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Earlier this month, Fed head Jerome Powell did what central bank chiefs usually do in a crisis: He went on 60 Minutes. His comments on the recovery’s potential length took most headlines, but economic policy wonks zeroed in on something different: a de facto admission that the Fed’s extraordinary actions in March and April exceeded the central bank’s mandate and expanded its original function well beyond anything in legislation. That has spurred a wave of think pieces on the wisdom and potential long-term consequences of these decisions, and in our view, they raise some valid points. These issues are worth weighing, and they could indeed have long-term ramifications. Yet we also think it is important for investors to distinguish long-term academic debates from issues that can affect markets in the here and now, and we think the case of the Fed’s mandate breach falls squarely in the former category. Projecting how this all ends amounts to sheer speculation and isn’t productive for investors to get hung up on today, in our view.
Since the 1970s, the Fed has had two main roles: adjusting monetary conditions to foster maximum employment with stable inflation (the famous dual mandate) and, the one it was created for in 1913, serving as lender of last resort during a crisis. That second part is traditionally limited to banks. In normal times, banks meet short-term obligations by borrowing from each other—a way for banks to keep the financial system liquid and stable while earning a very small return on spare cash. But when the system gets stressed, those short-term funds can dry up. When this happens, the Fed steps in, providing short-term loans to carry solvent-but-illiquid banks through a rough patch. It is a bridge to better times, not a bailout—a move designed to mitigate the broad economic impact of vast bank runs and panics that characterized 19th century America.
This time around, banks were in overall fine shape. The COVID crisis didn’t destroy their balance sheets or cause funding markets to freeze. Instead, as Powell pointed out, it was the “real economy” that saw funding disappear. That is pundit-speak for normal households and businesses small and large. Furloughed workers weren’t receiving paychecks. Businesses forced to close weren’t bringing in revenues. Larger companies that would ordinarily tap bond markets saw demand for new issuances dry up as investors fretted credit rating cuts and the potential for longer-than-expected closures to raise bankruptcy and default risk. Small businesses without significant collateral faced high hurdles to obtaining bank loans. State and local governments faced tax revenue shortfalls, raising fears of big deficits and troubles in muni bond markets. So, identifying those myriad trouble spots, the Fed chose to intervene as lender of last resort—not to banks, but to businesses, households and municipal governments. Or, if you prefer, to Main Street.
Slightly less awful than April. That is our primary takeaway from last week’s release of May’s IHS Markit preliminary—or “flash”—purchasing managers’ indexes (PMIs) for many major world economies. PMIs tally the breadth of economic activity, and while more companies are now reporting an uptick, the results still show most businesses are contracting. This, despite gradual reopening, likely contributes to what seems to be an increasingly common view: that any economic recovery will be slow and drawn out. How fast that economic revival moves from here probably depends on further reopening progress. But for stocks, we think what matters most is how the economic trajectory squares with expectations.
May’s flash PMIs broadly rose versus April’s extremely low levels. But all remained well under 50, indicating contraction—just not as widespread as last month’s. (Exhibit 1) Services activity—the lion’s share of developed world GDP—saw the biggest jump off of April’s depressed levels, leading the increase in composite PMIs. Yet services’ readings remained worse than manufacturing’s across the board.
Exhibit 1: Major Economy PMIs
Source: IHS Markit and FactSet, as of 5/21/2020.
In non-COVID news, last week the UK announced its post-Brexit trade policy—both within the nation and with the rest of the world—chipping away at no-deal Brexit dread. EU trade deal or none, the country looks open for business, countering long-running fears that Brexit is a protectionist nightmare.
Last Tuesday, the government unveiled a tariff regime—the UK Global Tariff (UKGT)—that shows what a Brexit on World Trade Organization (WTO) terms would look like. As an EU member, the UK had to apply the tariffs Brussels set for EU trade with the rest of the world. Post-Brexit, the UK can set its own terms based on its most-favored-nation status at the WTO. UKGT fleshes out those terms, which will apply to all nations the UK doesn’t have a separate free-trade agreement with.
The result, contrary to widespread fears, is broadly freer trade with simpler terms than the EU’s. The plan eliminates all “nuisance” tariffs presently set at 2% or lower and reduces most others. It also reduces the percentage of imported products subject to tariffs from 53% to 40%. In value terms, 60% of imports will be tariff-free. But there are still carve-outs to “protect” pet industries. For instance, the plan cuts tariffs on car parts and other strategic manufacturers’ components, but levies will apply to competing final goods—such as assembled cars, as well as agricultural and fishing products.
For several weeks now, France and several southern European nations have argued the only way to fund the EU’s fiscal response to COVID-19 without sending Italy and others into a debt crisis is to issue so-called coronabonds—joint bond issuance by all 27 EU member-states. Germany, Austria, the Netherlands and most of northern Europe have long opposed this concept, seeing it as a wealth transfer from fiscally responsible to spendthrift nations. Until Monday, that is, when Chancellor Angela Merkel and French President Emmanuel Macron announced their joint support for a €500 billion coronabond issuance, sending cheers throughout European markets. But the enthusiasm was short-lived, as the deal’s many caveats and a raft of opposition emerged on Tuesday. The debate probably won’t resolve soon, and even if the deal goes through, the proceeds won’t be an immediate benefit. Regardless of the outcome, however, an EU economic recovery likely doesn’t hinge on coronabonds.
Though the name “coronabonds” is new, the concept of pooled EU or eurozone debt isn’t. Member-states considered the concept but rejected it when the euro was born, preferring to have a monetary union without a fiscal transfer union—a unique arrangement that led many to see the eurozone as incomplete. After all, most areas that share a currency and monetary policy also share fiscal policy, including transfers from wealthier nations to weaker states. That is how it works in the US, with federal tax revenue and bond proceeds redistributed across all 50 states, as well as the UK, which redistributes revenue from England to Wales, Scotland and Northern Ireland. The EU, by contrast, has always had a limited budget funded by pre-set contributions from member-states, and that budget is mostly for operational and development purposes, not transferring funds to national budgets. Some eurozone member-states sought to change that during the 2011 – 2013 sovereign debt crisis, viewing it as an opportunity to “complete” the currency union, but opposition from several northern European nations rendered the idea of “eurobonds” dead on arrival. Asking their voters to underwrite what many viewed as irresponsible spending on the periphery was a non-starter.
And then came COVID-19, which hit Italy and Spain particularly hard both medically and economically. That naturally heightened calls for a fast, huge fiscal response. But with Italy’s debt finishing 2019 at 135% of GDP and Spain’s at 96%, most presume neither has the bandwidth to borrow a few hundred billion extra euros this year without causing a new debt crisis that could risk splintering the euro.[i] It seems the tragedy of COVID was enough to convince Merkel she could sell this to voters as a sacrifice necessitated by events out of everyone’s control, rather than a bailout of profligate spenders.
With lockdowns starting to ease, many pundits are shifting their thoughts to possible paths forward. Since consumer spending is almost 70% of US GDP, many questions hinge on consumer behavior. The dominant theme: Fear that plunging consumption in March and April is a prelude to persistent weakness past economies’ reopening as virus worries, high unemployment and rising savings rates flatline spending and quash growth. But in our view, this overrates consumer spending’s variability—even given the current, very unusual economic circumstances.
Retail sales have tanked since shelter-in-place orders spread nationwide, falling -8.3% m/m in March and -16.4% in April.[i] To see the full effect of these twin monthly drops on retail sales—and its major underlying industry groups—Exhibit 1 shows the cumulative percentage change in retail sales from February – April 2020.
Exhibit 1: Percentage Change in Retail Sales Components, February – April 2020
Source: FactSet, as of 5/18/2020. Percentage change in components of US retail sales and food services, February 2020 – April 2020.
China released several widely watched economic reports last Friday, providing more insight about the country’s performance since lifting its most severe COVID-containment policies in early March. Some doubt China’s numbers will shed much light about post-COVID life elsewhere—mostly citing unique features of the country’s lockdown and rebound. There is some sense in that. China’s experience won’t look exactly like Continental Europe’s, which won’t look perfectly like America’s (etc., etc. and so forth). Still, in our view, China’s nascent economic recovery offers an instructive preview of life following a virus-driven shutdown—and should help set investors’ expectations.
In China’s first full month without national COVID restrictions, April industrial production rose 3.9% y/y, returning to positive territory after March’s -1.1% slip and January – February -13.5% decline (China typically consolidates January and February economic data to account for the monthly skew from the shifting Lunar New Year holiday). Retail sales fell -7.5% y/y—the second straight month showing slower declines. Both these measures have improved markedly from the start of the year, when authorities extended the Lunar New Year holiday as part of China’s COVID-19 containment effort.
Exhibit 1: China Retail Sales and Industrial Production, April 2019 – April 2020
With more and more economic data coming in, the sheer scope of the hit to the global economy from well-intended lockdowns is becoming clear. With it, so is the importance of reopening the economy—both to growth itself and markets. Four weeks ago, we outlined the earliest European nations’ reopening plans—from Denmark and Austria. But now, many other nations have joined them in beginning to reopen. For investors, we think a quick look at some major developed nations’ plans can help further form expectations about the economic contraction’s duration—and global stocks’ likely path forward.
The following is a roundup of major nations’ plans. Of course, their leaders have repeatedly warned these are subject to change (read: delay or reversal) if COVID-19 case counts resurge. These gradual plans—plus governments’ caveats—should help keep investors’ expectations of the path to reopening low. In our view, those low expectations are a plus for stocks, likely helping reduce negative surprise power.
Source: BBC and Reuters, as of 5/18/2020. Individual states’ roadmaps may differ.
Japan reported Q1 GDP this morning, rounding out the preliminary results of COVID-19’s impact on major developed economies, and as most everyone expected, the Land of the Rising Sun joined Germany, France and Italy in recession. As we warned readers a few weeks ago when the US reported GDP, national statistics agencies’ various reporting preferences may make comparing countries’ growth rates difficult. Hence, we have done the math to bring everything in line and show what the results do—and don’t—mean for stocks.
Under more typical circumstances, the variance among countries’ GDP growth rates wouldn’t get a ton of scrutiny—just a quick “A is growing faster than B,” and then everyone moves on. But in the COVID-19 era, investors are desperate for any hint of how the virus and the related stay-at-home orders are affecting the global economy, particularly with countries’ lockdowns (and reopenings) on differing timetables. Just looking at news coverage or national statistics bulletins probably won’t give you everything you need to know, however, because countries use different reporting methods. The eurozone and most of its member-states focus on year-over-year or quarter-over-quarter results. The former is the percentage change between GDP in Quarter X versus the same quarter in the prior year. The latter is the percentage between GDP in Quarter X and the preceding, usually with seasonal adjustments. The US and Japan report GDP growth at seasonally adjusted annualized rates, which is what you get if you compound the quarterly growth rate over a full year. So to make life easier for you and us, we made Exhibit 1, which displays seven major nations’ (plus the eurozone’s) annualized GDP growth rates over the past three quarters.
Exhibit 1: Annualized GDP Growth Rates
Last Thursday, fed-funds rate futures dipped negative—seemingly hinting that some traders anticipate the Fed enacting a negative interest rate policy by mid-2021. Accordingly, chatter—and fear—about the prospect is up. President Trump tweeted his support for it. Yet several Fed members, including Chairman Jerome Powell on Wednesday, have stated they have no plans to cut rates below zero. That seems sensible to us. We find little evidence of negative interest rates stimulating growth anywhere they have been tried, mostly amounting to a mild negative. Here is why.
To be clear, we aren’t talking about market-determined Treasury rates, which can (and have) dipped below zero at times.[i] We are referring to Fed-set overnight rates—like those that influence rates banks charge one another for overnight funds and/or earn by depositing funds at the Fed itself. Presently, these are barely positive.[ii] Negative rate proponents argue flipping them below zero would boost growth and inflation by spurring banks to lend. But in countries deploying negative rates in recent years—Sweden, Denmark, Switzerland, Japan and the eurozone—lending didn’t get an apparent turbo-boost.
Sweden’s Riksbank was the first to implement negative rates in July 2009. This first foray lasted until September 2010, and it may seem to have “worked.” An eight-month deflationary stretch ended in December 2009, after which Swedish inflation gradually accelerated to 3.4% y/y in August 2011.[iii] But this was part of a global trend of higher inflation as the world emerged from the global financial crisis, so it looks less like a policy success and more like a byproduct of the global recovery. Sweden reinstated negative rates in February 2015 and ended them this February. During this span, the policy looks less “successful”: Inflation was at or above the bank’s 2% y/y target less than a quarter of the time.[iv]
Friday, $10 billion worth of 30-Year US Treasury bonds originally sold at auction on May 15, 1990 will mature. Partly to refinance this, the government sold new 30-year bonds on Wednesday—$22 billion worth. The results of this swap highlight a key point about US debt: While the amount of debt outstanding is up a lot, so is debt affordability.
Let there be no doubt: US federal government debt has grown dramatically these last 30 years—and seems set to rise substantially this year, too, given the fiscal response to coronavirus lockdowns. On May 12, the Treasury put overall (gross) federal government debt at $25,188,757,825,113.86.[i] Call it $25.2 trillion for simplicity’s sake. Of that, the government itself (not including the Fed) owns $5.9 trillion. As this is both a federal government asset and liability, it effectively cancels. Hence, most economists and analysts look at net public debt, which removes intragovernmental holdings. It stands at $19.3 trillion presently.
When the government issued the 1990 bonds that mature Friday, America had about $2.4 trillion in net public debt.[ii] Looking at this metric, to say that the aggregate amount of federal government debt has grown some is an understatement.