re: Discussion of Fed Liquidity’s Impact on Equity Markets

Yes, the market was damn near pricing in deflation in mid-March. Breakeven inflation has recovered rapidly since then, but is now at the lowest level since the Jackson Hole speech.

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My guess is we'll get the divergence again by 2021. A broad increase in consumer prices isn't really possible right now because you still have disinflationary forces at work. The aggregate demand is just not there even with stimulus checks and $50k minimum wage like we had before August.

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Agree with everything you wrote except for what’s in bold. I think the convergence holds, but that both inflation expectations and the market go down. It sounds like you’re in agreement with me on disinflation / deflation, but that you still see the market going higher?

I'm struggling to find my inner-bull. I haven't gone short the market, but I'm still heavy cash and currencies. When I consider that ...

1. corporate earnings growth stalled even years prior to COVID;

2. the headwind to y/y comps presented by the fact that low rates and taxes are not likely to get much lower, if at all, and the implication that has for #1;

3. historically high valuations;

4. the current, completely unsustainable levels of debt-to-GDP;

5. we've arguably seen "Peak Fed" unless they begin wiping their collective arse with the Federal Reserve Act;

6. the Fed's desperation for inflation, and the impact the opposite would have on risky assets; and

7. the potential for reality to begin being priced in as hopes for a V-shaped economic recovery are dashed

... I just can't get excited about this stock market. For stocks to continue to perform well would go against everything we are supposed to be rooting for as multi-generational stakeholders in the U.S. economy.

Simply put, there are a few things that need to be unwound (Fed balance sheet, US debt levels, ridiculously low rates, Mike Green might even add "passive") and I don't view any one of them as bullish. If we get more than one at once, God help us all.

Now, if the market gets back to March low levels, you'll see me start perking up pretty quickly, but I can't underwrite a heavy equity exposure at current levels, despite how horribly difficult it is to time the vagaries of the stock market.

Thanks, I'll check it out.

Warning: long post ahead

As a compliment to my previous post, I ran some numbers from FRED. What you see are corporate profits scaled logarithmically going back to 1980 (first chart = after-tax and second chart = pre-tax; both shown as blue line) and the 8-qtr. moving average (both shown as red line). Both charts ignore inventory valuation and capital consumption adjustments. All data are taken from the BEA's quarterly GDP reports via FRED.

Looking at the after-tax data first, you can see corporate earnings after-tax reached a new zenith in 3Q of 2019, but just barely. For the most part, corporate earnings after-tax have been flat since 2012.

On a before-tax basis, the small recent uplift since 2016 falls off, as all of that small recent uplift was due to the Trump tax cuts.



Where does that leave us? Basically, this is the longest period of flat corporate earnings "growth" going back to the late 1990s (and this is actually true going back to the earliest date in the series (1946) - which I cut off for presentation's sake).

The primary difference between today and the late 1990s is that the Fed Funds Target Rate in the late 1990s prior to the Dot.Com bust was 6.5%*. As Greenspan lowered rates from 6.5% to 1.0% over 2000-2004, you can see that this spurred a robust recovery in economic activity. That's the beauty of having higher rates BEFORE a recession. The fact we went into our recent recession with the lowest rates in history is a travesty of policy making, in my view.

Fast forward to today, the Fed Funds Target Rate is at 0.25%. In addition, Public Debt-to-GDP was approximately 50% in 2000, approximately 16 p.p. less than where it had been in the mid-90s. Thus, it was hardly problematic when fiscal stimulus between 2000 and 2004 raised this to only 60% or so. What is that figure today? 108%. You think we're going to have diminishing marginal returns on fiscal stimulus today vs. the last time we had a bubble of this size? (Lacy Hunt would stress the "overuse of one factor of production.")

Finally, corporate tax rates then were 35%. Today, they are 21%. Given the ballooning Public Debt-to-GDP, what's going to look like an attractive solution to the problem, particularly to a Democrat? And if that event occurs, how will that impact our blue line in the first chart above?

As I see it, the Fed's solution to all of this is to tinker around with QE since they've more or less given themselves an artificial floor of 0% when it comes to nominal rates. Thus, how do you get real rates lower if you're forced to keep nominal rates at 0%? You inflate the hell out of your currency, which is exactly what they are trying to do. BUT ... and this is a big but ... if the Fed fails to produce inflation and we have deflation, that means real rates would be going higher (0% nominal rate minus negative inflation equals a positive number). You couldn't have a more reliable pin to prick a bubble than effective interest rate "hikes" in an overly indebted economy.

Some claim that technological progress will save the day, and that's possible. But the chances of us experiencing the kind of step function technological progress we saw with things like the electricity grid, the advent of mass production during the World War periods, the Internet, etc. are likely pretty low. In addition, the government has been crowding private investment out of the market in their endless quest for deficit dollars. Look how much less currency in the economy circulates as US government spending increases.



This all leads me to believe that we may finally be facing the consequences of failing to deleverage after the Great Recession and keeping rates artificially low for years on end. This is also why I believe the inflation vs. deflation debate is the key to all of this.

*Of course, Greenspan's decision to raise rates to 6.5% in the first place is often attributed as the pin that pricked the Dot.Com bubble, but that's beside the point. Even before that, he still had about 500bps to work with vs J. Pow's 25bps at present.

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This all leads me to believe that we may finally be facing the consequences of failing to deleverage after the Great Recession and keeping rates artificially low for years on end. This is also why I believe the inflation vs. deflation debate is the key to all of this.

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I agree with all of this. I hope I’m not letting my imagination get the best of me, but I have serious concerns. The debt-to-production bubble was already a serious problem in its own right, but with the shutdowns/government stimulus complications I don’t see a peaceful way of unwinding.

IMO there are three (general) ways it could be handled:

1. The European model of strangling marginal players to prop up the majors (also known as “austerity”). It’s a terrible idea that will very likely result in the collapse of the EU and (effectively) default on debt. For a more in-depth analysis watch Mark Blyth’s videos on the subject.

2. The Japanese model of nationalizing banks and spreading the debt out over an incredibly long period with low, controlled interest rates. As I understand it they are effectively defaulting on the debt very slowly, but most of the debt is held by their own citizens, not foreign creditors, so it’s acceptable.

3. The most likely scenario is we experience a hard crash/reset sparked by deflation. The U.S. doesn’t have the political unity/fortitude to pull off the Euro or Japanese plans.

The major winners will be those who sat on cash and avoided the cheap debt trap we are in the middle of right now (ie. Buffett).

Solid post. I tend to agree with you, but would add a couple of nuances as I see them.

I think you can add an additional scenario, and that's for the real value of the debt to be reduced via inflation. Since debts are repaid in nominal dollars, inflation reduces the real value of the debt. This is the Fed's preferred approach, in my opinion, but it comes with a number of complications which could limit its effectiveness.

The first complication is that there is no guarantee the Fed will be able to create inflation. Inflation, in its most basic sense, is an increase in the price of goods. Among the causes of price increases are when demand for goods exceed the supply of goods or when the growth in supply of currency exceeds the growth in production of goods. Given COVID's impact on aggregate demand, the former is unlikely to produce inflation. The Fed is thus increasing the supply of money in an attempt to conjure up inflation that way.

But not all money is created equal. Assume that currency in this example are apples. The Fed, by law, can not directly create apples. But they can create apple seeds, which they hope become apples in the future. This is what quantitative easing does: it expands the supply of apple seeds in the economy.

Now, given the close relationship between apple seeds and apples, it's possible the creation of apple seeds alone will be enough to drive inflation, as people figure it's more possible than not that those apple seeds will become apples. In that case, the value of each individual apple may decline on account of it being expected that there will be more of them in the future without any corresponding increase in goods for them to chase.

But what if the apple seeds never become apples because those who receive the seeds store them away in a jar (i.e. leave them in reserves) instead of planting them (i.e. lending them out in the form of loans)? In that case, you may not see any inflation at all, as the supply of actual apples has not yet increased and may not be expected to increase any time soon.

This is basically where I think we are today. The Fed is saying, "The country was overleveraged before COVID, now its even more overleveraged, and on top of that incomes have declined. We have to help ease the burden of this debt and the most politically expedient way of doing so is by reducing the real value of it by inflating the currency."

However, what I think the market is saying in response is, "Not so fast, Fed. To have inflation absent any increase in demand, there's got to be an increase in actual apples, and you guys can only create apple seeds. Moreover, we don't expect those apple seeds to become actual apples because there aren't enough people out there looking for more apples (i.e. more loans). In actual fact, the country has too many loans to begin with!"

The second complication which limits the Fed's ability to create inflation is that it effectively acts as a tax on retirees living on a fixed income, and this is a growing segment of our population. In 2009, 13% of the population was 65+ y.o. and 20% of the population was under 15 (7% spread). Today, 16% of the population is 65+ and 19% of the population is under 15 (3% spread). And, unfortunately for politicians who want to inflate our debt problems away, only one of those two cohorts can vote and it's the one that's expanding as a share of the population and who is most negatively impacted by the loss of purchasing power.

With respect to your outline, I'd also add that I think #1 and #3 end up being more or less the same. Just as inflation reduces the real value of debt, deflation increases its real value. For an overly indebted society such as ours, this in itself will create austerity as debtors have no choice but to tighten their belts in order to continue to service their debts. This would only be exacerbated if governments raise taxes at the same time.

Finally, I agree with Dandaman that another option could be that Congress gives the Fed the power to create actual apples instead of just apple seeds, in which case inflation will skyrocket. It's hard to tell which would be worse (deflation or rapid inflation / stagflation).

Thanks - going to keep diving as deep as possible and will keep posting thoughts and articles as I come across noteworthy discussion points.

I don’t see much in the way of legal hurdles apart from the fact it would have to be approved by Congress, which is where the politics may come into play. Normally, I’d say the opposition, if it came from anywhere, would come from the Republicans, but that was before we had a Republican President openly lobbying for a more accommodative Fed.

I guess it’s also possible they could just do it and see if they can get away with it. They’ve already done things that are questionable re: the FRA to begin with (purchase of corporate debt, which, as I understand, requires some creative liberty with regards to interpreting what the FRA allows).

You got your evidence today that the market will be sensitive to fiscal stimulus

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Here's an interesting inflation/deflation discussion on Real Vision that seems like it belongs in this thread. Real Vision - Diego Parilla

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Enjoyed this. I like Diego’s thoughts at the 28-min mark about “strikers” and “goalkeepers,” particularly the notion that “the market provides you the cheapest insurance precisely when you need it the most.” In other words, the time to start protecting your portfolio is precisely when the market begins pricing in the belief that nothing is wrong, which also happens to be when “goalkeepers” such as VIX, USD, long gov bonds etc. look cheapest. I want to say that’s common sense, but I’m not sure how common it actually is. Diego put it very eloquently.

In addition, the discussion starting at the 33:30 mark sounds a lot like what WTF has been saying on here around using options to gain leverage while protecting principal. From 50:00 on when he actually “reveals” his strategy was fascinating - basically making proxy bets on less followed assets that you expect to mimic the payoff produced by the more followed assets, and thus keeping premiums low.