After the shock of coronavirus lockdown, with the world literally grounding to a halt, global central banks flushed the monetary system with so much liquidity with the intention of avoiding any hints of a recession let alone deflation or depression. The economy is like a riggity old car, the mechanic unable to scrap this one and buy a new one, has just been throwing more and more money into it. It just needs it to keep moving, even if slowly. Being scared of it completely shutting down, the mechanic has tied the car to a tractor to enable it to move forward, but the car is losing parts along the way and soon it may not be able to even move. But that debate is for another day.
The Fed's actions in March did the trick, it halted a complete collapse of the financial and economic system as they vowed to buy trillions in corporate and junk bonds and open the floodgates to every central bank in the world that demanded dollars. The Fed is the central bank of last resort. It may have stemmed the financial crisis for now, but the Fed, as much as it would like, cannot print a vaccine nor change human psychology.
Given the jolting shock of system closing down, despite all the Fed and PPP help, some businesses have permanently shut down and most are laying off people permanently as they are just unable to cover their costs and survive for the next few years. This is something the Fed is unable to control, it cannot print jobs. But their thinking is that enough money will solve the problem. What this does create is too much liquidity in the system, leading to inflation. We all know inflation is a matter of when not if, especially given the unprecedented amount of QE done by the Fed. Their balance sheet is around $7 trillion with about $4 trillion injected over the past few months. The bigger question is before we get to inflation or even hyperinflation, are we going to go through a period of sustained deflation? This transition is crucial as it has implications for risk assets and asset classes.
If we are indeed seeing a recovery, V-shaped as they call it given the sharp bounce seen from almost zero in April, then this means genuine recovery in risk assets, especially cyclical stocks and sectors. But if this recovery is nothing other than a short sharp bounce before we plateau, then we could be in a period of lower deflationary growth given the impact this shutdown has had on the global economy - U or W shaped recovery. The latter is bearish for cyclical assets and sectors, including commodities, as the demand is just not there to soak up the supply. Combine this with higher inflation, and we have the double whammy negative for equities and cyclical assets - we have stagflation!
Growth stocks have been outperforming Value since 2007. Technology stocks have heaps of cash on their balance sheet and earnings growth of 25%+, as they have benefited from significant disruption, deliver phenomenal sales and user growth at the cost of Value which is mostly Energy denominated. It is also the trade that makes most portfolio managers salivate at the thought of "getting the timing right", to make a killing as everyone is positioned in the former and underweight the latter. The market is willing to pay any price for this exposure and yield. Value stocks are dogged by their deteriorating earnings and strapped balance sheets, like Energy and Financials. They are cheap, but cheap can always get cheaper. Timing this is crucial. Every time there is a hint of a recovery, Value rallies only to then fizzle out, and start underperforming again.
We may have jump started the economy with floods of liquidity, but higher asset prices do not mean higher GDP growth. As the number of Covid-19 cases are growing, with the U.S. at 3 million + infected, states are shutting down and people will start to take precautions spending or travelling. It is human nature. Until and unless we fully understand the nature of this virus and its full impact, let alone being a year away from a functioning producing vaccine, life as we know it or demand will take years to come back to the pre-Covid January 2020 levels.
As the CARES act ends in July, consumers did not feel the pinch as the Fed insulated them with unemployment benefits that made them better off than actually being in a job. Now as they will be forced to go back to their jobs, if there is even one, the permanently unemployed numbers will continue to rise. Deferred payments on mortgages are picking up, this will start to be a problem for banks exposed to the housing market. As seen by Wells Fargo (WFC) , some banks are tightening their lending standards, making it harder to borrow, despite the Fed giving the banks the money. Tons of multinational companies are laying off workers, with those jobs not coming back anytime soon. The money printed by the Fed is going to service the old debt of companies in effect making them zombie companies, and productivity will be on the decline.
Do not look at the S&P 500 index, which is masked by the top five leading Technology stocks vs. everyone else. The rest of the market is slowly breaking down and unable to hold onto their gains. The US 10-year bond yields have finally moved lower, trading at 0.57%. The bond markets never lie. They are signalling distress and deflation. Sentiment is at highs, and day traders feel invincible as they seem to have "figured the market out". We know the rally over the past two years has happened each time the Fed embarks on their QE path. But they have stopped growing their balance sheet, with last week seeing three weeks of declines. Low and behold, the S&P 500 has not been able to make new highs since it peaked in June. It seems like it will be a bumpy road ahead.