“You better tuck that in. You’re gonna’ get that caught on a tripwire.” – Lieutenant Dan, Forrest Gump

There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which block would cause the tower to give way?

A Coronavirus

Pneumonia of unknown cause first detected in Wuhan, China, was reported to the World Health Organization (WHO) on December 31, 2019. The risks of it becoming a global pandemic (formally labeled COVID-19) was apparent by late January. Unfortunately, it went mostly unnoticed in the United States as China was slow to disclose the matter and many Americans were distracted by impeachment proceedings, bullish equity markets, and other geopolitical disruptions.

The S&P 500 peaked on February 19, 2020, at 3393, up over 5% in the first two months of the year. Over the following four weeks, the stock market dropped 30% in one of the most vicious corrections of broad asset prices ever seen. The collapse erased all of the gains achieved during the prior 3+ years of the Trump administration. The economy likely entered a recession in March.

There will be much discussion and debate in the coming months and years about the dynamics of this stunning period. There is one point that must be made clear so that history can properly record it; the COVID-19 virus did not cause the stock and bond market carnage we have seen so far and are likely to see in the coming months. The virus was the passive triggering mechanism, the tripwire, for an economy full of a decade of monetary policy-induced misallocations and excesses leaving assets priced well beyond perfection.

Never-Ending Gains

It is safe to say that the record-long economic expansion, to which no one saw an end, ended in February 2020 at 128 months. To suggest otherwise is preposterous given what we know about national economic shutdowns and the early look at record Initial Jobless Claims that surpassed three million. Between the trough in the S&P 500 from the financial crisis in March 2009 and the recent February peak, 3,999 days passed. The 10-year rally scored a total holding-period return of 528% and annualized returns of 18.3%. Although the longest expansion on record, those may be the most remarkable risk-adjusted performance numbers considering it was also the weakest U.S. economic expansion on record, as shown below.

They say “being early is wrong,” but the 30-day destruction of valuations erasing over three years of gains, argues that you could have been conservative for the past three years, kept a large allocation in cash, and are now sitting on small losses and a pile of opportunity with the market down 30%.

As we have documented time and again, the market for financial assets was a walking dead man, especially heading into 2020. Total corporate profits were stagnant for the last six years, and the optics of magnified earnings-per-share growth, thanks to trillions in share buybacks, provided the lipstick on the pig.

Passive investors indiscriminately and in most cases, unknowingly, bought $1.5 trillion in over-valued stocks and bonds, helping further push the market to irrational levels. Even Goldman Sachs’ assessment of equity market valuations at the end of 2019, showed all of their valuation measures resting in the 90-99th percentile of historical levels.

Blind Bond Markets

The fixed income markets were also swarming with indiscriminate buyers. The corporate bond market was remarkably overvalued with tight spreads and low yields that in no way offered an appropriate return for the risk being incurred. Investment-grade bonds held the highest concentration of BBB credit in history, most of which did not qualify for that rating by the rating agencies’ own guidelines. The junk bond sector was full of companies that did not produce profits, many of whom were zombies by definition, meaning the company did not generate enough operating income to cover their debt servicing costs. The same held for leveraged loans and collateralized loan obligations with low to no covenants imposed. And yet, investors showed up to feed at the trough. After all, one must reach for extra yield even if it means forgoing all discipline and prudence.

To say that no lessons were learned from 2008 is an understatement.

Black Swan

Meanwhile, as the markets priced to ridiculous valuations, corporate executives and financial advisors got paid handsomely, encouraging shareholders and clients to throw caution to the wind and chase the market ever higher. Thanks also to imprudent monetary policies aimed explicitly at propping up indefensible valuations, the market was at risk due to any disruption.

What happened, however, was not a slow leaking of the market as occurred leading into the 2008 crisis, but a doozy of a gut punch in the form of a pandemic. Markets do not correct by 30% in 30 days unless they are extremely overvalued, no matter the cause. We admire the optimism of formerly super-intelligent bulls who bought every dip on the way down. Ask your advisor not just to tell you how he is personally invested at this time, ask him to show you. You may find them to be far more conservative in their investment posture than what they recommend for clients. Why? Because they get paid on your imprudently aggressive posture, and they do not typically “eat their own cooking”. The advisor gets paid more to have you chasing returns as opposed to avoiding large losses.

Summary

We are facing a new world order of DE-globalization. Supply chains will be fractured and re-oriented. Products will cost more as a result. Inflation will rise. Interest rates, therefore, also will increase contingent upon Fed intervention. We have become accustomed to accessing many cheap foreign-made goods, the price for which will now be altered higher or altogether beyond our reach. For most people, these events and outcomes remain inconceivable. The widespread expectation is that at some point in the not too distant future, we will return to the relative stability and tranquility of 2019. That assuredly will not be the case.

Society as a whole does not yet grasp what this will mean, but as we are fond of saying, “you cannot predict, but you can prepare.” That said, we need to be good neighbors and good stewards and alert one another to the rapid changes taking place in our communities, states, and nation. Neither investors nor Americans, in general, can afford to be intellectually lazy.

The COVID-19 virus triggered these changes, and they will have an enormous and lasting impact on our lives much as 9-11 did. Over time, as we experience these changes, our brains will think differently, and our decision-making will change. Given a world where resources are scarce and our proclivity to – since it is made in China and “cheap” – be wasteful, this will probably be a good change. Instead of scoffing at the frugality of our grandparents, we just might begin to see their wisdom. As a nation, we may start to understand what it means to “save for a rainy day.”

Save, remember that forgotten word.

As those things transpire – maybe slowly, maybe rapidly – people will also begin to see the folly in the expedience of monetary and fiscal policy of the past 40 years. Expedience such as the Greenspan Put, quantitative easing, and expanding deficits with an economy at full employment. Doing “what works” in the short term often times conflicts with doing what is best for the most people over the long term.

“The process by which money is created is so simple that the mind is repelled.” – JK Galbraith

By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.

Most investors seem unable to grasp why the Fed’s actions have been, thus far, ineffective. In this article, we explain why today is different from the past. The Fed’s current predicament is unique as they have never been totally up against the wall of zero-bound interest rates heading into a crisis. Their remaining tools become more controversial and more limited with the Fed Funds rate at zero. Our objective is to assess when the monetary medicine might begin to work and share our thoughts about what is currently impeding it.

All Money is Lent in Existence.

That sentence may be the most crucial concept to understand if you are to make sense of the Fed’s actions and assess their effectiveness.

Under the traditional fractional reserve banking system run by the U.S. and most other countries, money is “created” via loans. Here is a simple example:

• John deposits a thousand dollars into his bank
• The bank is allowed to lend 90% of their deposits (keeping 10% in “reserves”)
• Anne borrows $900 from the same bank and buys a widget from Tommy
• Tommy then deposits $900 into his checking account at the same bank
• The bank then lends to someone who needs $810 and they spend that money, etc…

After Tommy’s deposit, there is still only $1,000 of reserves in the banking system, but the two depositors believe they have a total of $1,900 in their bank accounts.  The bank’s accountants would confirm that. To make the bank’s accounting balance, Anne owes the bank $900. The money supply, in this case, is $1,900 despite the amount of real money only being $1,000.

That process continually feeds off the original $1,000 deposit with more loans and more deposits. Taken to its logical conclusion, it eventually creates $9,000 in “new” money through the process from the original $1,000 deposit.

To summarize, we have $1,000 in deposited funds, $10,000 in various bank accounts and $9,000 in new debt. While it may seem “repulsive” and risky, this system is the standard operating procedure for banks and a very effective and powerful tool for generating profits and supporting economic growth. However, if everyone wanted to take their money out at the same time, the bank would not have it to give. They only have the original $1,000 of reserves.

How The Fed Operates

Manipulating the money supply through QE and Fed Funds targeting are the primary tools the Fed uses to conduct monetary policy. As an aside, QE is arguably a controversial blend of monetary and fiscal policy.

When the Fed provides banks with reserves, their intent is to increase the amount of debt and therefore the money supply. As such, more money should result in lower interest rates. Conversely, when they take away reserves, the money supply should decline and interest rates rise. It is important to understand, the Fed does not set the Fed Funds rate by decree, but rather by the aforementioned monetary actions to incentivize banks to increase or reduce the money supply.

The following graph compares the amount of domestic debt outstanding versus the monetary base.

Data Courtesy: St. Louis Federal Reserve

Why is QE not working?

So with an understanding of how money is created through fractional reserve banking and the role the Fed plays in manipulating the money supply, let’s explore why QE helped boost asset prices in the past but is not yet potent this time around.

In our simple banking example, if Anne defaults on her loan, the money supply would decline from $1,900 to $1,000. With a reduced money supply, interest rates would rise as the supply of money is more limited today than yesterday. In this isolated example, the Fed might purchase bonds and, in doing so, conjure reserves onto bank balance sheets through the magic of the digital printing press. Typically the banks would then create money and offset the amount of Anne’s default.  The problem the Fed has today is that Anne is defaulting on some of her debt and, at the same time, John and Tommy need and want to withdraw some of their money.

The money supply is declining due to defaults and falling asset prices, and at the same time, there is a greater demand for cash. This is not just a domestic issue, but a global one, as the U.S. dollar is the world’s reserve currency.

For the Fed to effectively stimulate financial markets and the economy, they first have to replace the money which has been destroyed due to defaults and lower asset prices. Think of this as a hole the Fed is trying to fill. Until the hole is filled, the new money will not be effective in stimulating the broad economy, but instead will only help limit the erosion of the financial system and yes, it is a stealth form of bailout. Again, from our example, if the banks created new money, it would only replace Anne’s default and would not be stimulative.

During the latter part of QE 1, when mortgage defaults slowed, and for all of the QE 2 and QE 3 periods, the Fed was not “filling a hole.” You can think of their actions as piling dirt on top of a filled hole.

These monetary operations enabled banks to create more money, of which a good amount went mainly towards speculative means and resulted in inflated financial asset prices. It certainly could have been lent toward productive endeavors, but banks have been conservative and much more heavily regulated since the crisis and prefer the liquid collateral supplied with market-oriented loans.

QE 4 (Treasury bills) and the new repo facilities introduced in the fall of 2019 also stimulated speculative investing as the Fed once again piled up dirt on top of a filled hold.  The situation changed drastically on February 19, 2020, as the virus started impacting perspectives around supply chains, economic growth, and unemployment in the global economy. Now QE 4, Fed-sponsored Repo, QE infinity, and a smorgasbord of other Fed programs are required measures to fill the hole.

However, there is one critical caveat to the situation.

As stated earlier, the Fed conducts policy by incentivizing the banking system to alter the supply of money. If the banks are concerned with their financial situation or that of others, they will be reluctant to lend and therefore impede the Fed’s efforts. This is clearly occurring, making the hole progressively more challenging to fill. The same thing happened in 2008 as banks became increasingly suspect in terms of potential losses due to their exorbitant leverage. That problem was solved by changing the rules around how banks were required to report mark-to-market losses by the Federal Accounting Standards Board (FASB). Despite the multitude of monetary and fiscal policy stimulus failures over the previous 18 months, that simple re-writing of an accounting rule caused the market to turn on a dime in March 2009. The hole was suddenly over-filled by what amounted to an accounting gimmick.

Summary

Are Fed actions making headway on filling the hole, or is the hole growing faster than the Fed can shovel as a result of a tsunami of liquidity problems? A declining dollar and stability in the short-term credit markets are essential gauges to assess the Fed’s progress.

The Fed will eventually fill the hole, and if the past is repeated, they will heap a lot of extra dirt on top of the hole and leave it there for a long time. The problem with that excess dirt is the consequences of excessive monetary policy. Those same excesses created after the financial crisis led to an unstable financial situation with which we are now dealing.

While we must stay heavily focused on the here and now, we must also consider the future consequences of their actions. We will undoubtedly share more on this in upcoming articles.

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30^th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

Consumers are viewed by many economic analysts as the last hope to keep the economy humming as the manufacturing sector seems to be in a recession. To wit, in the newly released third-quarter GDP report, personal consumption accounted for 100% of GDP growth.  However, weakness in the business sector may trigger a decline in consumer confidence. The October ISM manufacturing sector report showed a contraction, while the ISM services report indicated continued expansion. Yet, the less followed PMI Services report for October came in above 50 but with a note of caution.  Chris Williamson, Markit Chief Business Economist noted:

“With inflows of new work drying up, firms are relying on previously-placed orders to sustain current output growth, meaning the rate of expansion could weaken further in the coming months if demand doesn’t revive. Hence we’re seeing jobs being cut at an increased rate among surveyed companies, with employment falling for a second successive month and to a degree not seen since 2009. Such a weakening of the survey’s employment index will likely feed through to the official jobs numbers as we move toward the end of the year.”

It is likely that Williamson’s concern about contracting business conditions will ‘leak’ over to workers. Regardless of job status, a worker’s experiences, what they see and hear, will likely undermine confidence as a consumer. Let’s look at CEO confidence versus consumer expectations.  In this chart by Lance Roberts, consumer confidence is derived from data provided by the University of Michigan and the Conference Board. He compares consumer confidence to CEO confidence:

Note that just prior recessions, there was a wide divergence between CEO confidence and consumer confidence.  CEO confidence is now at its lowest level since 2008 and at similar levels that preceded the four prior recessions. Why is there such a large gap between the consumer and CEO perspective on the economy?

The consumer perspective is primarily a micro view of the economy.  Workers are concerned about job security and the income needed to support themselves and their families.  Consumers spend based on their ability to continue to pay their rent or mortgage, make car payments, buy food and spend what is left over for entertainment, travel or other interests. Many consumers also try to save some income for a rainy day. The consumer has a near term, day to day, month to month economic experience based on their present job, expenses, and spending circumstances.

The CEO receives a continuous flow of reports scanning the economic horizon at both the firm and macro level.  The marketing department provides sales, competition, and market analysis for the next year, three or even five years. These sales projections and other economic research are used by management to decide where to allocate resources, such as building new plants, locating offices, and hiring or downsizing staff. The sales staff talks with customers daily, assessing sales prospects, and sending forecasts to executive management.  The CEO has both a broad economic view of trends in world-wide markets and, more narrowly, how economic trends will affect the company’s future growth. The confidence of CEOs in the aggregate is warning of a major economic decline.

Workers know that executives’ concern about declining sales and profits means their jobs are in jeopardy. For most firms, worker wages, benefits, and overhead costs are 66 – 70 % of all expenses. Employment is beginning to decline concerning temporary workers as the ISM Manufacturing report showed a decline in the hiring of temporary workers to a three year low.  Management usually starts the expense control process by not hiring more temporary staff. If needed due to poor sales or profits, temporary staff is first to be laid off.  Next, full-time hiring is frozen, and if further cuts are needed, full-time workers are terminated. In this chart from Danielle De Martino Booth, continuing unemployment claims are up 2. 5 % over the last year, non-farm payrolls are declining, the ASA temporary payroll index has been contracting for 9 months, and higher paying worker payrolls have fallen for the last three months:

Source: Danielle De Martino Booth, The Daily Feather – 11/4/19

De Martino notes that the top two quantiles of higher paying workers account for 60% of all consumption.  A fall in payrolls for higher paid workers is likely to cause a decline in future spending as they become anxious about job security. Declining employment or even the prospect of layoffs will cause consumers to pull back on spending. Layoffs are even more of an issue when workers believe that finding another job may become more challenging. Job openings peaked last summer and have continued to fall. On a year over year basis, the number of job openings has contracted to levels last seen two years ago.

Sources: The Wall Street Journal, The Daily Shot – 11/5/19

Uncertainty in the job market, declining economic conditions, and the trade war are becoming more of a concern for consumers as they begin to worry about their finances. This was highlighted by the Bloomberg Personal Finance Index which dropped sharply in October.

Sources: Bloomberg, The Wall Street Journal, The Daily Shot – 11/8/19

As manufacturing jobs have become scarce, many workers have taken contract jobs. McKinsey & Company estimates 52 million people are gig economy workers of a 156 million person workforce. Contractors have no job security.  Gig workers 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 slowdown. To meet budget demands many middle-class workers have multiple jobs.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19.

Note that the present level of multiple job holders is higher than during the 2009 recession and significantly higher than during the 2000 DotCom crash.

Over the past six months, wages have increased due to tight labor market conditions, yet overall earnings, especially for men over several decades, have been flat since 1975.

Sources: U.S. Census Bureau, 2019

With wages stagnant, workers have taken on exceedingly high levels of debt to maintain their lifestyle.  Auto purchases are now often financed over a 7 or even 8year period. Over 35% of these purchases are made with negative equity, meaning they are not only financing a new car but the remaining debt balance of a trade-in car.  Often these payments are quite high, and as the scheme continues, will grow to unmanageable levels. Similar to the sub-prime mortgage crisis in 2008 many of the negative equity car buyers have sub-prime credit scores. Dealers anxious to increase vehicle sales approve the financing deal anyway at higher interest rates than positive equity purchasers.

Sources: Edmunds, The Wall Street Journal – 11/9/19

The auto financing binge is now showing up in the number of auto loan delinquencies, which are at their highest level since 2011.

The other largest single purchase for consumers, housing, is showing signs of financial deterioration as well. First-time home buyers are becoming delinquent on their mortgage payments at an increasing rate of 4.25 % over the past year and a half. Even for non-first time buyers their rate of delinquency is moving up significantly to 3.5 %. The deterioration in mortgage payments is indicative of financially overdrawn purchasers with all too willing lenders. Sound familiar?

Sources: Ginne Mae, The Wall Street Journal, The Daily Shot – 11/8/19

What does this mean in terms of consumer spending? While there have been a few spikes in consumer spending, most likely due to tariff hurry up buying, the overall direction is down.  A decline in consumer spending is what we should expect with the uncertainty caused by a manufacturing recession, China-U.S. trade war, increasing prices of imported goods, job insecurity, high levels of auto debt, and increasing delinquencies for auto and mortgage payments.

Sources: Commerce Department, The Wall Street Journal, The Daily Shot – 10/31/19

Due to significant economic headwinds, we don’t expect the consumer will be able to continue to offset the decline in manufacturing and global slowdown.  The real question is, when will consumer spending shift to contraction levels? 

We expect that consumers will keep up present levels of consumer spending through the holidays.  By the spring of 2020, clear evidence will emerge on the impact of the trade war on U.S. businesses and economic declines in Europe and Asia. Business growth will decline as indicated by a major weakening in sales and profits. Corporate balance sheets will tighten causing workers concern about the future of their job.  Hiring freezes and layoffs will be announced. As job insecurity increases consumer spending will drop dramatically resulting in economic activity spiraling down.

We leave you with one final thought. Will a divisive election and negative economic headlines provide confidence?

PowerPoint slide provided By Real Investment Advice

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 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.

Let’s look 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.

Non-financial 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

Is this 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?

The issue 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.

The profit 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

Why have 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.

In 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

Since 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. 

While the 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.

Corporate 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

The concerns that CEOs see in revenue and profitability were borne out in 3^rd 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 3^rd quarter of 2019.

Source: Factset – 10/25/19

Are equity 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 market complacency 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.