Need to Be Ready for a Two Block Trade World – U.S. and China”
On Bloomberg TV, VMware CEO, Pat Gelsinger, observed that with
escalation of the trade war he sees, “two
separate trading blocks forming the United States and China, we want to be a
player in both and will have to adjust,
our strategy, investments, supply
chains and operations as a result.”
He sees both countries digging in for the foreseeable future.
The evolution of a two trading block global economy has a major
impact on how businesses operate in the next five to ten years. Those with major operations in China that ship
products to the U.S. will continue to be adversely affected by U.S. tariffs on
Chinese goods. Growing trade headwinds also face, U.S. companies shipping goods
to China. Besides tariffs, trade research shows Chinese importers will need to
deal with U.S. non-tariff barriers that are not only costly but time consuming.
Here is a list of industry sectors most impacted by the trade war
with businesses exports and imports to China:
Sources: U.S. Census Bureau, Marketwatch – 6/27/19
Major software and electronics companies like Apple, with $56b in
sales making up 20% of total global revenue from China, will continue to see declining
sales. Apple, and other companies in the same shoes, will have to radically
shift supply chains and sourcing for manufacturing.
CISCO, a global network systems manufacturer, recently reported to
shareholders a 25% drop in sales of network products to both state-owned and private
corporations in China. Many American manufacturers’ source components and
sub-assemblies from China which are then shipped to the U.S. mainland for final
manufacturing. These supply chains will have to change if they are to sustain
Caterpillar, in the transportation sector, recognizes 10% of
global revenue from China and has experienced a significant drop in sales. Tariffs have significantly reduced soybean
exports to China by U.S. farmers to nearly zero. The Federal Reserve in
Minneapolis reports farm bankruptcies have reached 2008 levels.
These are just a few examples. Each day the list of impacted
industries and companies grows longer.
What does the two block trading world mean to investors?
The trade war seems to be here to stay. As such, agile CEOs are already planning for the U.S and China to be heavily competing for global trade. Investors will need to assess the implications for both short and long term investments.
Short term tactical investments:
Research business sectors with major exposure to imports and exports to China
Identify companies with exposure to China trade and related operational vulnerabilities
Identify countries that may act as bridge zones between the two blocks, ie: Australia, Singapore, and Vietnam
Long term strategic investments:
Identify companies that are well-positioned to leverage quickly the now forming two block trading world
Research bridge countries that are making investments in shipping infrastructure and establishing long term trade treaties with both the U.S. and China
Watch the business horizon for new businesses or services that will evolve as a result of the new U.S. – China trade competition
A new global trading structure is forming fast presenting both
opportunities and pitfalls for investors.
Agile investors might want to position themselves for optimal growth and
income in bridge countries or firms like VMware, where the CEO is moving
quickly to establish good relationships with both countries.
Investors should also consider longer-term investments in
Australian based companies or U.S. firms with major operations in Australia as
a bridge country. Many U.S. firms have
regional operations headquarters in Sydney. Sydney, positioned in the Asian region, offers
a well-skilled labor force, is an open country to many immigrants from all over
Asia that speak and write many languages. Further English is the main language
for easy use of technical documentation and recruitment of support staff. The
Australian government has been an ally of the U.S. for decades and yet has a bilateral
free trade agreement with the Chinese government signed in 2015. As a bonus,
the Australian economy has been in expansion for 27 straight years. The incredibly long string of growth is likely
due to a diverse economy, welcoming immigrants who start new businesses, an abundance
of natural resources, located at the nexus of Asian growth and a business positive
government and culture. It is these same traits that should help them thrive in
a two trading block economy.
Investors should be wary of Hong Kong or China-based businesses with American ties that are not politically correct. The Chinese economy is a state controlled managed economy of state run businesses and private businesses that run under strict guidelines. Problems in Hong Kong go beyond the present protests. The island city has seen the CEOs of a few local businesses ‘disappear’ when making trips to mainland China. In some instances these disappearances have happened for months throwing the businesses into turmoil and dropping stock prices by 70 – 80%.
Hong Kong’s future is highly uncertain as the Chinese government is growing increasingly concerned that democracy might ‘leak’ to the mainland and thereby threaten authoritarian rule. The Chinese government has announced the development of an ‘entites’ list of U.S. companies that Chinese firms are not to do business. American firms affiliated with these targeted firms will see significantly reduced sales. On the U.S. side, the Trump administration has gone back and forth on suppliers to Huawei and is now writing a ‘blacklist’ of Chinese firms that American companies are to end business with. Smart investors will need to keep track of U.S. and Chinese government pronouncements and policies in regard to which companies are ‘in’ and which are ‘out’. These may change by the day or week.
Monitoring markets or executive behaviors that are likely to catch
government scrutiny will offer investors an early warning of which firms may
soon appear on the lists. One possible new sector of scrutiny are cybersecurity
companies, which provide both countries an edge in the digital economy. Both
countries will want to maintain control, access and future development of digital
The two trading block global economy will require careful research, constant monitoring, and quick moves as politically ‘in’ companies can become ‘out’ at the whim of government leaders in both countries. Investments in stable countries, with firms that have a long history of bridging their business between both China and the U.S. are likely to be the best investment opportunities over the long term. Note that in any global recession, these bridge countries and companies are likely to be the first to recover from a recession.
Patrick Hill is the Editor of The Progressive Ensign writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Stock Buybacks Imperil Corporate Viability
Goldman Sachs just completed an analysis of corporate balance
sheets and found that dividend and stock buybacks accounted for 103.8% of their
free cash flow. Meaning that they were paying more out in cash than they had on
hand! Over the last year, free cash flow has dropped 15 %, while debt is
up 8 %.
balance sheet squeeze is unprecedented; it is the worst cash flow crisis since
1980 and is unsustainable. Corporate executives have turned to excessive
borrowing levels to keep this financial merry-go-round going. A good amount of
this debt is used for stock buybacks to hype share prices and keep earnings per
share higher than they would be without buybacks.
If sales and
profits drop due to the trade war and/or consumer spending declines as it has
in the last four months, some corporations will default on their debt. A
downward economic spiral can be triggered.
Maybe this is
another reason the Fed announced a cut in interest rates and a shift to an
‘inflation averaging framework.’ JPMorgan recently commented in Marketwatch
that they believe Fed economists are shifting to a position of not worrying
about inflation but instead on keeping money flowing to corporations at low
interest rates possibly as low as zero in the future.
rates extraordinarily low, the Fed enables executives to waste profits on stock
buybacks to increase their stock-based compensation and further increase stock
prices. If we want strong, durable, and sustainable economic growth, then we
need strong companies making investments in research, development, innovation,
productivity improvements, employee training, and raising wages. When the
economy works for all democracy is strengthened.
music will stop when sales and profits decline and an already desperate cash
flow position becomes untenable, putting many companies viability in
doubt. Looking out a year or two, we expect the Fed to come to the rescue
after possible zero interest rates have panned out. Last March, former Fed
Chair, Janet Yellen recommended that the Fed be authorized to purchase
corporate stock and bonds to keep the economy going if a recession hits.
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