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Market Thoughts - Q2 2020

Earlier this year, I began the practice of sharing thoughts with my family every quarter or two on how I'm thinking about things on a market and macro perspective. I wanted to share my latest thread this month. All thoughts are my own and I welcome any feedback, disagreements, or additional insights.


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Hey everyone,


I wanted to follow up on this thread with a few data points to help you think about where we currently stand in the economic cycle. When I wrote in late February, it was impossible to anticipate the events that would unfold over the next few months, but as it turned out, the coronavirus was merely the straw that broke the camel's back. The coronavirus exploded the small cracks beginning to form into gaping holes that, as of today, have largely been filled with seemingly endless amounts of fiscal and monetary stimulus.This cannot and will not continue forever without long-term consequences and second order effects. In a global pandemic the likes of which haven't been seen in over 100 years, it's hard to believe we've seen the stock market crater by 35% in a matter of weeks only to regain its footing and set new highs, while main street is suffering one of the worst blows in decades. This all underscores one simple lesson - the stock market is not the economy. The markets, in the short term, are driven by liquidity (of which there has been ample amounts as of late), and long-term are driven by real economic growth.


Since the government's lockdown response to the coronavirus began in late March of this year, fiscal and monetary stimulus combined have amounted to an estimated $4-$6 trillion depending on how you count the cost of the CARES act and the Federal Reserve's balance sheet expansion. Per the Brookings Institute (emphasis my own):


"On June 10, however, the Fed said it would stop tapering and would buy at least $80 billion a month in Treasuries and $40 billion in residential and commercial mortgage-backed securities until further notice. Between mid-March and mid-June, the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.1 trillion."


Translation: the Federal Reserve will do whatever it takes to keep interest rates low, monetize (buy) US debt, and support the residential & commercial real estate markets. As Seth Klarman of The Baupost Group recently said in his latest quarterly letter (emphasis my own):


"By maintaining these seemingly never-ending policies and willfully ignoring developing bubbles, the Fed has engineered a strong market recovery even as the unemployment rate tests Great Depression levels. The Fed balance sheet grows larger and larger, and the annual US budget deficit approaches a level triple its previous ignominious record high. Investors are being infantilized by the relentless Federal Reserve activity."


Politically, it's simply untenable for the Federal Reserve NOT to pursue its mandate to support economic activity and for our politicians to ensure money continues to flow in our otherwise heartbeat-less economy. Our economy is a system that works to move goods and services via voluntary transaction. Most, if not all, of us have never experienced an absolute halt in the flow of goods and services to the extent we did in March and April. For a moment, I almost thought that this would be a battle that would unite us all as Americans. How wrong I was.


In most cases, coronavirus simply accelerated trends that were present prior to the outbreak. E-commerce exploded. Online education is here. Remote work accelerated. Telemedicine was rapidly adopted. Capital vs. Labor relations became even more strained. Inequality as a political focal point reached a fever pitch. And politics got nastier. Particularly along the political dimension, it has been noteworthy to watch the division over wearing masks and common sense protocols to combat the spread of the virus as well as the more draconian measures taken by some states and municipalities.


Whither art thou, common sense?


Moving on, here are a couple indicators I watch and some thoughts on each.


The ten year minus three month treasury spread (cost of borrowing minus the cost of deposits for banks) is clearly showing that the yield curve inversion has passed and we are well into a deep recession. The latest quarterly GDP number reflects a negative 9.5% effect on GDP due predominantly to the effects of the coronavirus shutdown. How long it lasts and how deep it cuts will depend on numerous interacting factors like additional monetary and fiscal stimulus, the possibility of a coronavirus vaccine, and the virus's growth trajectory.


On the employment side of things, as of the beginning of August, there were over 30 million Americans receiving some kind of unemployment assistance per the Department of Labor statistics. That is a mind numbingly large number. This represents the people who, as of the latest unemployment numbers, were receiving some sort of government stimulus and have much less disposable income than prior to the coronavirus pandemic. This ripple effect, in my opinion, has yet to be felt fully due to the copious amounts of fiscal and monetary stimulus given to individuals and businesses.

The one bright spot was the ISM purchasing manager's index (PMI), coming in at 54.2, meaning actual expansion occurred. I do wonder if this snappy recovery from the April-May will last or if we will see a double-dip in the PMI numbers as stimulus effects wane.


When and Where to invest?


As I mentioned above, the stock market is not the economy. In my opinion, it 'feels' like the economy is on morphine that is wearing off and we're wondering whether there is more (fiscal stimulus) available to stave off the underlying pain that is inevitable. But, in my opinion, the pain is coming, particularly in the private markets where transactions take longer to consummate and longer to show signs of distress. Seth Klarman wrote the following in his quarterly letter on the lag between public market pricing and private market pricing:

"There is usually a lag between public markets falling and private opportunities beginning to surface. This cycle appears to be no different... As conditions on the ground deteriorate, however, our real estate pipeline is starting to fill with potential opportunity that is reminiscent of prior cycles... For now, counterparty urgency appears limited, and our underwriting is necessarily conservative so it is hard to know when the pace of capital deployment might pick up."


I'm not a gold bug and never have been. I prefer cash-flowing assets that yield high returns on capital for the foreseeable future (opportunistic real estate, royalty-based asset light companies, and market leading technology companies). But as one person commented recently, the exploding price of gold doesn't reflect gold actually becoming more valuable, it merely reflects the reality that the dollar is weakening. There are deeper ramifications to a weaker dollar both domestically and globally as we debase our currency (the global reserve currency) at an alarming rate, but I'll leave that to another write up. Suffice it to say that the laws of economics do not care whether your currency is the reserve currency or not. All that matters is supply and demand. Demand for dollars may be high now for the reserve currency, but supply has never increased at such a rate as we are seeing today, putting this reserve status at risk. Printing dollars, in my opinion, will not translate to real economic gains, but merely paper gains that reflect the debasement of our nation's currency. Howard Marks wrote in his most recent memo warning of the dangers of extreme currency debasement a la Zimbabwe and Argentina:


"There is a delicate balancing at: markets certainly allow credible governments like Japan and the US to borrow enormous amounts without much concern, but the key issue is what could undermine that credibility? If that does happen, the consequences would certainly be titanic."


I wonder if measuring wealth in the coming decades may be measured by number of acres, properties, or ounces rather than in dollars.


How does this end?


Who knows. But what you can know is that this has all happened before in the past in other currencies and countries. Now, we must use history as our guide while peering into the thick fog that is the future. I can't help but wonder about how the future unfolds given: 1) we are creating even bigger moral hazards than in 2008-2009 with the copious amounts of fiscal and monetary stimulus while trying to 2) compete with a nation that fundamentally cannot be divided by nature of its political-economy (China) all while 3) dealing with our current domestic political division. There are plenty of answers and opinions, but only one way history actually plays out. Betting against America has been a losing bet for over two and a half centuries and I believe it will continue to be a losing bet in the long term. But the short term headwinds are worth consideration. Move forward, but with vigilance and an open mind to all possibilities.


Best,

Benton


PS - I highly recommend Ray Dalio's Changing World Order as it helps put things in perspective for how long-term arcs of countries have typically played out in the past.


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