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Advisors are watching this market in disbelief and wonder how to properly balance the risk and return tradeoff of this market without inevitably losing ground to perfect hindsight. Marginally reduce equity exposure, they lose; realize some profits, they lose; increase liquidity, you lose; purchase put options, you lose; sell covered calls, you lose. No matter the strategy in this powerfully trending market the smart manager loses ground. To make matters worse is the inevitable comparison with some inappropriate reference benchmark. “Well the ‘market’ went up by X% and you went up less than that…” Managers and advisors believe that they are truly caught between a rock and a hard place. We offer some suggestions on how to navigate away from this position.

It is a market for the short sighted and inexperienced. The instant gratification crowd is living large. Living in the now with no understanding of the path taken or the path forward defines the fear of missing out (FOMO) crowd. We are not nihilists, but I do dearly want the markets to reflect some representative valuations across the board. Allow some reversion to fair value to shake out the current insanity. Current valuations and spreads simply do not reflect justifiable discounting of future earnings. It is impossible to believe that can be true. We are at valuations higher than pre-pandemic when we were at the highest level of employment ever seen accompanied by organic economic growth and an oh so accommodating central bank. [We realize that the central bank seems to be always accommodating.] In other words, the future was far brighter than it is today. So how is it plausible to be at higher valuations now? It’s not. Even with the short-term liquidity insertions and misguided fiscal handouts it is impossible to reconcile. But this market is in defiance of fundamentals. Talking heads and politicians cheer it on and take credit for it. I wonder where they’ll be when this market corrects.

Source: The Economist.

Armed with this logic, it is understandable that experienced advisors would lean toward risk management. But they are faced with the unrelenting trend across risky assets. It is a market valued for impossible growth and economic utopia. Discipline and clear communication with investors are direly needed at this time. Manage risk as cost effectively as possible. In an efficient market every cent used to manage risk will not participate in the trend and accountability based on perfect hindsight, against misplaced benchmarks, is painful. But fiduciaries must be able to deal with this discomfort if they are to fulfill their responsibility. For the best interest of your investors wealth aggregation you must properly manage risk. The aforementioned myopic crowd may sneer and try to steal your clients but sleep well knowing that decades of experience have allowed you to develop a respect for risk even when they claim it does not exist. An advisor’s job is to build and protect wealth. It is a balancing act between the two. Operating solely on fear of hindsight is not balancing but cowardly. Cowards never win. Nor does ignorance.

Transparency and Proper Benchmarks

We would rather lose the greedy and uninformed client than compromise our ethics or our understanding of market dynamics. Pigs are greedy and most pigs are eventually slaughtered. We prefer to lose marginally now in order to ensure wealth is protected. Operate with the clear objective of acting in the best interest of your clients all the time. Don’t make decisions based on the possibility of losing the marginal client or being judged against an inappropriate benchmark with perfect hindsight. Develop transparency with clients and proper benchmarks with them. Build into your benchmark a cost for proper risk management and clearly explain why it is necessary. With this more appropriate benchmark the advisor can more properly manage client expectations. Doing so removes the rock and allows easy mobility away from the hard place. Time is of the essence.

Fear

Our society is operating under the fog of fear. Fear created by the media and politicians. Our fear empowers both the media and the political elite. It is a new weapon being used by them to get the result they want. A population will not behave the same as without the fear. We will alter the way we make decisions to allay our fear. We consume differently as a result. This benefits a select few entities. Politicians bring their leadership to “testify” all the while winking and nodding. It is a pathetic attempt at misdirection. They exploit our collective fear to benefit themselves. It has never been so apparent what is going on because the means on how it is being done are so nefarious. The destruction of our society, and particularly our youth, is complete.

Many suggest that the election is an important demarcation when this will end. This logic is perverted. Why would the election have anything to do with our current situation? It shouldn’t unless it is all fabricated. And why would it end? Politicians don’t develop an effective tool to further their empowerment and abandon it. Now that they have tasted increased power you can bet that they will continue to exploit it. It seems that we are moving toward a CCP outcome. Fear based leadership is the tool of the communist not the democratically elected. Conform or be forever shamed. Does that sound familiar? We are certainly not conspiratorial but either the China virus is irony of the highest order or an effort by the political elite and the media to utilize tactics more commonly associated with communist dictators. Think about that in November. God Bless America.

Capital Markets and the Morning Hike

Each morning my daughter and I hike with our two GSD’s. It’s early, the earth’s spin introduces the sun to a new day. Quiet reigns as our community begins to wake up.  Usually, sans the dog training, the chatter is minimal as we both contemplate our forthcoming day. She plans her virtual learning as an Industrial Engineering major at Virginia Tech and I work through the logistics of meetings, calls, and deliverables. It is peaceful.

As I gain comfort with my game plan for the day, I tend to cogitate on deeper, highly relevant, problems. A recurring thought is that of the state of the capital markets. The footing on our hike is often tricky as we navigate terrain that varies in slope and quality. As such I must spend much of my time looking down at the immediate challenges I face as to not slip or roll an ankle. Rarely, do we look far ahead at the path in front of us. This morning I realized that this dynamic seems highly analogous to the current state of the investment universe. Moreover, my daughter and I also almost never look back to see where we have been. It seems that our hike captures most contemporary investor’s decision process perfectly. Who cares where we’ve been or where we’re going in the long view? Look down and watch your next step. It’s all about the short-term gratification of avoiding the fear of missing out rather than understanding what has transpired and the long view.

I mention this to my daughter, and she rolls her eyes and states that I am a bit strange. I am perpetually contemplating the state of the investment universe. I find the current state of the equity markets unfathomable given the economic, public health and political backdrop. When everyone and anyone can invest, or thinks they can invest, no one can. When this occurs the markets usually are way ahead of themselves. It is the classic contrarian indicator. We are certainly there now. But like hiking they are not looking ahead at the long view.

Investing is a long-term game. Most investors today seem to mistake trading with investing. Trading is watching your feet as you negotiate terrain. Investing is looking up and seeing where you’re going and learning from where you’ve been.  We must thoroughly understand not only the next step but also how you are going to get to your destination (and enjoying the view as well). Time will tell as we move forward how many of these traders have the stomach for real volatility. Ultimately, I believe that this will meaningfully exacerbate volatility as the traders exit the markets.

As I interact with folk’s each day, I am dismayed by the statements being made by them. I coach football and lacrosse. Coaches and parents always pepper me with questions when they discover what I do for a living. These are college students, gym teachers, electricians, wood workers, stay at home moms, etc. All noble pursuits but not what I would categorize as investment professionals (though in fairness most investment professionals are not very knowledgeable either). The most common theme is how easy it is to invest right now and how everything is going up. This is during a pandemic, political upheaval, and a recession. The disconnect is extraordinary and their collective overconfidence in equities very unsettling. The only other time I felt this way in my almost 30 years of doing this was in 1999 when I was buying a car. The car salesman began to outline how he has purchased technology stocks on margin because “they never go down”. This time might be different but note that it rarely is.

We will continue to monitor the capital markets for the best opportunities. We recognize we can’t hide in a bunker as the market continues this irrational trend. However, we can be smart about how we manage the ever-increasing risks. Shorter duration high yield (preferably those that the Fed is buying), equal weighted equity exposures to exploit equity rotation out of the highfliers and maintaining above average liquidity to be able to take advantage of any decoupling that arises.  In our long view this is the most responsible approach to risk management in the current environment.

Leading from the Fetal Position

Too many elected leaders have decided to make decisions as they lay in the fetal position and whimper. To make matters worse, they demand that their constituency do the same. It is maddening to experience. Fear, panic, and laying in a supine position while whining about everyone who chooses to live their lives is no way to conduct business. Yet it seems that many governors are doing just that. Come on man, grow a backbone.

Objective leadership would evaluate the data and realize that the Wuhan virus isn’t worthy of this insanity. Statistics don’t lie. Youth are far more likely to be harmed by a lightning strike than the virus. Healthy adults have similar statistics as do most part of our society. The harm being done by elected leaders is far worse. It is unfathomable to watch these idiots let the ideologically driven media make their decisions for them. The damage being done will take generations to overcome.

I had the virus. I am bordering on the “danger” group of 60 years of age. It wasn’t a big deal. A few days of fever, shortness of breath, and a cough. I continued to do everything I normally do. Most folks don’t even know they have it. That’s most of our society. Why are we being told and warned that this is the end of the world? It’s just ridiculous. It’s now politically incorrect to raise common sense questions regarding the virus (and climate change, equality, racism, etc.). The narrative has been created in order to do as much damage as possible to our country by November, so the election goes a certain way. That is the only explanation for this nonsense. An election between two incompetents isn’t worth it.

The collateral damage, unfortunately, is not being considered. The poor and less fortunate lose the most and no one seems to care. Youth in general lose more than most and no one seems to care. Young adults lose out on college and no one seems to care. Social interaction is now frowned upon and no one seems to care. Student-athletes are missing out on once in a lifetime experiences and no one seems to care. Sports fans lose and no one seems to care. Parents are desperately trying to balance their children’s education and their livelihood, and no one seems to care. Seniors are in perpetual lockdown and no one seems to care. All for an election? The disingenuousness of the media and elected leaders is just plainly insulting. They are fomenting anger, resentment, discrimination, frustration, and hatred that will not go away. They are forever altering civil society toward an uncivil one and no one seems to care.

Now professional athletes are nothing more than pawns within this media driven narrative. They spew social justice propaganda that alienates huge majorities of fans while having no understanding of the organization they are touting. It’s embarrassing. The NBA is now becoming the CCPBA. I am for them all moving to Wuhan. It will serve them right. Professional sports are destroying themselves by promulgating the media driven fictional narratives of the virus and social justice. The irony is that they are now on a nihilistic path and have created their own circular firing squad. I hope some of them figure that out before it’s too late. Unfortunately, pawns are usually sacrificed long before the game is over.

Perhaps the most egregious outcome is the behavior of the teacher’s unions. Union leadership is now exhibiting such intransigence that it is transparently obvious that they don’t give a hoot about the kids they supposedly teach. It’s all about getting something for nothing. And right now, they are literally arguing for paid leave for an undetermined length of time. It is payback for all the years of supporting elected leaders. Additionally, they smell blood and want to end private school competition while they get paid to do nothing. It really is a smack in the face for taxpayers. Why not shore up our monopoly while our accountable competition suffers economically due to being forced to shut down? It is disgraceful.

I am hopeful that several miscalculations have been made by dark forces that seem to be at work here that offers me some optimism. They have underestimated some elected leaders who are leading using objectivity and balancing appropriate tradeoffs while letting the citizenry live their lives. Also, while they anticipated everyone to be sheep many are now fed up with the misinformation and day to day virus scorekeeping by the media. They are breaking ranks and living. Lies are hard to keep telling when facts are overwhelming them. Ultimately, these will accelerate, and our country can return to normal and our youth can resume their lives. I just hope the damage isn’t too great and that those who have exploited their fellow countrymen for their gain are eventually held to account.

We have been criticizing monetary policy for well over a decade now. Many of our concerns can be found in our other commentary. This morning the Wall Street Journal contains an editorial entitled, “Jerome Powell’s Price-Fix is In”. The essence of the piece was that the Federal Reserve is seriously contemplating fixing the US Treasury curve across all maturities. The idea is that the Fed wants the yield curve to effectively be static. The consequences of this are many and we will try to address a few of them here.

The Term Structure as Pricing Numeraire

The Treasury term structure of interest rates is the numeraire used for all fixed income valuations throughout the global economy. It represents the discount rate for a default free cash flow at each maturity. From this default free rate every other asset class is valued by adding premiums to it. In this way, all risky assets are valued. So, it serves as the basis from which literally all securities are valued from whether it is equities, real estate, commodities, currencies, or private assets (and all contingent claims on these assets). The level, slope, and curvature of the term structure serves as an information signaling device for the global capital markets. The literature on the informational content of the curve is vast but many believe that the geometrical shape of the curve contains information regarding economic growth, inflation and so on. Without this dynamic the pricing dynamic throughout the capital markets will suffer mightily. In other words, if the Federal Reserve makes it static the entire valuation framework will be destroyed.

We have presented this graph in other commentary, but it is worth illustrating here to contextualize this new policy tool being considered by the Fed.

The Fed wants to add to their toolbox by fixing the entire term structure. Can you imagine what happens to the curve above if the Fed is forced to buy up US Treasuries to maintain its target yield? They will have to add so much liquidity to the market their balance sheet will explode. The line will go vertical. We were concerned with the balance sheet prior to this proposed policy change. Now the operational concerns are beyond contemplation. Additionally, the potential volatility of liquidity throughout the market will become unprecedented. So, while the prices to Treasuries stay virtually static, the underlying operational aspects of the markets will become untenable and approach chaos.

The reasoning why the Fed wants to do this is difficult to understand. Perhaps, it is merely a political power grab. Exploiting the recent capital market turmoil to increase their power base. This would be the traditional political playbook. We would not be surprised by this in the least. Or, perhaps they are simply trying to increase their abilities to bleed down their balance sheet. If they want to decrease liquidity throughout the banking system, they can sell Treasuries and remove cash from the system. Of course, this assumes they want a higher yield curve than currently stands. Given the macro economic back drop this seems extremely unlikely. The asymmetry of this perspective is dangerous as well. Once the precedent is set, and the tool implemented, the Fed will misuse it for generations to come.

Many market participants look to the Fed in what is almost an ecclesiastical manner. We say wake up to reality. The Fed is not helping the capital markets we depend on to aggregate wealth. They are destroying how markets function. The faith based legacy perspective must be refreshed using recent chairpersons. Not since Alan Greenspan has the Fed had a chairperson that gave a hoot toward anything other than their own reputations. They spend all their time now justifying their actions to preserve their egos. Their actions were monstrously short sighted and ill considered. Every disruption seems to be met with more policy mechanisms that are based on panic and fear. No deliberation whatsoever. The Fed needs massive restructuring toward a Taylor rule framework. Remove the political and economic rewards of the Fed completely. It’s the only way we can return to a properly functioning market.

Conclusion

The sheer hubris of this idea is so preposterously insulting to the core principles that underly our capital markets that I feel intellectually violated. Removing the price finding mechanism from our term structure will destroy trillions (possibly quadrillions) of derivative securities. When you remove all return variation, valuation models simply revert to static models and thus are useless. Moreover, the ultimate numeraire throughout the capital markets is the UST curve. Removing that dynamic will destroy all risk and return relationships that are generally utilized for asset allocation decisions. The Fed seems determined to flat out destroy the entire way markets function. This madness must stop. They are a danger to every investor in the world. These simple-minded political appointees must be controlled, not empowered further.

Equities are now at a point in the investment cycle where they are exclusively relying on exogenous forces to defend current valuations. At the turn of the century, we experienced similar mis-valuations. Then, markets were still operating correctly, and valuations eventually cleared to fair value. Now, due to the Fed and fiscal idiocy, markets are no longer functioning correctly. The Fed is not allowing the markets to clear and thus the exogenous dependency. We have become a market that exclusively depends upon the decision making of political appointees. Politicians and their appointees never make decisions that will adversely impact their personal ambitions. So, our capital markets are waiting for the moment when the rest of the world tires of the dollar and US Treasuries. At that moment, policy makers will no longer have anything left to counter those forces. In the meantime, we manage risk with a close eye on the machinations of the underlying flows throughout the capital markets.

I received a newsletter this morning from a self-proclaimed contrarian value investment firm. The gist of the piece was that the US economy was experiencing a “V” recovery and that was going to be accelerated by the next fiscal and monetary intervention. The conclusion reached by these folks was that the next “stimulus” would “propel equity markets to sharply higher highs.” Again, this is a contrarian value investor! Their entire thesis hardly fits the confines of a traditional value shop. This is the same reasoning as the FOMO, BTFD, and Don’t fight the Fed types. Apparently, all approaches get you to the same place. The asymmetry of risk aversion is a behavioral reaction due to massive monetary insertions that have made market clearing impossible. Many market participants of the last decade seem to believe that downturns are so short lived that they no longer need to even consider them when allocating resources. So simply buy equities no matter what the backdrop and no matter what the path taken to this point might be. Golly, it’s gotten way too easy to manage exposures and risk. But what if it hasn’t? What’s next after the CARES Act insanity runs its course? According to our contrarian friends, more free stuff is coming our way so systematic risk has been removed from the investment decision process. We would like to present a few concerns that are largely being ignored by market participants. Each will have a negative economic impact starting in August and certainly through the balance of the year and beyond.

The End of Disincentives

The $600 extra hand out to those claiming unemployment will run its course at the end of this month. The big question then is whether there will be jobs waiting for these people. Hopefully, any fiscal insertion will contain contingencies to incent people to get back to work. Under this assumption we think it will be a mixed bag going forward. It is extremely likely that many jobs will be permanently gone, and that the new equilibrium unemployment rate will be meaningfully higher than it was prior to the pandemic. In our opinion this is unavoidable, and no fiscal package can avoid it. It will take a long time for these displaced people to find gainful employment and in the meantime this will result in slower economic growth.

Landlords

As evictions spike over the coming months landlords will become public enemy number one. Just wait. Like everything in today’s culture, the AOC Sandinistas will make every effort to vilify and condemn them for trying to earn a living. So, either the landlords will suffer more hardships than they should have to in a country with personal property rights, or the evicted will experience homelessness at levels not seen since the Great Depression. Either outcome is undesirable as they are inevitable.  The eviction process, like the bankruptcy process, takes time to develop and it seems many in our media and capital markets are simply looking the other way. Commercial and residential real estate investments are going to experience material changes in the coming quarters. Fiscal policy merely postpones reality it can’t eliminate it.

Bankruptcies

Bankruptcy takes several quarters to be realized. The pandemic will irrefutably produce the largest number of bankruptcies and defaults that our country has ever experienced. Despite the efforts of the PPP and the EID programs large swaths of small businesses will disappear. Too many of these businesses were operating at razor thin margins or even at a loss prior to the pandemic. Many took out PPP/EID loans only to default on them when the time comes. We have written about this in previous commentary. They are rightfully disgusted that the government mandated their destruction. For those that try to hang on as long as they can, the severe government imposed operational constraints will ultimately dictate insolvency. As these entities unwind in the coming quarters the economic impact will be material. As with the eviction process above, many market participants seem to be completely ignoring this inevitability. Eventually, valuations will be impacted.

The Federal Reserve Balance Sheet

Bernanke and then Yellen bloated the Feds balance sheet beyond any historical reference point. Powell has decided to take that to an entirely new level. Printing money (a liability) to insert liquidity into the capital markets has become the policy choice for the Fed. They buy securities (assets) throughout the capital markets using newly minted money (see the graph below). They have increased the size of the balance sheet by about 75% over the past few months. It is likely to increase to 100 to 125% over the coming months. Eventually, they will double the size of their balance sheet in less than a year – and this doubling was from an already bloated starting point. It is obscene what the Federal Reserve is doing. I realize we have written about this ad nauseum, but we just can’t help it given how the Fed has so perverted behavior and valuations. They literally are the primary reason why the markets have so decoupled from economic reality and that the fixed income markets have been virtually destroyed. When contrarian value investors use monetary policy as the only reason to be bullish, we’ve entered a new paradigm. How the Fed manages the balance sheet going forward will be an issue overhanging the markets for decades.

Meanderings

Tesla, an entity that wouldn’t exist without huge government subsidies, is now being valued more than all other car companies in the world (see the graph below) . This is simply ridiculous. This market is beginning to invite more Enron type madness. It is remarkably and eerily like the turn of the century when fundamentals were declared unnecessary. Too few stocks are driving this market. The performance gap between equal weighted and their sister cap weighted indices are at historical highs. Be patient.

How can an equity market (Nasdaq) hit new highs with the macro economy being what it is? A little common sense is in order. At the beginning of the year we had record low unemployment and sustainable supposed organic economic growth. Now, we have fiscal and monetary injections creating purely synthetic valuations, no organic growth, and unemployment not seen for decades. Somehow, this is good news for technology stocks? It defies logic, basic present value analysis, and equity valuation principles. If you are tearing your hair out trying to understand valuations you are not alone!

Federal Debt Levels

With each fiscal “stimulus” package we add to the federal debt. The debt level is now at approximately 125% of GDP, an historical all time high greater than even the short-term levels that resulted from financing World War II (see the graph below) . This will increase toward 150% as tax revenues decrease and more fiscal profligacy continues. If the Democrats sweep the election, we will undoubtedly approach Japan like leverage ratios. If the findings of Rogoff and Reinhart have any validity, then we can expect extraordinary low growth or far worse. Moreover, as local decision makers prevent kids from going back to school due to the pandemic, we will eventually have a generation that are maladjusted and even more angry; making them responsible for an irreversible debt load will negatively impact how they are able to live their lives even further. Thank you government. Like the Fed balance sheet, this will be a generational issue.

The Vaccine Option

It seems that the only other option that the markets are clearly betting on is that of a new vaccine to end the pandemic and completely erase all memories of it. Every news item that touts a successful trial adds a few percentage points to the equity markets. Interestingly, when it is proved that the vaccine is ultimately ineffective the market doesn’t lose any value. It’s a ratchet option. It is the fervor of this market. Stairway up will ultimately lead to an elevator down in our opinion. A vaccine is minimally several quarters away and will not be the global panacea the markets are betting on. Flu vaccines never are; from personal experience the worst flus I ever had were the years I had gotten a vaccine! We need to temper our expectations. Adding to the questionable effectiveness is the manufacturing and distributional logistics. It is a difficult road. Until then, the increasingly draconian measures being taken will further dampen economic growth. Volatility will increase as well.

Patience and Liquidity

We preach liquidity, patience, and conservative exposures. Investment opportunities will present themselves in due course. Managing risk smartly will be the most important part of the investment process. Currently, it is a tertiary consideration for inexperienced market participants. Too few of us have been around long enough to recognize market decoupling’s when we see them. Like 2000 and 2008 we realize that we may fall short in the very near term as the market squeezes returns out, but our job is to accumulate wealth optimally over the long term.  Insert a presidential election into this dynamic and we are in for a lot of volatility over the coming months. Those that state “this time is different” will have to learn the lesson the hard way. Our clients won’t.

Spreads

High yield and lower quality investment grade spreads have contracted precipitously over the past few weeks as a result of the Fed. This is seen in the graph below. The magnitude of these spread contractions imply that default risks have dropped by an extraordinary amount over that same period. Is that an accurate assessment? As investors we need to be compensated for accepting risk. Has default risk really decreased so dramatically over that period? Or, is it because the Fed has inserted itself so impactfully that they have artificially distorted the markets? You know where we lie on this issue, but it bears repeating. The Fed is impacting the capital markets in ways that has dramatically perverted fundamentals and in so doing has made it impossible for the markets to clear and function properly. No informed fixed income investor can possibly defend this reduction in risk in terms of the probability of economic contraction and thus defaults. Investors and savers continuously lose all opportunity to be rewarded for the risks inherent throughout the fixed income markets disallowing them to generate meaningful income. The Fed is responsible for this outcome. By using massive liquidity insertions and market intrusions they have effectively destroyed these markets.  For anyone buying these bonds, you will not be compensated for the significant likelihood of defaults and bankruptcies that are going to happen over the coming quarters. Again, we preach patience.

CFOs will certainly be tempted to issue new paper to exploit the Fed’s foolishness. Why not stack up on cheap financing and build up cash knowing that the coming quarters are going to be very challenging for the real economy? After all, the Fed is signaling economic apocalypse by their actions so best to prepare for the worst. This leads to higher leverage and far less attractive fundamentals for the foreseeable future. This will certainly lead to more downgrades and meaningful turnover across bond portfolios. Moreover, it will make security selection throughout the credit markets more difficult and thus credit markets will become more speculative and volatile. How can the Fed exit then? They are setting up an impossible scenario for themselves. I doubt any of the Fed governors have even bothered to consider this outcome. They are about today with little regard for tomorrow. This treadmill of short termism is leading to the accumulation of higher and higher pressures that eventually must be released. Will it be gradual or sudden? We are certain that the continued destruction of one asset class (bonds) for the benefit of another (equity) can not last forever. Ironically, the Fed’s attempt to help markets in the short term may be ruining them in the long term.

Levels and Slopes

Another striking dynamic is the rate of change of the US Treasury level and slope over the same period. This is illustrated in our exhibit below. The 10-year US Treasury yield has collapsed over the past several months with about half of this collapse happening since the onset of the pandemic. This is a combination of a flight to quality along with massive purchases by the Federal Reserve both pushing up valuations. Simultaneously, the slope of the Treasury curve as measured by the difference between the 10Y and the 2Y Treasury yields has increased five-fold over the recent period. This is a result of monetary policy on the front end of the curve. As the Fed returned to a zero-funding rate, the entire front end of the curve was essentially forced to zero. So even with a massive reduction in the 10Y yield, the 2Y yield fell even faster and more dramatically resulting in a slope increase. Notice that the slope had turned negative (downward sloping curve) last year. The only way for that to happen at these levels is for the 2Y yield to increase and that will be difficult given monetary policy and what the Fed has stated of late.

Questions that we deliberate on daily include: Can the 10Y continue at these all-time lows as profligate monetary policy continues? At what point does the Debt/GDP tradeoff begin to influence UST yields? And when does the dollar begin to suffer? The answer to these questions must be managed with proper duration and yield risk management. Investment strategies must be deployed with a significant eye on liquidity and within a range of the term structure that enables an optimal duration to yield tradeoff.

Money Supply

Our final graph illustrates the level of monetary supply M2 over the same overall period. This clearly shows the insane impact monetary policy has had on the supply of money. The Fed has been purchasing all these assets while tendering the dollar in exchange. The result is a bloated Fed balance sheet, increase in the supply of money, and in the short-term lower Treasury levels and corporate spreads. The demand side has been dominated by the Fed. A major concern of bond managers, or risk managers, is how long can this dynamic last? As economic growth continues to be challenged, do spreads begin to reflect true default risk? Does the Fed insert itself again to suppress these price changes and continue to bloat M2 and their balance sheet? At what point do UST yields reflect M2 supply and inflation?

Investment Consequences

As portfolio and risk managers we manage our duration exposures with all these issues in mind. Currently, we feel that yields are extremely expensive per unit of duration. We therefore prefer the front end of the high yield curve and the lower quality IG curves. In assessing our exposures, we balance liquidity with income as a function of duration risk. We believe that we can more effectively manage our risk this way and ensure that we can nimbly alter allocations as opportunities present themselves. These opportunities may take place discretely and with proper management we will be able to move exposures profitably. As with the equity markets, the 800-pound gorilla is the Fed. Such exogenous influences make duration risk management less about fundamentals and more about watching monetary liquidity insertions. Either way, we are very confident in our current credit/fixed income strategies.

We have extensively commented on the economic and political situation in the United States. However, what about other regions? All investors should be globally diversified, so the situation in other parts of the world matters greatly for US investors. In this commentary we’ll start with Europe. We’ll discuss the Asia-Pacific region in due course.

It’s All about the Virus

As Larry Summers outlined in an interview recently, time should nowadays be measured not in calendar time units but in virus time units. In virus time, Europe was the second epicenter of the coronavirus pandemic after Asia. As of now, the new epicenter is the Americas with most parts of the continent being severely impacted. While it may seem like the worst of the virus outbreak is over in Europe, nobody can be certain. While the worst might be over from a narrow medical point of view, the economic impact has been severe and will be long-lasting even if we do not see a second wave of the virus. Of course, if a second wave is realized, then we will have to reassess our outlook.

Pre-Coronavirus Times

Even before the coronavirus, the European economy had been stagnating even though the European Central Bank (ECB) had implemented ultra-loose monetary policy. The European economy has been artificially propped up by irresponsible ECB policies since the financial crisis in 2008. Most of these policies are short-term in nature or purely cosmetic, such as, for example, the measures taken to prop up otherwise bankrupt European financial institutions by “embellishing” their balance sheets in various ways. In classic Italian tradition the former ECB President Mario Draghi has managed to sweep most of the fundamental problems with the European economy under the rug. Moreover, the European economy as well as its political system has been weakened by Brexit. While the impact of Brexit is likely to be much more severe for the United Kingdom than other European nations, it has been a disruptive force that can be felt in all of Europe. Conceptually, the idea of Brexit has some merit, its implementation, so far, has been somewhat disastrous. The fact that the task at hand has now been handed to someone who is often labelled a “European Trump” is extremely unlikely to help matters. Trumpian politics seems to revolve around carrying a big stick and using Twitter to insult anyone who offers constructive observations. Crudeness has replaced civility.

The advent of the Virus

Developments in Europe have been dominated by the coronavirus since the beginning of March. Italy was the first country to be affected and the virus has had devastating effects on both the people and the Italian economy. Despite the fact that the European Union exists on paper, most things of importance are still done on an individual country basis. In that spirit, we have seen almost no coordination on a Europe-wide level to address the virus. As a result, borders were closed, and different European countries adopted completely different policies to fight the virus. While some countries such as Germany and some Scandinavian countries (and notably Greece) started preparing for the pandemic in a timely manner, other countries, such as the UK, procrastinated all actions until the last moment and then muddled their way through. The results of these differing policies can now be seen very clearly.

The economic consequences, just four months after the crisis started, are devastating. Many companies have gone out of business. The unemployment rate has not skyrocketed yet because of furlough schemes that have been put in place, financed by public money. These furlough schemes, however, cannot continue for long because they are extremely expensive.  Economic uncertainty has increased exponentially and thus consumer spending has plummeted. In many areas, even though lockdown measures have been lifted, consumers have meaningfully reduced spending, presumably because they don’t know whether they will still have any reliable income in a few months’ time. Interestingly, European talking heads, like in the US, try to spew platitudes of recovery in an effort to alter the behavioural impact of the past several months. Who can believe them? What else are they going to state? They can’t state the truth as that would exacerbate the situation. Once free money is expended, then what? That’s when we’ll begin to observe the true economic consequences of the virus.

While some companies received emergency loans and subsidies that have kept them alive for now, these are short-term measures that are impossible to sustain in the longer term. The way the global economy works nowadays is that most industries are very competitive.  This means that if an entity has meaningfully reduced revenue as a result of health mandates (eg, social distancing), it will result in substantial losses. Reduced revenue is a very realistic prospect for many companies nowadays, such as airlines, restaurants, small business owners, etc. Most of these companies know that by continuing to operate, they lose money. If they are unable to address this dynamic through cost cutting (eliminate employees) they will go out of business. This cycle will take time but, in our opinion, it is inevitable despite fiscal profligacy.

European growth was anemic prior to the pandemic. It is difficult to believe that over the near and intermediate term the pandemic doesn’t severely dampen this low growth environment further. European exposure will need to be tactically selected in any well diversified portfolio.

Political Problems resulting from the Economic Crisis

As has been the case for decades, the stronger and more responsible countries in Europe (e.g. the northern countries) will have to bail out the other countries (e.g. the southern countries). The Mediterranean countries (with the possible and notable exception of Greece this time) will have to be bailed out again by other stronger economies. While the German government at the beginning categorically denied this basic fact, they have now already initiated an enormous transfer of wealth together with France. This further highlights the fact that the EU can only work as long as richer nations pay for the poorer ones. However, unlike their governments, people in richer nations are increasingly frustrated by this fact. They ask themselves, why as a German citizen with a comparatively high income, do I have to pay more than 50% tax on my income to support poorer European nations that have never acted responsibly and which have to be bailed out repeatedly? The consequence will be a shift to the right along the political spectrum. That has happened to some degree already but, in our opinion, it is likely to increase in the coming years. One problem with this shift to the right is that in many European countries the right is made up of primarily populist political parties. We already have populist governments in the UK, Italy, Hungary, Poland as well as a few others.  Populism is more about retaining power and very little about a disciplined ideology that voters can understand and depend on. Populists exploit a frustrated and desperate electorate. They generally aren’t leaders with a clear vision on how to make their country a better place for its citizens. Exploitation of anger is not a productive plan. However, the more ideologically disciplined parties have created this environment by refusing to adhere to any kind of principles. They deserve to be ousted. In the end, this political chaos will not lead to sound economic growth for a very long time. The EU as an experiment will end as it is a source of great angst across the populations of many countries. Populists will use its destruction as a rallying cry. It’s just a matter of time. Again, European exposures must be tactically managed within any investment strategies.

So, where do we stand?

While Europe, at least in the most optimistic scenario, might be over the worst of the coronavirus, the problems caused by the virus and those that came to the surface because of the virus are severe. The pandemic has exacerbated an already fragile EU structure. Some would argue that the timeline toward an inevitable end of the EU may have been accelerated by the pandemic. It is very hard to imagine a good outcome anytime soon, even if a coronavirus vaccine is found before by the end of the year. Many problems that have existed for a long time and which have now prominently resurfaced will haunt the European economy for the foreseeable future. Once the ECB has run out of productive policy ammunition to push up financial markets, investors will exit rapidly. Tactical exposures that properly account for risk and liquidity are the only sensible approach.

Plausibility

We have written extensively over the past several weeks regarding the seemingly decoupling of economic reality and the state of the capital markets. Instead of reinforcing that argument with the endless and obvious fundamental reasons for concern we decided to take a different approach and try to answer the following question. Under what scenario can current valuations be justified? There are always research reports that are more cheerleading than substantive. These reports are painful to read because they arrive at the same bullish conclusion no matter what the facts. The bottom line of all these bullish arguments is very simply monetary profligacy. They lack any empirical, conceptual, or theoretical evidence and emphatically cheer equities as long as the Fed continues inserting themselves into the markets. But what else has to happen to sustain valuations and reach justifiable equilibrium? That’s the narrative we try to tell here. Please mind the sarcasm throughout.

Vaccine

The most obvious assumption being made by our cheerleaders is that a vaccine will be available to the masses later this year. The vaccine will eliminate the spread of Covid-19. Furthermore, all health issues associated with Covid-19 will be immediately eradicated. The vaccine will eliminate the virus completely. This explains why current spikes in outbreaks are being completely ignored (to the dismay of our media who seem to be rooting for the virus by keeping daily scores). Nothing left. It will be gone. The backlog of untreated health problems will also simply disappear. Apparently, it will also erase our memories of it as well and our society will binarily return to full employment, spending, and prosperity. This dynamic will take place and all small businesses, like ours, will return to our 2019 revenue levels. Restaurants, service-oriented business, and entertainment venues will be at full capacity again and consumers will just return to business as usual. In fact, to justify current market dynamics they will have to return to a higher level of consumerism than before the pandemic. It’s going to be awesome!

Employment

Small and medium size businesses that were forced to shut down completely and those that currently are operating at a fraction of capacity will binarily return to full capacity. Our society, having been brainwashed to forget the pandemic completely, will immediately return to levels of employment higher than before. Employers will hire at higher wages to induce former employees off their juiced-up unemployment benefits and they will all come swarming back to work. The incurred debt through the PPP and EID loan programs (CARES Act) will be completely forgiven by the government so businesses are in a better fiscal state then they were prior. Tens of millions of people will instantaneously return to work at higher wages and we will all get promotions. This will entice even more people to participate in the workforce and thus the magical virtuous employment cycle will end in even a better place than before. Again, it’s going to be awesome!

Societal Behavior

Apparently, no human being will be impacted by the recent experiences of lockdowns, media death counts and infection numbers, social distancing, masks, and now even social unrest. We will return to our narcissistic ways with no changes to our behavior whatsoever. We’d argue that they assume we will return to an accelerated spending cycle in order to make up for lost time. Consumers will be programmed to live life for the now. Borrow, borrow, spend, spend. Consume like there is no tomorrow. After all, if a second wave comes and no vaccine exists who cares about debt? Our future may never come. Orwellian like brainwashing will be universal. It’s going to be awesome!

Monetary Policy

Any hiccup along the way will be quickly remedied by monetary policy. Any valuation dynamic that poses even the slightest possibility of fundamental realities will be swiftly wiped away with a liquidity insertion. The size of the liquidity insertions matters not. If market participants react properly to the insertion its size means nothing. What’s a few trillion dollars anyway? Chump change when you can simply create some more. This has been the most powerful, and most likely, force behind the markets for the past decade. The Pavlovian psychology behind these markets has been nothing short of extraordinary and is the root cause of the BTFD mentality. Again, it’s going to be awesome.

Fiscal Policy

Another exogenous force that the markets are assuming to continue is fiscal insanity like the CARES Act. In addition to the aforementioned debt forgiveness it is clearly assumed that another massive fiscal stimulus is going to take place. Only its size may be debated. Certainly, a continuation of free money is in order. Inflation? Doesn’t exist according to these folks. Like monetary policy, what’s a few trillion more dollars to our debt load? Afterall, the empirical findings behind Rogoff and Reinhart’s conclusions mean nothing to the Keynesian’s now in charge. The fiscal policy can’t include more perverse unemployment incentives as that would counteract our employment scenario so giving money away should do nicely. Moreover, the Trump administration has completely lost any credibility regarding fiscal discipline and with the election around the corner will certainly be complicit in accepting anything that comes out of Congress. Simply buy the votes. The debt and deficit are a problem for someone else down the road. Not our problem. Carpe Diem, baby! It’s going to be awesome!

What could possibly go wrong?

According to our cheerleaders, nothing. They are proud members of what we call the Markovian Club. History, facts, empirical evidence, theory, and conceptual underpinnings mean nothing. It is purely about the now. Today is all that matters. Our policy makers have been members for a very long time. Membership requires proof that you act and behave in a manner where the path taken to every point in time is purely random. Each member must show that they ardently follow the principle that where we came from and where we are going is nothing but chance. It seems that large swaths of the United States are climbing over one another to join. Tearing down historical monuments regardless of their significance is all the vogue to gain admission into the club. It’s going to be awesome!

God Bless America!

Spreads

The Federal Reserve continues to insert itself in the capital markets. Now they are buying fixed income exchange traded funds (ETF) as well as individual corporate bonds. So, they are now copying the Bank of Japan and the ECB and becoming an outright buyer of publicly traded non-government assets. These policies have led to virtually zero economic growth for decades. Is that the end game here? What is it that they fear for them to do this? We have written about this in earlier commentary, but is this a signal by them that the worst is yet to come?  Are they trying to bridge the gap between economic calamity and sustainable organic growth? Are they desperately hoping that fiscal stimulus will save the day and facilitate equilibrium? Is this equilibrium real? Or is it transitory due to the synthetic exogenous measures taken to arrive there? Stasis only happens at market clearing levels and this market has not cleared. Until policies support organic growth and market efficiencies, we will have to endure markets that are violently stochastic, technical in nature, and almost exclusively behavioral. Again, we preach patience here. Risk remains the primary dimension throughout the investment space.

High yield and lower quality investment grade spreads have contracted precipitously over the past few weeks as a result of the Fed. The magnitude of these spread contractions imply that default risks have dropped by about 50% over that same period. Is that an accurate assessment? As investors we need to be compensated for accepting risk. Has risk really decreased so dramatically over that period? Or, is it because the Fed has inserted itself so impactfully that they have artificially distorted the markets? You know where we lie on this issue. The Fed is impacting the capital markets in ways that dramatically pervert fundamentals and in so doing has made it impossible for the markets to clear and function properly. No informed fixed income investor can possibly defend this reduction in risk in terms of the probability of economic contraction and thus defaults. It is a preposterous notion to even try. Investors and savers continuously lose all opportunity to be rewarded for the risks inherent throughout the fixed income markets disallowing them to generate meaningful income. The Fed is responsible for this outcome. By using massive liquidity insertions and market intrusions they have effectively destroyed these markets.  For anyone buying these bonds you will not be compensated for the significant likelihood of defaults and bankruptcies that are going to happen over the coming quarters. Again, patience.

Wiley CFO’s will certainly be tempted to issue new paper to exploit the Fed’s foolishness. Why not stack up on cheap financing and build up cash knowing that the coming quarters are going to be very challenging for the real economy? After all, the Fed is signaling economic apocalypse by their actions so best to prepare for the worst. This leads to higher leverage and far less attractive fundamentals for the foreseeable future. This will certainly lead to more downgrades and meaningful turnover across bond portfolios. Moreover, it will make security selection throughout the credit markets more difficult and thus credit markets become more speculative and volatile. How can the Fed exit then? They are setting up an impossible scenario for themselves. I doubt any of the Fed governors have even bothered to consider this outcome. They are about today with little regard for tomorrow. This treadmill of short termism is leading to the accumulation of higher and higher pressures that eventually must be released. Will it be gradual or sudden? We are certain that the continued destruction of one asset class (bonds) for the benefit of another (equity) can not last forever. Ironically, the Fed’s attempt to help markets in the short term may be ruining them in the long term.

Stocks and Pop Culture

The popular press has become obsessed with the daily vagaries of the equity markets. The swings from day to day have become the replacement of watching competitive sports. It’s the only thing to write about that is of any interest. I have had conversations with young adults about their desire to start day trading. They believe that the up and downs can be easily gamed. As I try to explain to them the backward-looking delusions of price dynamics creates the illusion that making profits from trading is easy. I further try to dissuade them from such tomfoolery. They make statements that the game isn’t fixed if you buy. “The Fed will never let the market go down,” they say. This is where we are in the market cycle. I think this is not only true amongst these newfound traders but much of the advisory space. For those of us that are old enough to remember the 1999-2001 period, this time may be much worse. Back then valuations were distorted due to the potential of an entirely new technology and like Tulipmania markets became untenable. Now, however, we have unprecedented government intervention destroying valuations. Then you had significant policy ammunition (as you did in 1987, 1989, and 2008-2009) to address economic and capital market problems. Now you don’t. The breaking point now will be the mother of all corrections. The present chaotic nature of prices may be the harbinger of this eventuality.

Individual Investors and Retirement Savings

When will market volatility begin to influence wealth management decisions around retirement investments? Eventually, responsible fiduciaries must advise clients to begin protecting capital and redeploy it more conservatively. Baby boomers will not stand for such wild fluctuations in their wealth as they approach the day when income goes to zero. This selling pressure is going to further influence risk dynamics going forward. Traders will be unable to forestall the selling; they rely on being able to sell to the next idiot and even the Fed has resource limitations. The Fed may be the last practitioner of BTFD!