Looking Forward: Tech, China & Tesla

December 17 (Thursday)

Strategy: The Day the Market Looked Ahead. Looking back on the year, September 2 was an unexpectedly important day. As summer was drawing to a close, the S&P 500 Information Technology stock price index made a high that it didn’t surpass until yesterday. In September, investors began looking ahead to 2021 with hopes of recovery from the pandemic and all the damage it has wrought during this terrible, horrible, no good, very bad year. Instead of buying tech names that benefitted from everyone working and shopping from home, investors began to snap up cyclical companies and those that would recover from a reopened economy.

The market’s optimism since September 2 is apparent in the cyclical sectors that have dramatically outperformed the broader index. Here’s the S&P 500 performance derby from September 2 through Tuesday’s close: Energy (14.6%), Financials (12.1), Industrials (11.2), Materials (7.4), Utilities (4.3), S&P 500 (3.2), Communication Services (2.7), Health Care (2.2), Consumer Staples (0.7), Information Technology (-0.3), Consumer Discretionary (-0.3), and Real Estate (-1.4) (Table 1).

A look at the top-performing industries since September 2 also makes clear investors’ willingness to bet on an economic recovery. Here are the top 10 S&P 500 industries from September 2 through Tuesday’s close: Copper (49.4%), Apparel, Accessories & Luxury Goods (37.4), Real Estate Services (34.8), Automobile Manufacturers (33.4), Semiconductor Equipment (32.9), Oil & Gas Equipment & Services (28.3), Diversified Chemicals (28.3), Hotel & Resort REITs (27.1), Airlines (26.6), and Consumer Finance (26.3). Just missing the top ten cut off are Regional Banks (25.0%), Industrial Conglomerates (22.2), Hotels, Resorts & Cruise Lines (21.1), and Steel (19.2).

The S&P 500 Information Technology stock price index fell from September 2 through the end of October and subsequently started climbing higher once again. It’s at 2243.06 as of Wednesday’s close—a just a hair above its September high (Fig. 1). Over the past four months, the S&P 500 Information Technology sector’s net earnings revisions have been positive: 15.2% in September, 12.6% in October, and 12.3% in November (Fig. 2). Analysts are forecasting that Information Technology sector’s earnings will grow by 15.3% in 2021 and 12.5% in 2022 (Fig. 3). That has helped its forward P/E to shrink a touch to 26.5, down from its recent peak of 28.3 on September 3 (Fig. 4).

And while the Tech sector’s earnings are commendable, if 2021 is the year when earnings growth returns, other sectors will boast much faster bottom-line expansion. Here’s the performance derby for the S&P 500 sector’s 2021 earnings growth: Energy (returning to a profit), Industrials (76.2%), Consumer Discretionary (53.2), Materials (28.3), S&P 500 (21.9), Financials (20.4), Information Technology (15.3), Communication Services (12.3), Health Care (11.4), Consumer Staples (5.9), Utilities (4.5), and Real Estate (-7.2) (Table 2).

The industries with the fastest expected earnings growth in 2021 look a lot like the list of industries that have had the best stock performance since September 2: Apparel Retail (441.7%), Copper (262.3), Apparel & Accessories (228.4), Consumer Finance (145.4), Automobile Manufacturers (102.0), Reinsurance (87.9), Auto Parts & Equipment (86.4), Commodity Chemicals (69.3), Gold (68.1), and Restaurants (50.2).

 China: Sleeping with the Enemy. Earlier this month, Goldman Sachs announced plans to acquire the 49% of a securities joint venture in China that it didn’t already own. The company was able to do so because China lifted restrictions on foreign ownership of its financial firms this spring.

While the relationship between the US and China was deteriorating in March, China allowed foreign firms to buy controlling stakes in Chinese securities businesses. In April, the country went a step further, removing ownership caps completely and allowing foreign firms to buy full ownership of Chinese financial firms. While the move undoubtedly is appreciated by global financial players, it does beg the question: Why? The US has placed tariffs on Chinese goods. It has outed Chinese nationals in the US who reportedly have been stealing proprietary information from corporations and universities. And the US is in the midst of passing a law that would delist Chinese companies trading on US stock exchanges that don’t use a US auditor.

It’s certainly possible that China has opened its financial markets to retain the goodwill of US financial executives who have longed to expand their presence in China. A December 2 WSJ article recounts a February 2018 meeting between Beijing’s chief trade negotiator Vice Premier Liu and a group of US business executives, mostly from Wall Street. His pitch: Help us with trade talks, and we’ll help you expand in China.

“Since the signing of the trade deal, JPMorgan will get full control of a futures venture in which it had a minority stake. Goldman Sachs and Morgan Stanley became controlling owners of their Chinese securities ventures. Citigroup Inc., meanwhile, won a custodian license to act as a safe keeper of securities held by funds operating in the country,” the article reports.

In addition to courting US executives, it’s possible the Chinese government has even larger, longer-term objectives in mind when opening its financial markets. Perhaps they are hoping the US firms will strengthen the Chinese capital markets and turn the Chinese currency into a world leader that rivals the US markets and the dollar.

An October 26 FT article quotes an unidentified “senior Chinese government official” who noted that opening Chinese financial markets will help achieve “Beijing’s longer term objective of increasing the renminbi’s attractiveness as a reserve currency vis-à-vis the dollar [which was] ‘impossible to do if you rely solely on Bank of China—it needs the JPMorgans, BlackRocks and Vanguards for it to be successful.’”

The article notes that the renminbi accounts for only 3% of central bank reserves outside of China, compared with 62%, 20%, and 5.7% for the dollar, euro, and yen. The Chinese have bristled under US economic sanctions, which our government is able to enforce primarily because the US dollar is the world’s reserve currency. If the Chinese currency and markets become global leaders down the road, US financial companies’ gain may be the US’s and the dollar’s loss.

Disruptive Technologies: Tesla’s Competition Heats Up. Just as Tesla makes it to the big leagues—its stock joins the S&P 500 on December 21—the company finds itself facing increasing competition. Small upstarts hope to replicate Tesla’s success, and established manufacturers intend to defend their turf. Meanwhile, opportunities for growth both at home and abroad are improving as more countries, primarily in Europe, require all new cars to be electric vehicles (EVs) in the 2030-40 time period. With its shares up more than 600% ytd, it seemed like a good time to look at the state of Tesla and the EV market:

(1) Still leading the pack. Tesla is still the EV manufacturer all others aim to beat, but the competition has gotten more serious and more technologically advanced. More than 20 new EV models are expected to enter the US market over the next year. One of the more promising offerings comes from Ford Motor. Its all-electric Mustang crossover, the Mach-E, received mostly solid reviews from the critics. One largely complimentary December 15 MotorTrend review was titled “Detroit Strikes Back.”

One of the Mach-E’s strongest selling points is its range. While most EV competitors run for only 200-250 miles per charge, the premium Mach-E runs for 300 miles per charge. Others crossing the 300-miles-per-charge mark are Nissan’s new Ariya crossover and Rivian’s SUV the R1S. That’s comparable to the range on most Tesla models, except for one. In June, Tesla proved it can stay ahead of the competition by introducing its Model S Long Range Plus vehicles, which travel 402 miles on a charge. Other EVs generating excitement include General Motor’s Hummer, Ford’s F-150 truck, Tesla’s Cybertruck, and Lordstown’s truck.

US EV sales rose by 8.4% to 345,285 vehicles this year, but that still represents only 2.3% of the new US cars sold, according to estimates in an October 30 CleanTechnica article. A flood of new models is expected to boost sales 70% next year to more than 500,000 vehicles, but again that represents only 3.6% of US car sales.

Industry players are hopeful that greater incentives to encourage the purchase of EVs will be enacted under a Biden administration. Currently, the first 200,000 EVs sold by a manufacturer can use a federal tax credit. The new administration could increase the number of EVs that would receive the tax credit beyond 200,000. During his presidential campaign, President-elect Joe Biden promoted a plan to have the federal government buy all clean energy and zero emissions vehicles. His campaign also said that a Biden administration would work to accelerate the deployment of EV charging stations.

(2) Europeans moving faster. The European EV market is making faster progress thanks to the stick provided by the European Union (EU) and many individual countries. The EU has CO2 emission standards, and noncompliant companies face large fines. The emission standards get progressively tougher each year, pushing companies to shift more of their portfolios to electric and hybrid vehicles to remain in compliance.

In addition, several countries have announced dates by which gasoline-powered new vehicles no longer can be sold. Norway’s ban on gas new car sales kicks in first, in 2025. The UK accelerated its ban on gas cars to 2030, up from 2040, but it will allow hybrid car sales until 2035. Other countries with a 2030 ban on combustion-engine new car sales include Germany, Ireland, and the Netherlands. France’s ban doesn’t go into effect until 2040. And the mayors of Paris, Madrid, Mexico City, and Athens have said they plan to ban diesel vehicles from driving in their city centers by 2025.

In North America, there are fewer restrictions. British Columbia has a sliding scale requiring that 10% of new cars sold be EVs by 2025, 30% by 2030, and 100% by 2040. California Governor Gavin Newsom signed in September an executive order banning all in-state sales of gas vehicles by 2035. But no other sales restrictions exist in the US.

EV new car sales in Europe are expected to be 10% of total car sales this year and 15% in 2021, according to the CleanTechnica estimates. In Germany, where there are many more EV and hybrid offerings than in the US, Tesla isn’t the market leader. The top electric and hybrid cars sold in Germany during November were: Renault Zoe, Hyundai Kona EV, VW ID.3, Smart Fortwo, VW e-Golf, and VW e-Up; the Tesla Model 3 comes in seventh, a December 15 Electrek article reported.

(3) Battle for battery supremacy. Tesla should be able to retain its dominant position as long as its cars continue to drive longer distances on a charge than those of most competitors’. But both QuantumScape and Toyota are working on solid-state batteries, which could be a game changer in the EV industry.

QuantumScape claims to have developed a solid-state battery that is smaller, lower cost, less flammable, longer lasting, and faster charging than the lithium electrolyte batteries used in today’s EVs, including Tesla’s. The solid-state batteries charge from 0 to 80% capacity in 15 minutes, less than half the time needed by currently used batteries. While only 10 years old, QuantumScape boasts a partnership with VW—and a $300 million investment from it—as well as an impressive board that includes JB Straubel, Tesla’s co-founder who has focused on battery technology, and venture capitalist John Doerr.

More established players are working on solid-state batteries as well. Toyota claims to have a solid-state battery that it plans to sell in an EV in the early 2020s, a December 10 Nikkei Asia article reported. This battery can power a trip of 500 km on one charge and recharge in 10 minutes. Nissan Motor is developing a solid-state battery for use in a vehicle by 2028, the article states. And Chinese tech group QingTao (Kunshan) Energy Development will spend roughly $153 million on developing solid-state batteries. And while it’s not working on solid-state batteries, Tesla is continuously working to make its batteries stronger and less costly.

QuantumScape’s shares have been on a wild ride that rivals the one enjoyed by Tesla’s stock. QuantumScape, which has no revenue or profits, agreed to a reverse merger with special purpose acquisition corporation Kensington Capital Acquisition on September 3, and shares of Kensington popped to $18.74 on the news. The reverse merger occurred on November 27 with the shares trading at $37.00. And after a presentation about its technology on December 8, QuantumScape shares rallied to $76.61 on December 12. They fell back to $62.20 on Tuesday.

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The Mobility Question

December 16 (Wednesday)

Business Mobility: Greasing the American Dream? Has income stagnated for most Americans over the past few decades? Has income inequality worsened over the past few decades? Has economic mobility decreased in recent decades? These are all highly controversial questions. From our perspective, if the standard of living has been deteriorating for years in the US, we doubt that the stock market would be making record highs. Nevertheless, that’s undoubtedly a controversial point of view, since others believe that the stock market is rigged for the rich and that the rich are getting richer. The controversy has only grown more intense amid the pandemic-induced recession and wobbly recovery, which some have suggested is a K-shaped one, i.e., good for the Haves and bad for the Have Nots.

Even before the pandemic hit, evidence suggested that the rich have been getting richer in recent years. However, they typically do during periods of prosperity. Those less well-to-do likewise tend to prosper during such times, but not as fast as the rich. In other words, the benefits of economic growth on personal finances may be unevenly distributed early in an expansion, but over time a growing pie benefits everyone. But as Melissa discusses below, income distribution is not static; there is movement among groups of those who prosper greatly and less so—i.e., economic mobility. So not only is income inequality a controversial subject; it is also a very dynamic and complicated one.

Of course, the pandemic isn’t over, and too many people and small businesses are still suffering. Nevertheless, we’d like to start today’s commentary with an upbeat and widely overlooked trend in America: The number of sole proprietorships has been growing very rapidly. We have become a nation of proprietors. The pandemic may weigh on that trajectory, but not for long once the pandemic is over, in our opinion.

This proliferation of sole proprietorships is an important development that challenges the core beliefs of proponents of class warfare. They see the economy as composed of numerous battlefields where workers clash with capitalists. The Communist Manifesto, written by Karl Marx and Friedrich Engels in 1848, was intended by its authors to be the proletariat’s declaration of war against the owners of capital. It was an overly simplistic analysis back then, resulting in some of the worst economic forecasts in history and widespread economic misery rather than a workers’ paradise. The class warfare concept is even less relevant today considering the growth of entrepreneurship.

The robust growth of the proprietors class certainly complicates the simplistic class warfare ideology, since they are both workers and owners of capital. Proprietors are entrepreneurial capitalists, which distinguishes them from crony capitalists. To stay in and succeed in business, they must satisfy their customers and keep their employees happy. Crony capitalists tend to be corporations that have grown big along with government. They have trade associations with lobbyists as well as their own lobbyists to influence the government’s regulatory policies, mostly aiming to create barriers to entry for would-be competitors.

Let’s cut to the chase and examine the available data on the growing importance of proprietors in our economy:

(1) The number of corporations. We have IRS data from 1980 through 2015 on the number of returns filed by business entities in America. The total number of corporations increased from 2.7 million to 6.1 million over this period (Fig. 1). These include C and S corporations. The former file corporate tax returns. Their profits are taxed at the corporate level, and the dividends they pay are taxed in individual tax returns. S corporations can have no more than 100 shareholders. Their profits are not taxed at the corporate level. Instead, they are treated as dividends and taxed in the individual income tax returns of their shareholders. That way, double taxation of income is avoided.

As a result, S corporations have become very popular. From 1980 through 2015, they increased 4.0 million from 0.5 million to 4.5 million, while the number of C corporations declined 0.6 million from 2.2 million to 1.6 million (Fig. 2).

(2) The number of passthroughs. S corporations are categorized as “passthrough” business entities since their profits are passed on to their owners to be taxed once as personal income. Sole proprietorships and partnerships are also taxed as passthroughs. The former has increased significantly by 16.3 million from 8.9 million during 1980 to 25.2 million during 2015 (Fig. 3). Over this same period, the number of partnerships has increased by 2.3 million from 1.4 million to 3.7 million.

Together, there were 33.4 million passthroughs in 2015, including 25.2 million sole proprietorships, 3.7 million partnerships, and 4.5 million S corporations. Each employed at least one worker, obviously—i.e., their owner. At the beginning of 2015, private payroll employment totaled 118.6 million, implying that passthroughs accounted for at least 28% of those jobs (Fig. 4). That’s significant and impressive!

(3) Impact on National Income. The IRS data show that, in 1980, C corporations accounted for a whopping 86.8% of business sales receipts and 74.6% of the net income of all businesses (Fig. 5). By 2015, these percentage shares were down to 60.5% and 36.7%. In 2015, these were the net income results for C corporations ($1,155 billion), S corporations ($457 billion), and sole proprietorships and partnerships ($1,112 billion) (Fig. 6).

Interestingly, in the National Income and Product Accounts (NIPA), proprietors’ pre-tax income is almost as large as corporate profits (Fig. 7 and Fig. 8). The former is currently running around 80% of the latter. Both having been trending higher at an annual growth rate of about 6%-7%.

In many ways, the business cycle is really a profits cycle. Profitable corporations and passthrough businesses increase their payrolls and expand their capacity. Unprofitable ones decrease their payrolls and cut back on capacity expansion. Therefore, the corporate profits and proprietor’s income cycles are procyclical, rising during expansions and falling during recessions (Fig. 9 and Fig. 10).

(4) Impact on capital spending. Nonfinancial noncorporate businesses accounted for 14.5% of capital spending in nominal GDP during Q3-2020 (Fig. 11 and Fig. 12).

(5) Impact on employment. ADP compiles monthly data for the private-sector payrolls of large, medium, and small companies. Passthroughs are likely to account for the bulk of small companies, which currently employ 31.3 million workers and account for 26.2% of total private-sector payrolls (Fig. 13 and Fig. 14).

Economic Mobility: Ceasing the American Dream? The pandemic has heightened concerns about income inequality, as lower-income households have sustained a greater economic hit than higher-income ones. Thanks to the recent emergency use authorization of Pfizer’s vaccine by the Federal Drug Administration, the pandemic may be over sooner rather than later. But discussions about income inequality are likely to persist, especially under the incoming Democratic administration.

In recent notes, Melissa and I have analyzed the data on income inequality, which suggest that—while it undeniably exists—it hasn’t worsened in recent years as much as some economists claim. We wondered whether a similar analysis of economic mobility—or the ability of individuals, families, or other groups to advance their earnings over time regardless of their socioeconomic status at birth—might yield insight into income inequality that supports our more sanguine view of it and quells the concerns of others. Unfortunately, the available studies we review below conclude that economic mobility has deteriorated in recent years.

We are clearly going to have to do more work to understand how economic mobility has worsened while income inequality has not, based on our previous analyses. Something doesn’t add up. For today, our focus is on the available studies of economic mobility. Consider the following:

(1) Measuring mobility. An upbeat 2008 US Treasury study purporting to shed light on income mobility really did not because of its narrow individual focus. It measured individuals’ income changes over time with no data relevant to children’s chances of faring better economically than their parents and no adjustment for the fact that people’s incomes tend to rise over time as skills and experience accrue.

A 2016 Federal Reserve Bank of Boston study took a hybrid approach. It evaluated income mobility for several overlapping decades (i.e., 1977 to 2012). The Treasury report did compare the 1996 to 2005 timeframe to the prior decade (i.e., 1987 to 1996), concluding that income mobility had remained relatively similar over the two decades, but the Boston study covered a much longer time horizon. The Boston Fed researchers found that trends in income mobility were not monotonic. That is, they moved “up over several periods, and then down, or vice versa.” That is part of the reason that earlier research, “which generally compares two adjacent periods, fails to document a significant downward trend,” the researchers observed.

The report concluded: “All the mobility measures except origin-specific measures for the rich show a decline in mobility in the most recent period, 2001–2011, compared with the next-most-recent period, 1999–2009, and furthermore indicate lower mobility during these two decades (which include the Great Recession) than in 1997–2007, before the recession began. It appears that the Great Recession further depressed economic mobility for those with low incomes.” It does not seem farfetched to think that an update of the research following the pandemic era would show further deterioration of economic mobility.

(2) Generational decline. Not many studies have directly linked earnings data between parents and children because of how cumbersome it is to obtain and analyze that amount of data, but there are a few relatively recent ones. In a 2015 report, Pew measured economic mobility in terms of “intergenerational elasticity,” which is the strength of the relationship between the income of parents and that of children. Pew found that about half of parental income advantages are passed on to children, which it qualifies as meaning that the US is “very immobile.”

Similarly, a 2016 National Bureau of Economic Research (NBER) working paper co-authored by economists at Harvard, Stanford, and UC-Berkeley found that rates of absolute upward income mobility in the US have fallen over time. Specifically, the fraction of children earning more than their parents at 30 years of age (adjusted for inflation) fell from 92% for those born in 1940 to 50% for those born in 1984.

(3) Bigger pie needed. Despite the apparent rise in income immobility, improved standards of living are evident across all income quintiles. We can look to historical evidence for this. For example, the US Treasury report found: “Median incomes of taxpayers in the sample increased by 24 percent after adjusting for inflation. The real incomes of two-thirds of all taxpayers increased over this period.”

On the other hand, the NBER researchers simulated the impact of various GDP growth rates on income mobility. They found that real GDP growth rates above 6% per year would be needed to return to the rates of absolute mobility seen for those born in the 1940s. In other words, “changing the distribution of growth naturally has smaller effects on absolute mobility when there is very little growth to be distributed. The key point is that reviving the ‘American Dream’ of high rates of absolute mobility would require more broadly shared economic growth rather than just higher GDP growth rates.”

(4) Connecting the disconnect. We are just thinking out loud, but the apparent disconnect between stable income inequality and worsening economic mobility may have to do with the growing share of higher-paying jobs on the income scale that rely on technology. It’s not so simple for workers to move up the income escalator if they don’t possess the skills or access to relevant education and training to leverage technology. In the past, moving up the income scale may have had more to do with workers moving into a supervisory or management position in a field in which they had gained knowledge and experience. Today, organizational leadership is increasingly horizontal, and the highest earners may be those who are able to most productively use technology rather than those that effectively supervise humans.

Separately, another possible reason for the disconnect is that income inequality is stable because government transfers have made up for worsening income gaps. In other words, income inequality would have worsened if it were not for government supports. We will further explore these hypotheses in future research.

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Corporate Financial Matters

December 15 (Tuesday)

Corporate Finance I: Accounting for Fun & Profits. Yesterday, Joe and I raised our estimates for S&P 500 revenues and earnings per share and profit margins to the following: 2020 ($1,400, $140, 10%), 2021 ($1,545, $170, 11%), and 2022 ($1,625, $195, 12%). As a result, our S&P 500 year-end targets for this year and the next two years are now 3740, 4290, and 4620. (See YRI Earnings Forecasts.)

Today, let’s focus on the broader related topic of corporate finance. On the income statement side of this topic, we will examine the latest profits data provided for all corporations in the National Income and Product Accounts (NIPA) compiled by the Bureau of Economic Analysis. On the balance sheet side, we will analyze the data compiled in the Financial Accounts of the United States by the Federal Reserve Board. Both sets of data were recently updated through Q3-2020.

The bottom line is that during Q3 profits have recovered remarkably well from the lockdown recession during the first half of this year. On the other hand, corporate balance sheets are loaded up with more debt than ever. However, much of it has been refinanced at record-low interest rates. It’s all bullish for the economy and the stock market as long as interest rates stay low.

 Corporate Finance II: Revenues, Costs & Profits. Let’s start with a review of the latest data on corporate revenues, costs, and profits. All are remarkably upbeat, on balance, considering the extraordinary circumstances:

(1) Revenues & GDP. Corporate revenues have rebounded smartly along with real and nominal GDP. S&P 500 aggregate revenues rose 10.1% q/q during Q3 following a drop of 14.7% during the first half of the year (Fig. 1). Nominal GDP increased 8.4% (not annualized) during Q3 following a 10.2% drop during the first two quarters of the year. The revenues rebound has been led by goods-producing industries, while many service-providing ones have remained pandemic challenged. Business sales of goods have fully recovered since they bottomed in April through October. Nominal GDP of goods rose to a record high during Q3, while GDP of services remained 5.4% below the Q4-2019 peak (Fig. 2).

We also raised our real GDP forecast yesterday to 10% (saar) during Q4-2020 to reflect the strength in the Atlanta Fed’s GDPNow tracking model (currently showing 11.2%). We lowered our outlook for the first half of 2021 to reflect renewed lockdown restrictions during the third wave of the pandemic. We boosted the second half’s growth rates, assuming that widespread vaccinations during the first half will boost the lagging service providers significantly starting next summer. (See YRI Economic Forecasts.) As a result of our revisions, we see real GDP fully recovering by mid-2021 (Fig. 3).

(2) Profit margin & productivity. During Q3, S&P 500 revenues rose faster than costs. As a result, both reported and operating margins are almost back to where they were at the end of last year before the pandemic hit (Fig. 4). During Q3, nonfarm business productivity rose 4.6% (saar), following a 10.6% jump during Q2 (Fig. 5). Unit labor costs fell 6.6% during Q3. The latest compensation data are very funky, showing a jump of 24.3% (saar) during Q2 and a drop of 2.3% during Q3, mostly because low-wage workers bore the brunt of the layoffs during Q2. Nevertheless, we believe that the pandemic accelerated the pace of technological innovation and adoption in ways that will continue to significantly boost productivity, thus keeping a lid on labor costs and boosting margins.

(3) Corporate profits. Reflecting the rebound in revenues and margins, the NIPA data show that after-tax book profits (reported on a tax-accounting basis) jumped 36.6% q/q (not annualized) during Q3 (Fig. 6). It’s at a new record high, though not much above its range-bound performance from 2012 through 2019. It is up only 13% since Q1-2012 through Q3-2020; yet the S&P 500’s reported earnings per share is up 43.8%, and the S&P 500’s aggregate after-tax reported earnings is up 31.9%, over this same period.

The S&P 500 accounts for roughly 50% of NIPA profits, which also includes S corporations, which are owned by no more than 100 shareholders. S corporations do not pay corporate taxes. Instead, their profits are paid and taxed as dividends to their shareholders. In other words, it doesn’t make much sense to use NIPA profits when thinking about and forecasting the S&P 500. (Perma-bears occasionally make that rookie’s mistake.)

Corporate Finance III: Dividends, Retained Earnings & Cash Flow. So what are corporations doing with their profits? The NIPA accounts focus on after-tax “profits from current production,” which is book profits including the Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj). These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP (Fig. 7). We prefer to call this measure “cash-flow profits” (Fig. 8). They are allocated to dividends and to undistributed profits.

As a result of the lockdown recession, companies reduced their dividends during 2020 slightly from last year’s record high. That allowed more of the Q3 rebound in profits to show up as a 202% q/q (not annualized) bounce in undistributed cash-flow profits. This category is back to where it was before the pandemic hit. As a result, corporate cash flow, which is the sum of undistributed cash-flow profits and tax-reported depreciation, rose to a record $2.63 trillion (saar) during Q3 (Fig. 9). That’s impressive.

Corporate Finance IV: Capital Spending. Just as impressive is the rebound in current-dollar capital spending, which not surprisingly tracks corporate cash flow closely. This is particularly so for nonfinancial corporate cash flow versus nonfinancial corporate capital spending, both using data compiled by the Fed (Fig. 10). Nonfinancial corporate capital spending accounts for most of nonresidential fixed investment in the GDP accounts (Fig. 11). The latter has been trending higher in record-high territory since Q4-2011. In current dollars and real dollars, it has increased 68% and 58% since the start of the expansions during Q4-2009 through Q3-2020, and both rebounded 5.1% q/q (not annualized) during that quarter, regaining most of the losses during the lockdown recession.

 Corporate Finance V: Borrowing & Debt. The bottom line, literally, is that there is plenty of cash flow to finance rising capital spending, which seems to be sufficient to support the productivity-led expansion of corporate America. Nevertheless, progressives have charged that undistributed corporate profits have been wasted on buybacks to boost earnings per share to enrich corporate managements. They’ve also charged that corporations have borrowed funds in the bond market to buy back their shares. Before we go there, let’s review corporate borrowing and debt using data compiled by the Fed.

Nonfinancial corporate business debt jumped during Q1 as many companies cashed in their bank lines of credit during March, fearing a credit crunch. When the Fed dramatically eased credit conditions later that month, they scrambled to issue bonds, both to raise cash and to refinance debt at record-low interest rates. Here are some specific figures:

(1) Debt and liquid assets. Nonfinancial corporate (NFC) debt jumped $0.3 trillion during Q2 to a record $11.1 trillion (Fig. 12). It edged down to $10.9 trillion during Q3. NFC bonds edged up to a record $6.5 trillion, while loans edged down to $3.7 trillion (Fig. 13).

The Fed report includes equities and mutual fund shares in the liquid assets held by NFCs (Fig. 14). Melissa and I prefer to exclude these items from liquid assets. On this basis, liquid assets held by NFCs jumped $0.9 trillion y/y to $3.5 trillion during Q3. The ratio of NFC short-term debt to the smaller measure of liquid assets was at a record low during Q3 (Fig. 15).

(2) NFC debt relative to cash flow. On the other hand, the ratio of total NFC debt to cash flow remains relatively high (Fig. 16). However, monetary interest paid by NFCs fell to a record low this year as a result of the Fed’s ultra-easy monetary policies in response to the pandemic (Fig. 17).

(3) Refinancing outstanding bonds. The Fed compiles a monthly series on NFC gross bond issuance (Fig. 18). Over the past 12 months through October, they totaled a record $1.5 trillion. The Fed’s quarterly database shows that net issuance totaled a record $0.7 trillion over the past four quarters through Q3, implying that a record $0.8 trillion was refinanced at record-low yields (Fig. 19).

 Corporate Finance VI: Stock Issuance & Buybacks. The Fed also tracks monthly corporate stock issuance by both financial and nonfinancial corporations (Fig. 20). Total issuance rose to a record $302 billion over the 12 months through October, led by a record $172 billion in NFC stock issuance and a $130 billion increase in stocks issued by financial corporations. Data available only through June show that NFC equity issuance over the 12 months through that month reflected a record gain of $125 billion in seasoned equity offerings and $22 billion in IPOs (Fig. 21).

What about stock buybacks? They dropped sharply during Q2-2020 to the slowest pace since Q1-2012 (Fig. 22). In our Topical Study dated May 20, 2019 and titled “Stock Buybacks: The True Story,” Joe and I concluded:

(1) Most buybacks are aimed at offsetting earnings dilution resulting from employee stock compensation plans. The funds for these buybacks are treated as compensation expense. So they aren’t paid for with either undistributed profits (at the expense of workers or capital spending) or funds raised in the bond market.

(2) The close correlation between buyback activity and the S&P 500 stock price index has been widely interpreted to mean that the former drives the latter. In fact, the performance of the stock market is driven by earnings and the economy, which have a direct influence on overall compensation, including stock grants and options.

(3) Neither compensation nor capital spending has been meaningfully depressed by buybacks aimed at boosting earnings per share.

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The Bulls vs the Virus

December 14 (Monday)

Strategy I: Infectious Bull. There are too many bulls. That’s often a contrary indicator suggesting that a correction, if not a bear market, is imminent. Occasionally, however, it has also confirmed that a meltup is underway (Fig. 1). That was the case in 1999. Ever since the S&P 500 rose above its February 19 record high to new record highs since August 18, Joe and I have been more concerned about a meltup than a correction or a bear market (Fig. 2).

We will become more concerned about the latter scenarios if the market continues to go straight up and investors “party like it’s 1999” all over again, to quote the singer Prince. Following the LTCM crisis, the S&P 500 and the Nasdaq soared 59.6% and 236.7% from the end of August 1998 through March 2000. So far, since the pandemic low on March 23, they are up 63.7% and 80.4% through Friday’s close (Fig. 3).

One sign of excessive exuberance is that the S&P 500 was 15.3% above its 200-day moving average at Friday’s close, among the highest readings of the bull market since 2009 (Fig. 4). In addition, the percentage of S&P 500 companies trading above their 200-dmas on December 11 was 90.9%, down slightly from the prior week’s 91.3%, which was the highest since July 12, 2013 (Fig. 5).

The meltup in the price of Tesla shares and the prices of recent IPOs is yet another sign of irrational exuberance. Furthermore, with all due respect to Bitcoin’s fans, we view it and other cryptocurrencies as “digital tulips.” We have no way to value them. We prefer assets with earnings, dividends, coupons, and rents—i.e., an income stream we can value. Nevertheless, we do watch Bitcoin’s price action as a gauge of speculative excesses, which are back at record highs according to this gauge (Fig. 6).

Strategy II: Raising Earnings Outlook. Joe and I have been infected with the bullish virus for quite some time. However, we are doing our best to avoid the deliriousness associated with Mad Bull Disease (MBD). Nevertheless, the stock market has been stampeding past bulls (like us) since it bottomed on March 23, and the economic fundamentals have been doing the same since they bottomed during April. As a result, we’ve had to raise our outlooks for both economic growth and S&P 500 earnings as well as our target for the S&P 500 index a few times since then. Here we go again:

(1) GDP and S&P 500 revenues. Debbie and I are raising our estimate for Q4-2020 real GDP growth from 5% to 10%. We are lowering both our Q1- and Q2-2021 growth rates to 2% to reflect renewed lockdown restrictions in response to the third wave of the pandemic. We are raising our Q3- and Q4-2021 growth estimates to 4% and 3% because we expect an economic boom after vaccines have been widely distributed during the first half of the coming year. That puts real GDP up 4.6% next year over this year, or up 2.8% on a Q4/Q4 basis. (See YRI Economic Forecasts.)

As a result, we are also raising our forecasts for S&P 500 revenues per share for 2020, 2021, and 2022 to $1,400 (still down 1.1% y/y), $1,545 (up 10.4%) and $1,625 (up 5.2%) (Fig. 7). During the December 3 week, industry analysts were projecting $1,335, $1,449, and $1,549. Both our and the analysts’ revenue scenarios would represent unusually strong rebounds from the pandemic-depressed levels earlier this year—especially compared to the more modest revenue rebound following the Great Financial Crisis (GFC) (Fig. 8). (See YRI S&P 500 Earnings Forecast.)

(2) S&P 500 profit margin. We are lifting our forecasts for the S&P 500 operating profit margin this year, next year, and in 2022 to 10.0% (up from 9.3%), 11.0% (up from 10.7%), and 12.0% (up from 11.8%) (Fig. 9). Our forecasts are similar to the analysts’ current consensus forecasts of 10.1%, 11.4%, and 12.5%. If these projections are on the mark, the Great Virus Crisis’ (GVC) margin pattern would be similar to the GFC’s margin pattern, but the level of the margin now is significantly higher than it was back then. The four-quarter trailing margin bottomed below 6% in 2009. It is likely to bottom around 9% this time!

Here is the performance derby for the operating profit margins of the S&P 500’s sectors during Q3-2020 and during their GFC lows: Information Technology (19.1%, 9.5%), Utilities (13.6, 7.6), Financials (13.1, -10.6), Communication Services (12.6, 6.8), S&P 500 (9.1, 4.2), Health Care (8.3, 9.3), Consumer Staples (7.8, 6.0), Materials (7.7, 0.3), Industrials (5.6, 6.4), Consumer Discretionary (5.4, 1.0), and Energy (-6.3, 4.3) (Fig. 10).

Here’s the bad news: If the Democrats win both Senate seats in Georgia on January 5, giving them majority control of the Senate, they are likely to raise the corporate tax rate from 21% to 28%. In that case, we would have to lower our profit margin estimate for 2022, since any tax hike passed next year probably wouldn’t be retroactive to the start of 2021.

Now for the good news: As Jackie and I discussed in our Morning Briefing of last Thursday, many companies have responded to the pandemic by slashing their costs only to find that their revenues weren’t as depressed as they had feared. We expect that they will continue to do whatever they can to boost their margins, which will mostly be by adopting productivity-enhancing technologies.

(3) S&P 500 earnings. Politicians justified lockdown restrictions in response to the pandemic by telling us repeatedly that they are “following the science.” We are following the arithmetic of E = R x E/R, i.e., earnings equal revenues times the profit margin. Given our estimates above, that means we expect S&P 500 earnings per share to be $140 this year (down 14.1% y/y), $170 next year (up 21.4%), and $195 in 2022 (up 14.7%) (Fig.11). During the December 3 week, industry analysts were projecting $138, $169, and $193. (See YRI S&P 500 Earnings Forecast.)

(4) S&P 500 forward earnings and index targets. To predict the S&P 500 at the end of 2021 and 2022, we need to forecast S&P 500 forward earnings. During the December 4 week, forward earnings was $167.07, after staging an impressive V-shaped recovery from the recent low of $141.00 during the May 15 week (Fig.12). Here are our forecasts for forward earnings at the ends of 2020, 2021, and 2022: $170, $195, and $210. Multiplying these three by the current forward P/E of 22 results in the following S&P 500 targets for year-end 2020, 2021, and 2022: 3740, 4290, and 4620.

(5) Roaring 2020s. Our economic and earnings forecasts are now even more consistent with our post-GVC scenario of technology-led productivity growth that boosts real GDP and keeps a lid on inflation. That happy outlook could last through the end of the decade, which is why we call it “the Roaring 2020s.”

US Economy: The Third Wave of the Virus. While the stock market is discounting the end of the pandemic once vaccines are widely distributed during the first half of next year, the third wave of the pandemic is taking a heavy toll on people’s lives. The latest wave of lockdown restrictions is likely to weigh on economic growth during the first few months of 2021. Consider the following:

(1) Casualties. The 10-day moving average of new positive test results has jumped to 204,000 as of December 11, as new tests have continued to trend higher along with the positivity rate (Fig.13). As a result, hospitalizations have soared to 103,000 as of December 11, and new deaths that day totaled 2,477. These all exceed the peaks during the first wave earlier this year. The current number of positive tests suggests that hospitalizations and deaths will continue to rise through the winter months.

(2) Collateral damage. The recent surge in hospitalizations and the resulting lockdowns may be starting to weigh on the economy, as evidenced by the recent weakness in gasoline usage over the four-week period through the December 4 week (Fig.14).

The Atlanta Fed’s GDPNow tracking model shows real GDP rising 11.2% during Q4. That’s the main reason we’ve raised our forecast from 5% to 10%, as discussed above. But the bad news on the health front of the war against the virus suggests a likely setback on the economic front over the next few months, which is why we’ve lowered our GDP growth expectations for the first half of next year.

Eurozone Economy: ECB to the Rescue. The latest wave of the virus in Europe caused the Eurozone’s Economic Sentiment Indicator to dip in November (Fig.15). This index is highly correlated with the y/y growth rate in the region’s real GDP, which was down 4.3% during Q3 and is likely to be even weaker during Q4. Reflecting the ongoing weakness in the Eurozone economy was November’s headline Consumer Price Index, which was down 0.3% y/y, based on the flash estimate. The core rate was up just 0.2%.

Not to worry: The European Central Bank (ECB) announced last Thursday that it will inject the European economy with more doses of liquidity, warning that the economic crisis caused by the pandemic is likely to linger well into 2022 despite the rollout of new vaccines. The ECB’s December 10 press release announced QE-for-longer:

(1) PEPP. “[T]he Governing Council decided to increase the envelope of the pandemic emergency purchase programme (PEPP) by €500 billion to a total of €1,850 billion. It also extended the horizon for net purchases under the PEPP to at least the end of March 2022. In any case, the Governing Council will conduct net purchases until it judges that the coronavirus crisis phase is over” (Fig.16).

(2) TLTRO. “[T]he Governing Council decided to further recalibrate the conditions of the third series of targeted longer-term refinancing operations (TLTRO III). Specifically, it decided to extend the period over which considerably more favourable terms will apply by twelve months, to June 2022. Three additional operations will also be conducted between June and December 2021” (Fig.17).

Movie. “Ava” (-) (link) stars the talented actress Jessica Chastain as Ava, a deadly assassin who works for a sinister black ops organization. Sadly, her talents are wasted by this lame action film. Instead of numerous car chases, which are traditional in this genre, we get one martial-arts (with machine guns) fight scene after another, with Ava dispatching numerous opponents in a hurry. The film is a mishmash of “Nikita,” “Homeland,” and “Wonder Woman.” One of its many flaws is Ava’s weepiness over her failed family life. Also wasted are the talents of John Malkovitch, Geena Davis, and Colin Farrell.

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The Margin Imperative

December 10 (Thursday)

Strategy: Cut Costs Today, Boost Margins Tomorrow. Cost-cutting was a unifying theme throughout many Q3 conference calls, as companies did what was necessary to survive until a Covid-19 vaccine can be widely distributed. While cuts of some expenses—like advertising or 401(k) contributions—are temporary, others will remain to boost margins after the pandemic.

Marriott CEO Arne Sorenson noted in the company’s Q3 earnings conference call that costs relating to food and beverages have fallen with the drop in hotel guests and will likely increase again as hotel occupancy improves. But other changes made in response to the pandemic, including staffing model changes and keyless entry, should reduce costs permanently. “We’ve probably reduced breakeven occupancy by three to five points, something like that depending on the brand,” he said. “Net-net, we’d expect that what we’ve done should deliver some long-lasting margin improvement. It’s a little too soon to be able to tell you what that number will be.”

Emerson Electric CEO David Farr called the company’s cost reductions “self help” in the company’s FQ4 earnings conference call on November 3. “We're on track to deliver the peak margin plan we laid out in February of 2020 despite sales being approximately $2 billion lower than we said back then before the pandemic, before, obviously, the recession we've had to go through. But the hard work on cost actions, the hard work in restructuring, the hard work in new product investments and the things we had to do to make this company stronger for our shareholders and for our customers, we have done. We have confidence in 2021.”

Analysts have begun to factor in a rebound in margins. Joe calculates analysts’ consensus forecasts for S&P 500’s profit margins by dividing their consensus earnings forecasts by their consensus revenues estimates. At the start of this year, analysts forecast the S&P 500’s 2020 profit margin would be 11.9%. By July 9, that estimate had fallen to its nadir of 9.3%, only to rebound to 10.7% currently. The real optimism lies in forecasts for the S&P 500 operating margin for 2021, which stands at 11.4%, and for 2022, which is 12.5% (Fig. 1). If the 2022 S&P 500 margin estimate is correct—and that is a big “if” given how far in the future 2022 is—margins would be better than their peak of 11.8% in 2018.

Let’s take a closer look at where margins stand in different sectors:

(1) 2020 margin massacre. The pandemic impacted sectors very differently. The S&P 500 Information Technology and Utilities sectors are expected to see improvement in their operating profit margins this year compared to 2019, and the Consumer Staples sector isn’t far behind, with unchanged margins forecasted for 2020. Margin strength in these sectors makes sense given that we were all stuck at home this year using more cleaning products and buying keyboards and monitors for home offices.

On the opposite side of that equation are the S&P 500 Real Estate, Energy, and Industrials sectors, which are expected to see the largest deterioration in their operating margins in 2020. Again, that’s not surprising since they’re also among the sectors with the sharpest expected drops in revenues and profits this year.

Here’s the performance derby for the S&P 500 sectors’ operating profit margins in 2019 and 2020, from largest y/y gain to largest y/y drop: Utilities (13.8%, 14.3%), Information Technology (20.8, 21.0), Consumer Staples (7.3, 7.3), Health Care (10.4, 10.4), Materials (9.3, 8.9), Communication Services (14.6, 13.7), S&P 500 (11.5, 10.1), Consumer Discretionary (7.1, 4.9), Financials (16.7, 13.1), Industrials (9.8, 5.4), Energy (5.2, -0.6), and Real Estate (20.6, 12.7) (Table 1).

(2) Things look brighter in 2021. Some of the margins hurt the worst by Covid-19’s effect on the economy are poised to improve the most next year as the pandemic ends—we hope! The S&P 500 Energy, Industrials, and Financials sectors are forecast to see their margins improve the most in the upcoming calendar year (Fig. 2, Fig. 3, and Fig. 4). Meanwhile, the Real Estate sector’s margins are forecasted to shrink for a second year, and there’s little improvement forecast for the Consumer Staples and Utilities sectors.

Here’s the derby for the S&P 500 sectors’ projected operating margins for 2021 and the percentage-point changes from 2020: Energy (2.8%, 3.4ppts), Industrials (8.7, 3.3), Financials (15.5, 2.4), Consumer Discretionary (6.7, 1.8), Materials (10.6, 1.7), S&P 500 (11.4, 1.3), Information Technology (22.2, 1.2), Health Care (10.8, 0.4), Communication Services (14.0, 0.3), Consumer Staples (7.5, 0.2), Utilities (14.4, 0.1), and Real Estate (12.7, -0.9).

It’s somewhat surprising that analysts continue to see the operating margin for the S&P 500 Information Technology sector continuing its upward trajectory in 2021, returning it to levels that are close to its peak of 23.1% in November 2018 (Fig. 5). It’s also impressive to see how well profit margins for the Materials sector have held up throughout 2020. That cyclical sector saw its margins drop roughly five percentage points during the Great Financial Crisis (GFC), but they dropped only 0.4ppt in 2020 (Fig. 6). And there may be opportunities in the Industrial sector, which saw the second largest drop in its operating margin in 2020 but is forecast to enjoy the second-largest rebound in 2021.

Economy: The State of the States. Political jockeying around a second Covid-19 relief bill is heating up as Congress attempts to get something passed before they recess for the holidays. Senate Majority Leader Mitch McConnell (R-KY) suggested moving forward with aid to individuals and dropping the items that are sticking points until next year. His proposed bill would not include Republicans’ request for businesses to get Covid-related liability protection, nor would it grant Democrats’ request to give financial aid to states and local governments.

While that may be the most expedient way to get relief to households that need it most, it’s bad news for the governors and local officials trying to plug swelling budget deficits. No doubt President-elect Joe Biden will try to provide fiscal relief to municipalities, but a prospective Republican-controlled Senate come January could hinder his efforts. Meanwhile, municipalities may need to take more aggressive action. As evidenced during the GFC, layoffs and cost-cutting by municipalities can slow the broader economy’s growth.

Here’s a look at some recent headlines and related economic data:

(1) Municipal misery. State and local municipal budgets are suffering from the double whammy of lower revenue and higher spending due to Covid-19. A December 4 report from the Center on Budget and Policy Priorities estimates that states could incur aggregate revenue shortfalls of $185 billion in fiscal 2020, $370 billion in fiscal 2021, and $210 billion in 2022. States are required by their constitutions to balance their budgets every year. So they understandably are hoping for relief from the federal government and will still need to raise taxes and cut spending. Without federal aid, those tax increases and spending cuts will be even more draconian.

In reaction to the fiscal stress, Moody’s Investors Service has lowered its outlook to negative on all municipal bond sectors except for housing finance agencies and water, sewer and public power, a September 4 WSJ article reported. Municipal bonds are sold by more than just state governments. Concerns are rising about municipal bonds sold by mass transit systems, airports, toll roads, universities, and nursing homes. And while still low at 55 episodes so far this year, municipal bond defaults have climbed sharply from the 35 defaults last year and are the highest since 2011, when there were 88 defaults.

Ridership and revenue on mass transit systems are down sharply given so that many people have been working from home and avoiding closed-in spaces this year. A December 6 NYT article reported that New York City’s transit authority forecasts a $6.1 billion deficit next year; Boston’s is looking at a $600 million budget hole, and Chicago’s shortfall is pegged at $500 million.

States may also have to cut Medicaid services and healthcare benefits because their costs have risen as enrollment for the fiscal year ending September 2021 is expected to jump 8.2%, a November 27 WSJ article reported. Medicaid represented about 30% of states’ fiscal 2018 budgets.

(2) Payroll cuts underway. While payrolls in the private sector increased by 344,000 in November, government payrolls fell by 99,000 (Fig. 7). Since bottoming in April, private payrolls have rebounded 12.7 million. Government payrolls have suffered a double dip this year. They dropped 1.4 million from the start of the year through May. Then government payrolls increased 752,000 through August, only to continue falling by 585,000 through November. Year to date, private and government payrolls are down 8.1 million and 1.2 million, respectively.

For those on the government payrolls, cuts were larger at the state and local level. Federal government payrolls fell 86,000 in November and 264,000 during the three months through November. That compares to state and local payrolls’ decline of 13,000 and 321,000 over the comparable periods (Fig. 8). That has brought payrolls back down to levels last seen in June.

Prior to the GFC, state and local employment peaked at 19.8 million in August 2008, and it declined for the next 59 months before bottoming at 19.0 million. Only late last year did the number of state and local employees return to pre-GFC levels. If Covid-19-related cost-cutting ensues, expect states and local governments to be a continued drag on total employment and spending. Spending by state and local governments accounts for about 15% of US economic activity.

Disruptive Technologies: Quantum Chaos. The race to develop quantum computers heated up last week when Chinese scientists claimed to have built a computer that has achieved quantum supremacy, which means it can operate faster than the fastest traditional supercomputer. Their triumph comes almost a year after Google claimed to have achieved quantum supremacy.

China’s news is disturbing on several levels. The Chinese government has been acting increasingly aggressively against the US and US allies in a number of areas. It certainly wouldn’t help the US position if China gained the technological upper hand. Quantum computers are expected to have the ability to unlock the computer security now commonly used by the Internet and traditional computers. Fortunately, scientists are working on a solution: quantum cryptography.

Let’s take a closer look at China and its latest move to dominate computing’s next era:

(1) A blunt warning. Over the last two years, we’ve related various stories about how the Chinese government under the leadership of President Xi Jinping was growing increasingly authoritarian and aggressive in its efforts to dominate both its own citizens and to grow more powerful than the US. Evidence came from the Department of Justice, which began prosecuting people delivering US government and industrial secrets to the Chinese government. The Chinese government has also behaved aggressively militarily toward neighbors Taiwan and India. And under Xi’s leadership, the government also punishes citizens, including those in Hong Kong, who advocate for democracy or criticize the government.

The latest warning about the Chinese government’s mal intent comes from John Ratcliffe, director of National Intelligence, in a contribution to the WSJ’s editorial pages last week. Ratcliffe’s article is shockingly blunt and eschews political correctness as it warns about the national security risk that the Chinese government poses to the US. Ratcliffe states: “The intelligence is clear: Beijing intends to dominate the U.S. and the rest of the planet economically, militarily and technologically. … I call its approach of economic espionage ‘rob, replicate and replace.’ China robs U.S. companies of their intellectual property, replicates the technology, and then replaces the U.S. firms in the global marketplace.”

While Russia and terrorism once were the main areas of focus for intelligence agencies, “China should be America’s primary national security focus going forward.” After laying out numerous examples of Chinese misdeeds, Ratcliffe concludes: “This generation will be judged by its response to China’s effort to reshape the world in its own image and replace America as the dominant superpower. The intelligence is clear. Our response must be as well.” The article is a worthy read.

(2) The battle for quantum supremacy. Chinese scientists have built a photonic quantum computer that they say has achieved quantum supremacy. Their achievement follows Google’s claim to quantum supremacy in October 2019.

China’s and Google’s quantum computers have different designs. The Chinese developed a photon-based quantum computer, called “Jiuzhang,” which carries out boson sampling, a specific type of calculation, a December 4 article in Phys.org reports. Google’s computer uses superconducting materials.

Here’s how the article explains the Chinese computer: “Boson sampling is a means for calculating the output of a straight-line optical circuit that has multiple inputs and outputs. It is carried out by constructing a machine in which photons are sent into a circuit in parallel, and once inside, are split by beam splitters. The split photons continue through the circuit, encountering mirrors and other beam splitters. Notably, if two photons happen to encounter the same splitter simultaneously, both unsplit photons will follow one of the paths away from the splitter. The process is repeated, resulting in a distribution of numbers that represent the network output. Conventional computers become bogged down very quickly when trying to calculate distributions of such a system. Jiuzhang was built to handle 100 inputs and 100 outputs using 300 beam splitters and 75 mirrors.” The researchers found that it took Jiuzhang approximately 200 seconds to provide an answer, far faster than the 2.5 billion years it would have taken the world’s fastest supercomputer.

(3) Not just a matter of ego. The fact that China has developed a quantum computer is problematic because it could mean the country is getting closer to cracking the encryption that protects all of our data. That’s bad news for public and private records as well as Internet communication. There’s also the potential threat that an adversary could be collecting encrypted data today with the intent of using a quantum computer in the future to access the data.

Fortunately, US scientists and national security types are working on a solution. They’re developing quantum-safe cryptography that they expect both government and private institutions will adopt. IBM recently announced that it’s offering “quantum-safe cryptography support for key management and application transactions in IBM Cloud.” The company aims to reduce the risk that hackers will retain encrypted data today and decrypt it later as quantum computing advances.

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Inflation Was Sooo 1970s!

December 09 (Wednesday)

Inflation I: Post-Pandemic Worry. I was an early believer in “disinflation.” I first used that word, which means falling inflation, in my June 1981 commentary titled “Well on the Road to Disinflation.” The Consumer Price Index (CPI) inflation rate was 9.6% that month. I predicted that Federal Reserve Chair Paul Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s, which he did.

Nevertheless, throughout my career, I’ve often fielded questions about the likelihood of a rebound in inflation from accounts who were worried that it just might make a comeback. After all, the Fed chairs who followed Volcker tended to favor stimulative monetary policies. This year, as a result of the unprecedented monetary and fiscal policy stimulus provided by governments around the world to offset the adverse financial and economic consequences of the Great Virus Crisis (GVC), I’m hearing more concern that inflation could come roaring back once the pandemic is over.

In this widely feared scenario, interest rates might soar. That would create all sorts of trouble. The mountains of debt accumulated by the public and private sectors would compound at a faster pace. The credit markets could seize up, causing a credit crunch and a recession, possibly worse than those of the Great Financial Crisis (GFC). Stock markets would fall into bear markets as earnings declined and valuation multiples tumbled. If inflation were to come roaring back, my upbeat Roaring 2020s outlook would be its biggest casualty.

Given the consequences of getting their expectations for inflation wrong, it’s no wonder investors are worried about this bad-case scenario even if they aren’t ready to do anything in response to it, other than talk about it more often. In any event, while I’m still a disinflationist, our YRI team is focused on watching out for signs of trouble on the inflation front. Before Debbie and I review what we are seeing, let’s briefly recount what happened during the Great Inflation of the 1970s.

Inflation II: A Brief History of Inflation in the 1970s. Almost everything that could go wrong did so back then. I reviewed what happened in my 2020 book titled Fed Watching for Fun and Profit. For starters, on August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold, which ended the Bretton Woods system that had kept the dollar’s value at a constant $35 per ounce of gold since the system was established in 1944. The value of the dollar in foreign exchange markets suddenly plummeted, causing spikes in import prices as well as the prices of most commodities priced in dollars.

During the summer of 1971, Nixon imposed wage and price controls. They didn’t work, and the controls were lifted in 1973. During 1972 and 1973, for the first time since the Korean War, farm and food prices began to contribute substantially to inflationary pressures in the economy. Also, there was a major oil price shock during 1973 and again in 1979 (Fig. 1).

Together, the two oil price shocks of the 1970s caused the price of a barrel of West Texas crude oil to soar 11-fold from $3.56 during July 1973 to a peak of $39.50 during mid-1980, using available monthly data (Fig. 2). As a result, the CPI inflation rate soared from 2.7% during June 1972 to a record high of 14.8% during March 1980. Even the core inflation rate (i.e., the rate excluding food and energy) jumped from 3.0% to 13.0% over this period as higher energy costs led to faster wage gains, which were passed through into prices economy-wide. During the 1970s, strong labor unions in the private sector succeeded in quickly boosting wages through cost-of-living clauses in their contracts. The result was an inflationary wage-price spiral (Fig. 3).

It’s my view that the 1970s were uniquely inflation prone. Paul Volcker stopped the inflationary wage-price spiral by tightening monetary policy significantly during the late 1970s and early 1980s, causing a severe recession. However, inflation continued to trend lower since then through today, mostly because of the four deflationary forces (i.e., the “4Ds”), which we have discussed many times along the way. (For a summary, see the excerpt from my 2020 book titled Four Deflationary Forces Keeping a Lid on Inflation.)

Inflation III: Will the 4Ds Drown in M1’s Tsunami? The question for us today is whether the 4Ds are still relevant or whether they’ve met their inflationary match in the extraordinary monetary and fiscal policy responses to the pandemic. The 12-month federal deficit rose to a record high of $3.3 trillion through October, while the Fed’s purchases of Treasury securities totaled a record $2.4 trillion over the same period (Fig. 4). Most of those expansions occurred since the week of March 23, when the Fed and the Treasury essentially embraced Modern Monetary Theory and morphed into “T-Fed” in response to the GVC.

Contrary to Milton Friedman’s claim that inflation is essentially a monetary phenomenon, it has remained subdued ever since the GFC notwithstanding the ultra-easy monetary policies of the major central banks. We soon should find out if money matters to the inflation outlook given that the GVC has resulted in ultra-easy monetary policies on steroids and speed combined! In the US, M1 has increased by $2.3 trillion since the last week of February to a record $6.2 trillion during the week of November 23 (Fig. 5). It is up an astonishing and unprecedented $498 billion during the latest week and 57% y/y! MZM and M2 are up 28% and 25% y/y (Fig. 6).

Our money is on the 4Ds. They should continue to keep a lid on inflation. Here is our current bottom lines on each of the 4Ds:

(1) Détente. In the grand sweep of economic history, inflation tends to occur during relatively short and infrequent episodes, i.e., during war times. The more common experience has been either very low inflation or outright deflation during peacetimes.

Periods of globalization follow wartimes. During peacetimes, national markets become increasingly integrated through trade and capital flows. The result is more global competition, which is inherently deflationary. The worsening Cold War between the US and China is a threat to globalization, but probably won’t heat up to the point of causing inflation now that a regime change is coming to Washington. In any event, China’s exports during November edged back up to the record high hit during July notwithstanding Trump’s trade war with that country (Fig. 7).

(2) Technological Disruption. Nevertheless, recent global trade tensions and the pandemic are likely to cause businesses to diversify their offshore supply chains away from China and to onshore more of them. That could be costly and inflationary. It could also be cost effective now that labor shortages attributable to global demographic trends are stimulating technological innovations in automation, robotics, artificial intelligence, and 3D manufacturing. These all enable onshoring and boost productivity to boot.

Nonfarm productivity jumped 4.0% y/y during Q3, the fastest pace since Q1-2010. We are expecting a secular rebound in productivity growth during the Roaring 2020s. So far, so good: The 20-quarter growth rate of productivity (at an annual rate) is up from a recent low of 0.6% during Q4-2015 to 1.7% during Q3 (Fig. 8). Jackie and I believe that the pandemic accelerated the pace of applying new technologies to boost efficiency and profit margins, as we will discuss more fully tomorrow.

(3) Demographics. Fertility rates have plunged below population replacement in recent decades around the world as urbanization has changed the economics of having children. Instead of being an important source of labor and elder care, as they were in agrarian communities, children are all cost in urban settings. Nursing homes have few vacancies, while maternity wards have plenty. Increasingly geriatric demographic profiles are inherently deflationary.

(4) Debt. During the 1960s through the 1980s, debt was stimulative; more of it stimulated more demand and added to inflationary pressures. Now, easy credit conditions aren’t as stimulative to demand as in the past because so many consumers have so much debt already. However, easy monetary conditions are a lifeline to zombie companies, enabling them to raise funds to stay in business and add to global supplies of goods and services, which is deflationary.

Inflation IV: By the Numbers. Now let’s review the latest inflation data around the world. Inflation remains remarkably subdued, as it has been since the mid-1990s. Consider the following:

(1) G7. The core CPI inflation rate among the seven major industrial economies has fluctuated in a flat range between a high of 2.2% and a low of 0.7% since 1997 (Fig. 9). The core rate was only 1.1% during October. Here are the latest core CPI inflation rates for the US (1.6%), Eurozone (0.2), and Japan (-0.4) (Fig. 10).

(2) China. While China’s economy has staged a significant recovery from its lockdown recession at the start of the year, the CPI inflation rate dropped from a recent peak of 5.8% during February to only 0.5% during October. The Producer Price Index was down 2.1% y/y during October.

(3) US. The pandemic has had a dramatic inflationary impact on only one component of the CPI: Used car and truck prices are up 11.5% y/y through October (Fig. 11). (They are up 14.4% in the PCED, or personal consumption expenditure deflator, measure.) This is a category with little weight in the CPI.

Rent of shelter has a much bigger weight, and its inflation rate has been falling sharply as a result of the pandemic because of two phenomena: people unable to pay their rent and renters becoming homeowners. This CPI item’s inflation rate is down from 3.4% at the start of the year to 2.1% during October (Fig. 12). It does include hotel and motel fees, which should reflate once a vaccine is widely distributed.

 Inflation V: Bonds, the Dollar & Commodity Prices. Notwithstanding all the above, the financial markets seem to be signaling that inflationary pressures are making a comeback of sorts. More likely, in our opinion, is that they’re simply signaling that the deflationary pressures initially unleashed by the pandemic are abating as the global economy continues to recover. Consider the following:

(1) Expected inflation rebounds. The 10-year US Treasury bond yield has been relatively flat just below 1.00% recently, while the comparable TIPS yield has been edging lower again following a smallish and shortish rebound from its fall earlier this year (Fig. 13). As a result, the yield spread between the two, which is widely used as a proxy for the average annual 10-year expected inflation rate, has rebounded from this year’s low of 0.5% on March 19 to 1.9% on Monday (Fig. 14).

(2) Copper is red hot. The price of copper has rebounded dramatically along with China’s economy as auto sales in China rose for a fourth straight month in October. The price of the red metal is up 65.5% since the year’s low on March 23 from $2.12 per pound to $3.51 on Monday (Fig. 15). The two previous rebounds that exceeded the current one since 2004 were not associated with rising CPI inflation.

Meanwhile, the ratio of the nearby futures prices of copper to gold continues to signal that the bond yield should be closer to 2.00% than to 1.00% (Fig. 16). There’s been a tight fit between the ratio (multiplied by 10) and the yield since 2004. Without the Fed’s open market purchases of Treasury notes and bonds, the yield would probably be higher, boosting the expected inflation proxy over 2.00%.

By the way, the reason why the copper/gold ratio tracks the nominal yield so closely is that the price of copper is highly correlated with the yield spread inflation proxy, while the price of gold is highly correlated with the inverse of the 10-year TIPS yield (Fig. 17 and Fig. 18).

(3) The dollar’s descent. Yet another interesting set of correlations is the ones between the inverse of the dollar versus the price of copper and versus expected inflation (Fig. 19 and Fig. 20). All three variables are consistent with rising inflation pressures. However, similar past episodes in recent years signaled that deflationary pressures were abating rather than inflation rebounding.

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The Myth of Icarus

December 08 (Tuesday)

Strategy I: Valuation Flying Closer to the Sun. The December 5 MarketWatch featured an ominous article about valuation titled “A popular stock-market indicator flashes red as Dow soars to records Friday.” It’s all about the Buffett Ratio, which the author defines as the market capitalization of the Wilshire 5000 to nominal GDP.

But that’s not the only valuation measure we see following in Icarus’s flightpath. If you’re not familiar with the story of Icarus, the Greek Mythology website tells it like this:

“Icarus was the son of the famous craftsman Daedalus in Greek mythology. His father was the creator of the Labyrinth, a huge maze located under the court of King Minos of Crete, where the Minotaur, a half-man half-bull creature lived. In order for the secret of the Labyrinth to be kept, Minos had then imprisoned Daedalus and Icarus in a tower above his palace. Daedalus managed to create two sets of wings for himself and his son, that were made of feathers glued together with wax. He taught Icarus how to fly and warned him not to fly too high, which would cause the wax to melt, nor too low, which would cause the feathers to get wet with sea water. Together, they flew out of the tower towards freedom. However, Icarus soon forgot his father's warnings, and started flying higher and higher, until the wax started melting under the scorching sun. His wings dissolved and he fell into the sea and drowned.”

The area where he fell is now called “the Icarian Sea,” while a nearby island is named “Icaria” and the island's airport “Icarus Airport.” That name can’t be good for attracting tourists into the airport.

The current altitude of the Buffett Ratio and other valuation measures has us all wondering how much higher they can go without risking a severe market meltdown, following in Icarus’s wax vapor trail. Let’s gauge these gauges of valuation:

(1) Buffett Ratio. Joe and I define the “Buffett Ratio” as “the total US equity market capitalization excluding foreign issues divided by nominal GDP” (Fig. 1). Both series are quarterly and not very timely. A very similar ratio can be derived by dividing the S&P 500 market cap by quarterly S&P 500 revenues, which also is not timely.

The timeliest Buffett Ratio of them all is the S&P 500 forward price-to-sales (P/S) ratio, which is available both monthly and weekly (Fig. 2 and Fig. 3). It’s currently right up there with Icarus, at 2.5 during both November and the last week of that month. Both are well above their previous record highs in early 2000, just before many high-flying technology stocks fell into a death dive.

(2) Forward P/Es. In our September 14 Topical Study titled “S&P 500 Earnings, Valuation & the Pandemic,” Joe and I observed: “However, this forward P/S ratio is very highly correlated with the forward P/E ratio, so it doesn’t really bring much additional value to assessing valuation (Fig. 4). And neither does the Buffett Ratio for that matter.”

The S&P 500 forward P/E rose to 22.1 during the first week of December. The air is getting thinner, but it’s still not as close to the Sun as it was at this ratio’s previous peak of 25.7 during the week of July 16, 1999 (Fig. 5). It’s getting very close to that level, however, which was followed by a significant and protracted meltdown.

The forward P/E of the S&P 500 Growth index heated up significantly from this year’s low of 17.7 during the week of March 19 to a recent high of 29.7 during the September 3 week (Fig. 6). It remained highly elevated at 27.4 during the last week of November but well below the record high of 40.9 during July 2000.

The justification for Growth’s current relatively high valuation is that bond yields are near record lows now, and certainly much lower than they were the last time that the P/E flew much closer to the Sun. To carry the Icarus metaphor further, perhaps the wax on this index’s wings is more heat resistant than it was in the past, so perhaps there’s room for Growth to fly higher without risking a meltdown.

The forward P/E of the S&P 500 Value index is cheaper than that of Growth, as it always has been, but not cheap by historical standards—a possible concern unless its wings, too, have extra-heat-resistant wax. Value’s forward P/E was 17.2 during the last week of November, around the upper end of its range since the early 2000s.

(3) Growth vs Value forward P/Es. Growth has outperformed Value so far this year until early November mostly because its forward earnings held up better during the lockdown recession and recovered strongly, as many companies in the Growth index actually benefited from the economic consequences of the pandemic (Fig. 7).

On the other hand, many companies in the Value index have been hard hit. However, they started to outperform during November on news that Covid-19 vaccines might be available for widespread distribution in coming months. If so, that would be a big shot in the arm for their forward earnings (Fig. 8).

Value stocks, particularly cyclical ones, tend to trade at relatively high forward P/Es when their forward earnings are most depressed. As their earnings recover, their P/Es tend to fall. That could happen again once most of us are inoculated.

(4) Normalized forward P/Es. Joe and I don’t usually look at forward earnings beyond the next 12 months, and neither does the stock market, in our opinion. However, the pandemic may be an exceptional period. The powerful rebound in stock prices since March 23 certainly suggests that the stock market has been looking at least six months beyond the current pandemic, anticipating that vaccines will end it and allow the economy to grow again. With the benefit of hindsight, the S&P 500 and Nasdaq certainly correctly predicted a V-shaped economic recovery so far.

These indexes continued rising in record territory during November on upbeat news about the vaccines. During the spring, Joe constructed the “normalized” S&P 500 P/E using 12-month forward consensus expected operating earnings per share ending 18 months from now and compared it to the one ending 12 months from now. The weekly versions of these series show (not surprisingly) that the former, normalized P/E tends to be lower than the standard one (Fig. 9). During the final week of November, the actual forward P/E was 22.2, while the normalized one was 20.4, i.e., not quite as near the Sun. Does that make you feel better about valuation?

(5) Here comes high-flying Tesla! Christmas is coming early for Tesla founder Elon Musk. He just leapfrogged Bill Gates to become the second-richest person in the world. Musk’s net worth has risen over $100 billion in 2020 alone.

Santa’s little helper in this case is Standard & Poor’s, which announced on November 16 that Tesla, Inc. (TSLA) will be joining the S&P 500 on December 21. The stock is up 46.8% in the 13 trading days since then through last Friday’s close and 616.0% ytd (Fig. 10). It’s having its very own Santa Claus rally. Tesla is now the sixth-largest publicly traded US company, with a market capitalization of $568 billion. It’s almost worth more than the entire S&P 500 Energy sector! Tesla currently trades at forward P/E and P/S ratios of 153.6 and 12.5, respectively.

Are we partying like it’s 1999 all over again? Tesla may be doing just that. In 1999, Yahoo surged 64% in the five trading days between the announcement that it would be added to the S&P 500 on November 30 and its inclusion after the close of trading on December 7. Yahoo! was eventually bought by Verizon in 2017 at a price approximately 75% lower than where the shares traded the day it was announced that the company would join the S&P 500.

Elon Musk is certainly a high-flyer. His SpaceX has had 24 successful rocket launches just this year. Musk is aiming to colonize Mars. The distance between Earth and the Sun is 91.6 million miles. Mars is 138.2 million miles from the Sun. Will he get to Mars before Tesla’s stock price gets too close to the Sun? Currently, Tesla’s stock price is closer to the Sun than SpaceX is to Mars. A visualization of all this would make for a good show at the planetarium!

Strategy II: Dividends as Rocket Fuel. During Q3-2020, the S&P 500 dividend yield fell to 1.75% (Fig. 11). That’s based on the four-quarter trailing sum of dividends, which was $487 billion for the S&P 500 through Q3. The 10-year US Treasury bond yield has remained below 1.00% since March 20.

Our Blue Angels analysis based on trailing dividends shows that the S&P 500 has been tracking dividends divided by a dividend yield of 2.00% since 2010 (Fig. 12). That’s been a remarkably stable trajectory for the S&P 500. However, this framework shows that if the market were discounting a dividend yield of 1.00%—i.e., closer to the current bond yield—the fair-value S&P 500 would be around 6000! Icarus, here we come!

As we have observed in recent weeks, the Fed seems to have been targeting the bond yield below 1.00% since late March by purchasing Treasury notes and bonds faster than the Treasury is issuing them. Here is an update of our discussion in the November 30 Morning Briefing:

From the last week of February through the last week of November, the Fed’s holdings of Treasury securities increased $2.1 trillion as follows by maturities: One year or less ($459 billion), 1-10 years ($1,300 billion), and over 10 years ($374 billion) (Fig. 13). From the end of February to the end of November, the Treasury increased its outstanding marketable debt by $3.7 trillion as follows: bills ($2,379 billion), notes ($925 billion), and bonds ($373 billion) (Fig. 14). In other words, the Fed financed 57% of the Treasuries financing needs across all maturities and purchased $376 billion more notes and bonds than were issued over that period!

I dubbed it the “Carrie trade” in the December 2 Morning Briefing. In our recent discussion of this trade, we observed that the bond yield should be trading around 2.00% but for the Fed’s intervention. Fortunately, the stock market seems to agree with us and is resisting flying as high as it might if stock investors decided to arbitrage the difference between the dividend yield and the bond yield.

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'There Will Be Growth in the Spring'

December 07 (Monday)

US Labor Market I: Not So Bad. November’s employment report, which was released on Friday, was mostly disappointing. The payroll measure of employment, which measures the number of jobs, rose only 245,000. The household measure of employment, which tallies the number of people with either a full-time job or one or more part-time jobs, fell 74,000. The unemployment rate edged down to 6.7%, but that was because 400,000 people dropped out of the labor force (Fig. 1). So far this year, the labor force has declined by 4.1 million, household employment has decreased 9.1 million, and unemployment is up 5.0 million.

Now for some good news: Excluding government, private payrolls rose 344,000, better than the comparable series reported by ADP (up 307,000 during November) (Fig. 2). (A decline of 86,000 in federal government employment reflected the loss of 93,000 temporary workers who had been hired for the 2020 Census.) Full-time employment rose 752,000 at the same time as part-time employment fell 779,000 (Fig. 3).

The really good news is that our Earned Income Proxy (EIP), which is highly correlated with private-industry wages and salaries in personal income, rose 0.6% m/m during November (Fig. 4). Remarkably, during October, the latter was only 0.4% below its record high during February! Our EIP suggests that wages and salaries rose to a record high last month, auguring well for consumer spending during the holiday season.

The clear message is that while the recovery in the labor market has lagged behind the recovery in overall GDP, both continue to regain ground lost during the lockdown recession of March and April. Indeed, the Atlanta Fed’s GDPNow tracking model showed real GDP up 11.2% during Q4 as of December 4.

Renewed lockdown restrictions in response to the third wave of the pandemic are likely to weigh on the economy in coming months, but we don’t expect a double dip. The economy could be booming next spring if enough of us are inoculated against the virus. As Chauncey Gardiner, protagonist of “Being There,” predicted: “There will be growth in the spring.” (“Being There” [1979] was a movie based on Jerzy Kosiński’s satirical novel [1970] of the same name. Chauncey, a literal-minded gardener, was mistaken for a great economic mind who imparted his wisdom in metaphors.)

US Labor Market II: Leaders & Laggards. Now let’s have a closer look at the employment data to assess the damage done by the March-April lockdown recession and the subsequent recovery through November:

(1) Household employment data. The household survey tracks the number of people who are employed (i.e., with one or more jobs) and the number unemployed (i.e., searching for a job). The sum of these two variables is the labor force. Everyone else is included as “not in the labor force.” The labor force peaked at a record 164.6 million during January (Fig. 5). It fell 8.1 million to 156.5 million during April. By November, it was back up to 160.5 million, which was still 4.1 million below the recent record high.

The number of workers with jobs peaked at a record 158.8 million during December; it then plunged 25.4 million through April. Over this same period, the number of unemployed workers jumped by 17.3 million from 5.8 million to 23.1 million (Fig. 6). Since then, employment has rebounded by 16.3 million through November but remains 9.1 million below its record high, while unemployment has dropped 12.3 million to 10.7 million. It remains 4.8 million above where it was at the start of the year.

Needless to say, the number of people counted as unemployed would be higher now if the labor force had fully rebounded. Instead, the number of working-age people (16 years and older) who are not in the labor force rose by 8.5 million from January through April to a record 103.4 million (Fig. 7). Since then, it dropped to 100.6 million during November, still 5.7 above where it was during January.

(2) Payrolls by industries. Nonfarm payroll employment peaked at a record 152.5 million during February. It then plunged 22.2 million through April. Since then through November, it has regained 12.3 million, but remains 9.8 million below its recent peak.

Real GDP of goods rebounded 61.0% q/q (saar) to a record high during Q3-2020. Manufacturing production has rebounded sharply by 19.1% from April through October, but remains 5.0% below its recent high (Fig. 8). Similarly, payroll employment in manufacturing has rebounded 764,000 over the past seven months through November, but remains 599,000 below the year’s high of 12.9 million during February (Fig. 9). Employment in construction has rebounded 804,000 over the past seven months through November and remains 279,000 below its 7.6 million high of the year during February.

Nongovernment employment in the service-providing economy is up 11.1 million over the past seven months through November, but remains 7.6 million below its record high during February (Fig. 10). As a result of the lockdown restrictions, this has been the first services-led recession in US economic history. While ongoing social distancing and renewed restrictions continue to weigh on many services establishments, many have been laggards in the economic recovery.

Debbie and I have been tracking the ones most at risk of layoffs, as their businesses have been disrupted by voluntary social distancing and governor-mandated restrictions. Here are this year’s payroll peaks, troughs, and November readings: retail trade (15.7 million, 13.3 million, 15.1 million), hotels & motels (1.7 million, 0.9 million, 1.1 million) air transportation (512,100, 378,600, 388,800), restaurants & other eating places (11.2 million, 5.8 million, 9.5 million), arts, entertainment & recreation (which includes amusements and gambling industries) (2.5 million, 1.1 million, 1.8 million), and temporary help services (2.9 million, 2.0 million, 2.6 million).

Altogether this year, their collective payrolls fell from peak readings of 34.5 million in February to 23.7 million during April, and rebounded to 30.6 million during October (Fig. 11).

US Labor Market III: Strong Income & Payroll Tax Receipts. Confirming that the labor market has been recovering quickly are the data series that Debbie and I track for US federal government receipts from individual income and payroll taxes (Fig. 12). We monitor the 12-month sums of both since they are very volatile on a month-to-month basis:

(1) The income-tax receipts series plunged from a record high of $1.76 trillion during March to $1.40 trillion during June. Then it rebounded to $1.65 trillion during July—a remarkably fast recovery that has held its ground notwithstanding a slight dip in October to $1.59 trillion.

(2) The payroll-tax receipts series is even more remarkable, showing no signs of rolling over. Instead, it’s been on a solid uptrend in record-high territory since the start of this year. That’s truly amazing.

(3) Perhaps the 12-month sums are smoothing out the downturn seen during the two-month lockdown recession of March and April. We asked Mali to run charts that compare this year’s actual (not seasonally adjusted) data to each of the past three years (Fig. 13 and Fig. 14).

There was a noticeable slowdown in income-tax receipts during the spring compared to the spikes during the previous three years at the same time, but the series jumped during the summer, inconsistent with the flattish seasonal pattern of the previous three years. That’s because the IRS extended the filing deadline from April 15 to July 15 this year, and tax returns are for 2019 incomes.

Meanwhile, the same analysis of the payroll-tax receipts shows that they’ve been following the seasonal pattern of the past three years, consistently exceeding the previous three series. In other words, there’s no sign that anything notable, like a pandemic and lockdown, even occurred this year.

(4) The data suggest that perhaps most of the job losses were borne by people in low-paying jobs that might have provided additional income through cash tips as well as people making a living from informal cash-only gig work (e.g., house-cleaning, odd jobs, child care, painting, carpentry, and plumbing) that they don’t report in income tax filings. Such workers were allowed to apply for unemployment benefits during the pandemic under the Coronavirus Aid, Relief, and Economic Security (a.k.a. CARES) Act’s expanded definition of “unemployed” and needn’t have been let go in the traditional sense.

Another factor that could have elevated payroll-tax receipts: The Paycheck Protection Program likely kept people on payrolls even though they didn’t go to work or worked from home.

US Labor Market IV: So How Many People Are Unemployed? The Bureau of Labor Statistics’ (BLS) monthly data show that the number of unemployed workers jumped from 5.9 million during January to a peak of 23.1 million during April, and then fell back down to 10.7 million during November. Yet the news media often states that 20 million people are out of work. That number comes from the weekly unemployment insurance claims that the BLS compiles from data provided by the states. The November 14 release shows that a total of 20.2 million persons claimed unemployment benefits in all state and federal programs.

Prior to the pandemic, there was a closer fit between the monthly unemployment series and the weekly one based on continuing claims reported by the states (Fig. 15). The pandemic seems to have distorted the weekly data, as Melissa discusses in the next section.

We are more inclined to go with the monthly data, which also have been infected by the pandemic but less so than the weekly data. The latest BLS employment report explains:

“Since March, household survey interviewers have been instructed to classify employed persons absent from work due to temporary, coronavirus-related business closures or cutbacks as unemployed on temporary layoff. As happened in earlier months, some workers affected by the pandemic who should have been classified as unemployed on temporary layoff were instead misclassified as employed but not at work. However, the share of responses that may have been misclassified was highest in the early months of the pandemic and has been considerably lower in recent months.

“For March through October, BLS published an estimate of what the unemployment rate would have been had misclassified workers been included among the unemployed. Repeating this same approach, the overall November unemployment rate would have been 0.4 percentage point higher than reported. However, this represents the upper bound of our estimate of misclassification and probably overstates the size of the misclassification error.”

US Labor Market V: Phony Claims. In a sweeping 387-page November 30 report titled “COVID-19: Urgent Actions Needed to Better Ensure an Effective Federal Response,” the US Government Accountability Office (GAO) charged that the Department of Labor (DOL) has “reported flawed estimates of the number of individuals receiving benefits each week throughout the pandemic.” That doesn’t surprise us. In our June 29, July 1, and September 30 Morning Briefings, Melissa and I concluded that DOL’s weekly unemployment insurance (UI) report was an unreliable indicator of the labor market as a result of the chaos caused by pandemic support programs.

In our previous writeups, we discussed our main area of concern in counting claims, specifically the federal government’s Pandemic Unemployment Assistance (PUA) program, which was intended to support the self-employed, gig workers, and others who would not typically qualify for benefits but who lost their income as a result of the pandemic. PUA was introduced on March 27 as a part of the CARES Act and will terminate at the end of this month. Previously, we suggested that the count of PUA recipients was likely grossly overstated due to reporting issues. We also cited a September 15 California Policy Lab analysis that questioned the reliability of the state’s UI data. In addition, we flagged fraud as a problem.

The UI section of GAO’s report emphasized the need for reliable data on new and continuing claimants in order to understand the roles that UI and PUA benefits play in the economy during the pandemic—and claimed that here DOL dropped the ball. In so many words, GAO stated that DOL has violated federal internal control standards stipulating that information be complete, accurate, and readily available. Maintaining its historical ways of collecting and reporting claims data during the pandemic has resulted in DOL’s inaccurate reporting about individual claimants, said GAO.

Further critiques of DOL’s UI data made in the report further confirmed our viewpoint, as follows:

(1) Multi-week claims. The report observed that the “number of weekly initial claims for UI benefits remains persistently high, though at a lower level than early in the pandemic.” However, “[i]nconsistent state reporting of PUA initial claims limits the conclusions that can be drawn about trends in that program,” the report stated. It added that the “number of initial claims is not intended to measure how many claimants were determined eligible to receive benefits or how many who filed for benefits earlier in the pandemic are still unemployed.”

GAO cited the very same California Policy Lab analysis that we previously covered, observing that “because some individuals remain unemployed for multiple weeks and can submit claims retroactively, the number of initial claims is not necessarily equivalent to the number of unemployed individuals receiving benefits each week.” Multi-week claims were especially prevalent early in the PUA program, as individuals accumulated weeks of unemployment when states implemented the new program, GAO noted.

(2) Not unique. PUA was one of the three federally funded temporary UI programs under CARES that expanded benefit eligibility and enhanced benefits. Federal Pandemic Unemployment Compensation allowed an additional $600 benefit through July 2020 that supplemented weekly benefits available under the regular UI and CARES Act UI programs. Pandemic Emergency Unemployment Compensation authorized an additional 13 weeks of UI benefits to those who exhaust their regular UI benefits through December 2020.

GAO further stated that the weekly DOL report represents continued claims submitted by states as the total number of people claiming benefits in all programs. However, GAO finds this characterization inaccurate, stating: “While DOL officials told us that they have traditionally used the number of continued claims to represent the number of individuals claiming benefits because they were a close approximation of each other, various issues arising from the pandemic have made this practice problematic.” In other words, DOL’s total is not an accurate summation of individual claims.

(3) Fraud schemes. Likely large fraud schemes in the UI programs further complicate counts as some states’ claims numbers may be inflated due to fraudulent claims. DOL has publicly released information on at least 14 ongoing investigations of UI fraud during the pandemic, concerning millions of taxpayer dollars potentially paid improperly, said the GAO. For example, the Maryland Department of Labor coordinated with the DOL and the US Attorney’s Office to uncover a scheme involving more than 45,000 fraudulent UI claims.

(4) Working on the problem. DOL is working with GAO to improve reporting, starting with a clarification in its weekly news releases that the numbers it reports for weeks of UI claimed do not accurately estimate the number of unique individuals claiming benefits. DOL agreed with the GAO’s recommendation to pursue reporting on the actual number of distinct individuals claiming UI benefits. But DOL did not agree with the GAO’s recommendation to do so retroactively. The GAO has maintained its stance.

Movie. “The Undoing” (+) (link) is a limited-series thriller on HBO starring Nicole Kidman and Hugh Grant about a perfect couple that’s undone by the murder of the mother of a student in their son’s private school in Manhattan. She is a clinical psychologist. He is an oncologist. There are lots of suspects, but the police charge the most obvious one with the crime. The Undoing is a stylish who-done-it with a great cast. It’s entertaining for sure, though not perfect.

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Delivering Vaccines During the Holidays

December 03 (Thursday)

Transports: Santa’s Helpers. With Covid-19 putting a damper on our willingness to visit stores, online shopping is soaring this holiday season. Cyber Monday spending rose 15.1% y/y, according to Adobe Analytics, which forecasts that online sales for the entire holiday season will jump 30% y/y. That’s good news for the transportation companies involved with getting that special package from the manufacturer, to the retailer, and into its designated stocking.

The S&P 500 Transportation Composite has risen 19.0% ytd through Tuesday’s close, trouncing the S&P 500 and all the index’s sectors except those heavily weighted with technology companies (Fig. 1). Here’s the performance derby for the S&P 500’s sectors ytd through Tuesday’s close: Information Technology (36.5%), Consumer Discretionary (30.2), Communication Services (20.9), Materials (16.6), S&P 500 (13.4), Health Care (8.3), Industrials (7.6), Consumer Staples (7.0), Utilities (-2.5), Real Estate (-4.8), Financials (-8.2), and Energy (-39.6) (Fig. 2).

Let’s take a look at what’s been driving the S&P 500 Transport stocks higher so far this year:

(1) Profits in the last mile. Propelling the S&P Transportation index are the S&P 500 Air Freight & Logistics stock price index, up 51.1% ytd, and the S&P 500 Trucking index, up 44.1%. They are sharply outperforming the solid ytd performance of Railroads (17.9%) and the horrible year the Airlines industry is suffering through (-31.7). Excluding the Airlines, the S&P 500 Transportation index would be up almost 30.0% ytd.

While all the members of the Air Freight & Logistics industry have beaten the S&P 500’s performance, FedEx, up 90.3% ytd, and UPS, up 43.5%, are the standouts. FedEx hit a new all-time high last week, while UPS hit its high in October and has fallen only 4.8% since then. FedEx received its most recent endorsement Tuesday from Barclays analyst Brandon Oglenski, who upgraded his (presumably 12-month) stock price target to $360 from $240 due to the company’s growth opportunities and the surge of e-commerce, a Street.com article reported Tuesday.

The challenge for the delivery companies this holiday season will be delivering the deluge of packages both profitably and on time given that their systems are already busy with the Covid-19 induced surge of shopping for everyday items. UPS “imposed shipping restrictions on some large retailers such as Gap Inc. and Nike Inc. this week,” a WSJ article reported yesterday. The temporary restrictions, which hadn’t been used in the past, will be lifted once more capacity in the company’s system becomes available, presumably in the next week. The shippers have been urging retailers to space out their promotions and start them earlier in October and November. Abercrombie & Fitch is telling customers to place orders by December 4 if they want them to arrive by Christmas using standard shipping.

In addition to watching how both companies perform during the holidays, the companies’ ability to deliver Covid-19 vaccines over the next year will come under a microscope. Delivery of Pfizer’s vaccine will be particularly tricky because it must be kept at temperatures of minus 70 to minus 80 Celsius. FedEx said it is working with the US Department of Health and Human Services, the US Department of Defense, and its healthcare customers on vaccine distribution plans as part of Operation Warp Speed. In a statement to Fox13 Memphis, FedEx noted its history of delivering flu vaccines each year and its various refrigeration facilities.

UPS, which is also working with Operation Warp Speed, put out a November 25 press release announcing that it has increased its US production of dry ice to 1,200 pounds per hour, which will increase the company’s supply-chain agility and reliability. “We have a great opportunity, and frankly a great responsibility to serve the world when a COVID-19 vaccine becomes available. When that time comes, our global network, cold chain solutions and our people will be ready,” said UPS CEO Carol Tomé on the October 28 Q3 earnings conference call.

The S&P 500 Air Freight & Logistics industry surprised industry analysts, who as recently as this summer expected 2020 to be a year of declining earnings. However, expectations reversed sharply in recent months, and now the industry is expected to see revenue growth of 10.5% and earnings growth of 18.9% this year (Fig. 3 and Fig. 4). Growth is expected to slow but remain strong in 2021, with revenue growth of 4.4% and earnings growth of 9.5% targeted. The industry’s valuation is a bit stretched, with a forward P/E of 19.3, which is near the highs of the past decade (Fig. 5).

(2) Santa needs truckers too. As noted above, the S&P 500 Trucking index, up 44.1% ytd, is also having a banner year, despite the October ATA Truck Tonnage Index reading. The seasonally adjusted index fell to 106.8 in October, down from 114.0 in September (Fig. 6). While the economy might be losing some momentum, ATA Chief Economist Bob Costello blamed the negative reading on atypical seasonality this year. Not seasonally adjusted, the index rose to 114.4 in October, up from the not seasonally adjusted September level of 111.4.

The trucking industry’s strength is backed by a number of other data points. For example, medium and heavy truck sales are 38.5% above their May low, even after dipping in November (Fig. 7). Also, trucking companies continued adding employees and average hourly earnings increased (Fig. 8 and Fig. 9). And prices for truck transportation of freight continued to improve in October’s producer price index (Fig. 10).

Old Dominion Freight Line’s CEO Greg Gantt seemed optimistic about the rest of 2020 and next year on the company’s October 27 Q3 conference call. “We believe the domestic economy and customer demand will continue to improve,” he said, noting that the company plans to invest in equipment and additional service center capacity and hire additional drivers and platform employees.

Old Dominion has performed better than the other S&P 500 Trucking industry member, J.B. Hunt. For the overall S&P 500 Trucking index, revenue this year is expected to rise only 1.0%, and earnings are forecast to drop slightly, by 0.6% (Fig. 11 and Fig. 12). Next year, results are expected to improve, with revenue growing a projected 10.4% and earnings expected to jump 24.7%. The industry’s main problem is the optimism priced into its forward P/E of 27.2, which is near recent all-time highs (Fig. 13).

(3) Rails rebound. Railcar loadings, based on a 26-week average, have jumped 10.4% from their lows this June, but they remain down 4.4% y/y (Fig. 14). The improvement is impressive given the sharp drop in oil and coal shipments (Fig. 15 and Fig. 16). Traffic was helped by a jump in auto transportation and continued improvement in trade. West Coast ports container traffic continued to edge higher in October after bottoming in June (Fig. 17).

Even so, analysts are expecting the S&P 500 Railroads industry’s revenue to drop 11.4% and earnings to drop 8.4% this year (Fig. 18 and Fig. 19). Investors, however, appear to have flipped the calendar to next year, when revenue is expected to increase 8.5% and earnings to jump 19.8%. The S&P 500 Railroad stock price index hit a new high on November 24, and its forward P/E, at 21.9, is near a 25-year high (Fig. 20).

(4) Airlines have room to improve. The one area in Transports that hasn’t priced in a full recovery is the S&P 500 Airlines index. It’s down 31.7% ytd but up 100.5% from its May 15 low (Fig. 21). After cratering through April, the number of passengers going through TSA checkpoints rose into the summer, but gains halted as Covid-19 cases surged in the western states. More than 1 million passengers flew during the Thanksgiving week, but that’s just half of the weekly passenger traffic seen at the start of 2020 (Fig. 22).

Analysts expect the S&P 500 Airlines industry’s revenue to fall 62.6% this year, resulting in losses (Fig. 23 and Fig. 24). Encouraged by the recent good news about vaccine developments, they’ve grown optimistic, projecting that revenue will surge 62.4% in 2021, but another loss is expected.

Disruptive Technologies: AI Becoming More Embedded. Melissa McCarthy’s movie “Super Intelligence” is sweet, has some chuckles, and takes you back to a time before masks. It also brings up the threat that artificial intelligence (AI) will break free of human control and threaten our existence. During the movie, an AI threatens McCarthy’s character by communicating with her through her cloud-connected appliances, her TV, and her Tesla—which the AI drives, of course.

AI is rapidly being imbedded in just about everything, including retailers’ chat boxes, CRM software, drug development programs, and autonomous vehicles. So far, humans appear to be retaining the upper hand. Or maybe that’s just what the AI wants us to think?!

I asked Jackie to take a look at some of the latest advancements in AI. Here’s what she found:

(1) CRM software gets smarter. Customer relationship software (CRM) has historically tracked sales leads and customers to help improve employees’ productivity. Add some AI capability, and that CRM software can now forecast customer demand, predict which customers will leave, and analyze e-mail messages before they’re sent to gauge the likelihood that they’ll be opened or otherwise acted upon. “IDC said AI CRM application revenue will reach $48.3 billion in 2024, up from $24.6 billion in 2020,” an informative November 20 WSJ article reported.

C3.ai hopes to tap into the excitement surrounding CRM AI, with expected IPO pricing that values the company north of $3 billion. The company also is selling an additional $100 million of stock at the IPO price to Spring Creek Capital and another $50 million to Microsoft, a November 30 TechCrunch article reported. Besides providing CRM AI, the company’s AI software has applications for predictive maintenance, fraud detection, sensor network health, supply network optimization, energy management, and anti-money laundering.

C3.ai was founded by Tom Siebel, who also founded Siebel Systems, the CRM software company that he sold to Oracle in 2005 for $6 billion. C3.ai is partnering with Microsoft and Adobe. They will compete with CRM industry leader Salesforce.com, which purchased Tableau last year for $15.7 billion to enhance its AI data analytics offerings.

(2) AI helping doctors. Eko Devices has developed a stethoscope that allows doctors to hear heart sounds, digitize them, and listen to a patient’s recordings over time to evaluate how they change, a November 9 WSJ article stated. The company claims to identify heart murmurs with 87% accuracy, compared to the 43% accuracy of using a traditional stethoscope. The private company has another product that combines a digital stethoscope with an electrocardiogram to detect atrial fibrillation and yet another that patients can use at home to monitor themselves and have a virtual meeting with the doctor.

(3) AI navigating the streets of San Fran. A number of autonomous vehicles got a major vote of confidence when given the ability to test cars on San Francisco’s roads without a safety driver. Cruise, the self-driving arm of GM, said it is allowed to test five vehicles on roads with speed limits of no more than 30 miles per hour and cannot drive on days with heavy rain or heavy fog. Waymo, AutoX, Nuro, and Zoox also have driverless permits. But Cruise says it will be the first to use the permit and put driverless cars on the street by the end of this year.

Waymo’s driverless cars have been tested in the Phoenix area since 2018 with preestablished riders of its ride-hailing service. In October, the company said its cars could pick up anyone looking for a ride. A remote team of Waymo employees watches real-time feeds of the vehicles’ eight cameras and can help if the software glitches.

(4) AI designing proteins. Alphabet’s DeepMind has a deep learning system, AlphaFold, that accurately predicts the structure of proteins. It matched the accuracy of other existing methods of mapping out a protein’s structure, but the DeepMind program did the job inexpensively and in a few days, not a few years. The problem is tougher than it sounds because proteins are made from amino acids that fold up with many twists and turns. The structure determines the function of the protein. And there are tens of thousands of different proteins in humans and billions of proteins in all living things.

“The breakthrough could help researchers design new drugs and understand diseases. In the longer term, predicting protein structure will also help design synthetic proteins, such as enzymes that digest waste or produce biofuels. Researchers are also exploring ways to introduce synthetic proteins that will increase crop yields and make plants more nutritious,” a November 30 article in MIT Technology Review reported. Next, DeepMind will study leishmaniasis, sleeping sickness, and malaria, because they all are linked to unknown protein structures.

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The Carrie Trade

December 02 (Wednesday)

Credit: The Bond Zombies. Carrie is a horror novel by Stephen King. It was his first published novel, released on April 5, 1974. It was turned into a movie in 1976 starring Sissy Spacek and John Travolta. Carrie is a misfit bullied in her high school and dealing with an abusive, religious fanatic mother at home. She finds that she can channel her angst into telekinetic powers, which she uses to exact revenge on her tormenters. Much blood is spilt along the way, including Carrie’s. In the final scene, she seems to rise from the dead but that’s just a bad dream.

The Bond Vigilantes have been buried by the Fed. However, in our nightmare scenario, they could rise from the dead like Carrie. It isn’t likely to happen if inflation also remains buried, as Debbie and I expect.

Meanwhile, there are other vigilantes in the financial markets. The Dow Vigilantes sent out a blood-curdling scream when the S&P 500 plunged 33.9% in 33 days earlier this year (Fig. 1). The Fed responded with QE4ever on March 23. The Dollar Vigilantes are threatening a crash in the currency if US fiscal and monetary policies continue to placate the Dow Vigilantes by swelling the federal budget deficit and the money supply (Fig. 2, Fig. 3, and Fig. 4). A plunge in the dollar could revive inflation and unleash a plague of Bond Zombies.

It’s hard to get a clear signal from the financial markets since their price mechanisms have been so distorted by the Fed and the other major central banks. The one clear signal may be coming from the commodity markets. Consider the following:

(1) CRB raw industrials. The CRB raw industrials spot price index continues to signal rebounding global economic activity (Fig. 5). It is highly inversely correlated with the trade-weighted dollar. The rising CRB index is bullish for the Emerging Markets MSCI stock price index, the Australian and Canadian dollars, and the S&P 500 Materials sector. (See our Market Correlations: CRB Raw Industrials Spot Price Index.)

The CRB index is also highly correlated with expected inflation as measured by the yield spread between the 10-year nominal Treasury bond and the comparable TIPS (Fig. 6). This spread has rebounded from this year’s low of 0.50% on March 19 to a range of 1.6%-1.8% in recent weeks.

(2) Copper. The price of copper is one of the 13 components of the CRB raw industrials spot price index (Fig. 7). (Petroleum and lumber products are not included in the index.) The copper price has been leading the overall CRB index higher since this year’s bottom. On Monday, copper closed at the highest price since January 2, 2014. Driving the price of the red metal higher has been China’s M-PMI, which has recovered solidly over the past six months through November (Fig. 8).

(3) Copper/gold ratio. When we multiply the ratio of the nearby futures prices of copper to gold by 10, the resulting series has shown a remarkably close fit with the 10-year Treasury bond yield since 2004 (Fig. 9). The ratio currently suggests that the bond yield should be closer to 2.00% than to 1.00%. As we discussed on Monday, the yield has remained under 1.00% since March 20, as the Fed has been buying Treasury notes and bonds faster than the Treasury has been issuing them.

That’s the “Carrie trade.” As long as it continues, the Bond Vigilantes will remain buried.

US Economy: The Public Pension Crisis. Only about half of the $9 trillion in state and local public pension entitlements is funded, according to the Fed’s Financial Accounts of the United States (Fig. 10). That means that states and municipalities do not have enough funds set aside to pay for all of the benefits accrued to public workers when they retire.

The problem is not new. During Q2-2020, 48.3% of public pension liabilities were unfunded (Fig. 11). This percentage has been quite stable around 50.0% since 2009. However, the Covid-19 pandemic has significantly stressed state and local finances, which is likely to exacerbate the underfunding problem for public pension funds.

How big is the problem? The Fed’s data seem to answer that question quite well. However, the exact level of US public pensions’ collective underfunding is hard to gauge but might be anywhere from $1.6 trillion to $6.0 trillion, observed a 2019 Reason Foundation article. That’s because the gap between the present value of plans’ liabilities (measured as the benefits promised to retirees) and plans’ assets (including stocks, bonds, and other investments) depends on various complex actuarial assumptions. Those include the discount rate used to calculate the liabilities and the rate of return used to project growth in assets, among others.

The Pew Research Center estimates that the aggregate funding gap for just the state pension plans will be about $1.4 trillion for 2020. The latest analysis of the most recently available full-fiscal-year data from Pew found a pension funding gap for the 50 states during 2018 of $1.2 trillion. Such a big gap may not be quite as scary as it looks, observed a 2019 Brookings report. The gap need not be reduced to zero for funds to remain viable, just to a level that can be sustained by municipal cash flows.

If the funds are not available to meet beneficiaries’ entitlements, then either catch-up employer contributions or reduced employee benefits would be necessary in the absence of external sources of funding. However, higher contributions or reduced benefits is not really an either/or decision. In many states, paying out public pension obligations is regarded as “sacrosanct,” as an article in the April 2 New York Times put it. So to meet higher contribution targets while staying on budget, states must either raise taxes or cut government programs. The only other solution is for the federal government to bail out the states, a highly politically charged concept, as we discuss below.

Fortunately, the deeply underfunded status of many public pension plans could be manageable and even avoidable if financially sound funding policies are implemented. Unfortunately, many states got into the public pension mess because they have mismanaged their plans due to political pressures. Consider the following:

(1) Funding status varies by state. State and local government pension plans support more than 21 million participants in more than 5,500 plans, according to data cited in an article from The Urban Institute. State and local government pensions account for 19% of total retirement saving assets. About 90% of members and 82% of assets are in state-administered plans, partly because many local government employees are covered by state plans.

Pew’s analysis of 2018 data linked above measured whether state plans are making enough contributions to reduce debt if plan assumptions are met (see Pew’s table here). The researchers found that if state plans achieve their average 7.2% annual investment return targets, only half of them would continue to reduce pension debt and improve funding levels. Pew observes that just seven states are at least 90% funded (ID, NE, NY, SD, TN, WA, and WI), while nine states are less than 60% funded (CO, CT, HI, IL, KY, NJ, PA, RI, and SC). South Dakota is in the top position at 100% funded, followed by New York at 98.0%. New Jersey is the worst on the list, with a funded ratio of just 38.4%. Illinois is not far behind at 39.0%.

(2) Those managed well manage well. The plans that have adhered to consistently sound funding policies are the most fully funded, according to Pew. Best-practice funding policies include the following: lowering investment return assumptions to allow for a better determination of future potential funding shortfalls, adopting employee cost-sharing policies to lower cost variability, and implementing pension stress-testing to assess potential shortfalls.

Plan designs also make a big difference to funding status. These are different across states, but most states provide some form of defined benefit plan that promises a lifetime annuity for retirees, observed the Tax Foundation in an April 15 note. That means that every new teacher, firefighter, and other public worker hired adds to public pension liabilities for a lifetime! Some states have recently transitioned to a defined contribution plan for new employees whereby employees control their investments and the upfront employer contributions are funded by the state, while others have shifted to a hybrid plan, wrote the Tax Foundation.

(3) How we got here. Unions often have pushed for increased pension benefits, explained an article on The Conversation website written by a public policy professor at the University of Virginia. Constrained by budgets, state lawmakers often have failed to contribute enough funds to meet future obligations, favoring other spending programs. Often, the first item cut from budgets has been the state pension contribution because doing so has few political consequences. To justify the inadequate contributions, pension plan sponsors often have bumped up their return targets to unrealistically high levels, the article observed. Other key assumptions—like the longevity of retirees and future costs of living—also have been adjusted unrealistically to justify lower contributions.

Risky return targets have led pension plans to acquire risker investment classes, the Urban Institute article highlighted. Corporate equities have increased as a share of pension assets to roughly 60% of total investments, on average, since the mid-1990s. Recent years have seen pension plans’ holdings of alternative investments—such as private equity, hedge funds, real estate, commodities, and other potentially risky asset classes—increase too.

States’ pandemic-related revenue declines and expenditure increases will likely make meeting their expected annual contributions to pension programs even more difficult. Moody’s Investors Service estimated as of early April that US public pension plans were on pace for an average investment loss of about 21% for the fiscal year ending June 30, according to Pensions & Investments. Plans’ investment performance mostly recovered by the end of June, according to an August 2020 Pew analysis. It found, however, that the typical pension fund still fell short of expected market returns for the 2020 fiscal year.

(4) Federal bailout up for discussion. If pensions can’t meet their return targets, can’t reduce future benefits owed because they are “sacrosanct,” and are unwilling to meet the appropriate level of contributions due to budgets, then only external funding can save the day. But whether it does is a matter of politics. In late April, President Trump tweeted: “Why should the people and taxpayers of America be bailing out poorly run states (like Illinois, as example) …? … I am open to discussing.” Five GOP senators agreed with the President’s suggestion that the federal government should not provide aid to the states hard-hit by the pandemic in April 30 letter. “We believe additional money sent to the states … will be used to bail out unfunded pensions, reward decades of state mismanagement, and incentivize states to become more reliant on federal taxpayers,” they said.

Those comments came on the heels of Senate Majority Leader Mitch McConnell’s April 22 comment that struggling municipalities should “use the bankruptcy route.” Later in the day, McConnell told Fox News that the federal government is “not interested in solving [state] pension problems for them,” according to Politico. In response, New Jersey’s democratic Governor Phil Murphy told CNBC: “The alternative is we will gut the living daylights out of the very services that our folks now are desperately relying upon.”

(5) Who is entitled to have a pension? The Great Virus Crisis will not be the last challenge to public pension funding status. That’s especially true given that the aging population will pressure plans’ cash flows. Less active workers will contribute to plans to support the increased share of retirees on the public pension payroll.

The Federal Reserve’s Distributional Financial Accounts (DFAs) show that the Baby Boomer generation holds the largest share of private and public pension entitlements (54.1%), followed by Gen X (28.9), the Silent Generation (9.6), and Millennials (7.4) (Fig. 12). We wonder whether Millennials are less interested in pension-providing state jobs than Boomers have been or whether plan sponsors are offering less attractive entitlement packages to more recently hired workers.

By the way, public and private pensions are largely held by middle-income groups in the 50th to 99th percentile. This cohort currently holds about 90.0% of pension entitlements, according to the latest data from the Fed’s DFAs (Fig. 13). That makes sense, since the folks who tend to earn pension entitlements (e.g., teachers, police officers, and municipal workers) also tend to fall in the middle to upper income groups. They tend to be college educated too (Fig. 14).

Experienced and educated working middle-to-upper class pension beneficiaries are unlikely to relent on demands for the future entitlements owed to them, so something will have to give. And that just might be Uncle Sam—or rather Uncle Joe. Forthcoming proposals from the incoming Biden administration, according to Biden’s website, include issues related to pensions, starting with passing the Butch Lewis Act. It would provide federally backed loans to underfunded multi-employer defined benefit pension plans, according to SHRM.

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What Could Possibly Go Wrong?

December 01 (Tuesday)

Strategy I: Too Many Bulls? Joe and I are still bullish, but so is everyone else. That has us wondering what will happen when something goes wrong, and what that something might be. As it turns out, making a worry list isn’t too hard at present. Topping the list: There are too many bulls. Consider the following:

(1) Bull-Bear Ratio. The Bull/Bear Ratio compiled by Investors Intelligence rose to 3.76 during the week of November 24 (Fig. 1). Readings above 3.00 sometimes provide sell signals, but they aren’t as trustworthy as readings below 1.00, which have always been great buy signals (Fig. 2 and Fig. 3).

The percentage of bulls rose to 64.6%, which is the highest reading since the final week of January 2018. The percentage expecting a correction was 18.2%, the lowest reading since December 2006! The percentage of bears was only 17.2%.

Just as upbeat are the comparable sentiment indicators compiled by the American Association of Individual Investors (Fig. 4). Their bull-bear ratio was 63.2 during the November 25 week with the bulls, at 47.3% and the bears at 27.5%. These are all frothy levels.

(2) The 200-day moving average. On Friday, the S&P 500 was 15.6% above its 200-day moving average (200-dma) (Fig. 5 and Fig. 6). That too is a frothy reading. Even frothier is the fact that on Friday, 90.7% of the S&P 500 companies were trading over their 200-dmas (Fig. 7). That’s the highest reading since July 2013 and a bearish signal for contrarians. The good news is that only 59.7% of the S&P 500 companies were up on a y/y basis, which is a bullish signal for contrarians (Fig. 8).

Here is the performance derby showing Friday’s readings for the S&P 500’s 11 sectors relative to their 200-dmas: Industrials (23.7%), Materials (23.0), Consumer Discretionary (19.4), Financials (18.6), Information Technology (17.8), Communication Services (17.3), S&P 500 (15.6), Consumer Staples (9.4), Energy (8.7), Health Care (7.7), Utilities (6.5), and Real Estate (5.1) (Fig. 9).

(3) Close to home. A few weeks ago, Joe and I moved our S&P 500 target of 3800 from the end of next year to the middle of next year. Last Tuesday, we raised our sights to 4000 by the end of 2021. Over the weekend, one of our accounts sent us an email wondering when we might raise our sights even higher to match the 4300-4500 range targeted by Goldman and JP Morgan. He sent us a link to a November 26 Barron’s article titled “The S&P 500 Could Jump 20% Next Year. Three Strategists Explain Why.” The plausible explanations for this outlook are “[v]accines creating near-term earnings momentum and low interest rates keeping valuations elevated.”

During most of the bull market since 2009, our projections for the S&P 500 were either the most bullish or among the most bullish of Wall Street’s investment strategists. Now others are getting ahead of us. We’ll let them have the glory. We would like to see fewer bulls.

Strategy II: The Worry List du Jour. So let’s consider what could possibly go wrong now that there is so much bullishness around about the market outlook. It might unnerve you to know that we find it easier to put together a worry list now than we ever have since the start of the bull market. That doesn’t mean that we are turning bearish. But it does mean that we see the risk rising that yet another panic attack will cause a stock market correction.

By our count, there have been 67 such occurrences since the start of the bull market. (See our Table of S&P 500 Panic Attacks Since 2009.) We haven’t tried to call many of them simply because that’s easier said than done, and we’ve viewed them as buying opportunities. Nevertheless, here are some possible causes of a prospective Panic Attack #68:

(1) Blue Wave makes a comeback. The Republicans seem to have held onto their Senate majority, though the final outcome depends on a couple of Senate seats in Georgia that won’t be decided until early January. On November 6, The Hill reported: “Democrats are pinning their hopes on being able to force a 50-50 Senate on a narrow, uphill path that requires them to win both seats in the typically red state. If Democratic nominee Joe Biden wins the White House [when the Electoral College meets], a 50-50 margin would hand them the majority because Vice President Kamala Harris could break a tie.” Electors from all 50 states will meet on December 14 to place their official votes for their states. On January 6, that vote count is finalized and election results are certified.

In politics, nothing is a slam dunk. By some estimates, Georgia is getting inundated with as much as $1 billion from the rest of the country to influence the two elections. What’s at stake is worth much more than a measly billion dollars. If the Republicans lose their majority, they would lose their committee chairmanships and thus the power to serve as a check on the Biden administration.

A November 8 WSJ editorial observed that in this scenario, “Bernie Sanders would run Budget, which means a squeeze on the Pentagon. Sherrod Brown of Ohio would run Banking, and Elizabeth Warren would run the financial institutions subcommittee, and torment bankers. Oregon’s Ron Wyden would run Finance. He supports the $4 trillion Biden tax increase plus he wants to tax even unrealized capital gains as ordinary income. That means taxing the appreciation in the value of assets even if they aren’t sold during the year.” On Saturday, November 7, Chuck Schumer (D-NY), the Senate Minority Leader, gloated: “Now we take Georgia, then we change the world. Now we take Georgia, then we change America.”

The January 5 runoff elections in Georgia could weigh on the stock market as they approach. If the Democrats pull upset wins in both, James Madison’s constitutional system of checks and balances will be broken for at least the next two years through the 2022 mid-term elections. The Democrats will have the unchecked power to raise taxes, increase federal spending, provide a universal basic income, nationalize healthcare, pack the Supreme Court, implement their Green New Deal, and so on.

(2) Fiscal stimulus cliff, evictions, and defaults. In yesterday’s Morning Briefing, Debbie and I argued that the economic recovery should continue even if Washington doesn’t provide a second round of fiscal support. A recent Deutsche Bank report cited in a November 27 Forbes article warned that the government needs to step in with another round of fiscal stimulus or risk derailing the jobs recovery. The report claims that “around 95% of GDP comes from counties with worsening Covid trends.” That sounds like a stretch to us, but this is a worry list after all.

Here’s more to worry about regarding the economy: A report issued this month from the National Low Income Housing Coalition and the University of Arizona estimates that 6.7 million households could be evicted in the coming months. That amounts to 19 million people potentially losing their homes, rivaling the dislocation that foreclosures caused after the subprime housing bust.

In addition, while the latest round of lockdown restrictions may not be as restrictive or widespread as the first round that caused the lockdown recession during March and April, they could nail the coffins of many small businesses that can no longer hang on. That could boost unemployment and increase defaults on bank loans.

(3) Dollar crashes. Almost every other prognosticator seems to agree that the dollar is going down and could crash. While we aren’t in that camp, the possibility deserves inclusion on our worry list.

The dollar has been trending mostly higher since 2011. It has given up its gains during the first three months of 2020 so far this year (Fig. 10). Why so? As we’ve often noted, there’s a consistent inverse correlation between the yearly percentage changes in the trade-weighted dollar and world non-gold international reserves (Fig. 11). The latter is up 5.2% y/y; that’s bearish for the dollar, but not overly so.

(4) Inflation and interest rates rise. Among the most unexpected and nightmarish scenarios would be a significant rebound in inflation, triggering a sharp rise in interest rates. While I’ve had lots of discussions about this scenario with our accounts, the conclusion is that it isn’t very likely to happen. But if it does, the resulting financial and economic dislocations could be severe.

For starters, it’s easy to calculate what rising interest rates would do to the federal government’s net interest bill. Over the past 12 months, it totaled $345 billion, implying that the government is paying less than 2% on its debt (Fig. 12). Here is what the net interest bill would be at 3% ($633 billion), 4% ($844 billion), and 5% ($1,055 billion). That’s based on the current amount of debt, which is projected to continue to grow rapidly in coming years.

Rising interest rates would likely cause a very severe stock market correction as valuation multiples get rerated to the downside. The correction could turn into a bear market if rising interest rates bury Zombie companies that have been allowed to live by refinancing their debts at record-low interest rates.

(5) Israel and Iran go to war. Well before the creation of Israel, the Sunnis and Shiites hated each other, but both hated Israel even more. In recent years, the Arab states dominated by Sunnis have come to fear Iran’s Shiite regime, which aspires to build a nuclear arsenal of bombs and missiles. So now the former has lots of security concerns about Iran in common with Israel, which Iran alleges was behind the assassination of Iranian nuclear scientist Mohsen Fakhrizadeh on Saturday. The November 29 New York Post reported that the executive action was carried out in Tehran by a hit squad of 62 people.

An opinion piece published by a hardline Iranian newspaper on Sunday reportedly suggested that Iran should attack the Israeli port city of Haifa if Israel indeed did carry out the killing of the scientist who founded the Islamic Republic’s military nuclear program in the early 2000s. That’s getting awfully close to home, since I was born in Haifa and still have relatives there. The Israelis may be attempting to change some facts on the ground before the Biden administration comes in with a more conciliatory approach toward Iran than that of Trump, who managed to orchestrate a rapprochement between Israel and some of the Sunni Arab states in the region in recent months.

A war in the Middle East or any escalation of tensions there that interrupts oil shipments through the Strait of Hormuz certainly could cause oil prices to soar, unleashing both inflationary and recessionary forces at the same time.

(6) Chinese bond market blows up. China’s roughly $15 trillion domestic bond market has been upset by the defaults of two state-owned borrowers. A November 26 WSJ editorial observed: “These companies held sterling credit ratings, seemed healthy, and investors thought the firms enjoyed implicit backing by the local governments. The defaults have caused bond yields to spike for similar firms as investors worry who might default next.” The editorial concludes: “Beijing’s gamble is that, with a sufficiently deft touch, the central government can harness bad debts in the cause of overdue financial reforms. Maybe it will work, but a controlled burn of the financial underbrush always carries the risks of becoming a forest fire.”

(7) 1999-style meltup sets stage for meltdown. Our biggest concern for some time during the current bull market has been a meltup, rather than a meltdown, simply because a meltup could set the stage for a meltdown. The market certainly has been melting up since this year’s low on March 23. The S&P 500 and the Nasdaq are up 62.6% and 77.9% since then through Friday’s close. By comparison, during the meltup of the late 1990s, the S&P 500 jumped 59.6%, led by an astonishing 234.7% increase in the index’s Tech sector, from its post-Russian-default low on August 31, 1998 through the March 24, 2000 peak. Over this same period, the tech-heavy Nasdaq soared by 231.0% (Fig. 13).

(8) Bottom line. All of the above suggests that the Santa Claus rally that often occurs during December might have occurred during November. The worry list might weigh on the market over the rest of this year and early next year. The good news is that 2020 is almost over.

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Dawn of a New Era?

November 30 (Monday)

US Politics: Same Old, Same Old. The S&P 500 is up 8.0% since Election Day on Tuesday, November 3 through Friday’s close (Fig. 1). By comparison, the index was up 2.4% over the comparable period following Election Day on November 8, 2016 through December 2, 2016 (Fig. 2). Back then, the stock market anticipated that the new incoming Trump administration would cut corporate taxes and reduce business regulations. This time, the market was relieved that the election campaign was over and that, while the results might be contested, Joe Biden’s margin of victory was sufficient to set the stage for a peaceful and orderly transfer of power. (However, as we previously observed: It ain’t over until it’s over. Trump’s legal team continues to contest the election and hopes to take their case to the Supreme Court.)

The rally also received booster shots on the following three “vaccine Mondays.” On Monday, November 9, Pfizer announced that it had a Covid-19 vaccine ready to go, though it requires extremely cold storage. A week later, on Monday, November 16, Moderna announced that its ready-to-go vaccine requires normal refrigeration. Both have remarkable effectiveness rates of over 90%. On Monday, November 23, Oxford-AstraZeneca also reported having a vaccine set to go, but the spotty disclosure of its data reduced the likelihood that it will be fast-tracked by regulators.

Last week, the market was also comforted to see 78-year-old President-elect Biden start to pick experienced people who’ve worked for Democratic administrations before to fill top positions in his administration. So far, it’s the same old crowd. He seems to be putting together a team of Baby Boom seniors consisting of establishment Democrats—such as John Kerry (76), who will be the special presidential envoy on climate change. It’s shaping up to be the same team that was rejected by many voters during the 2016 election and gave Trump his unexpected victory. Biden now also risks upsetting Progressives in his party, who clearly helped him to win and also clearly dislike establishment Democrats.

In other words, the Era of Deranged Partisanship isn’t over. However, that doesn’t rule out the possibility of the Roaring 2020s once we are inoculated from the virus. After all, the economy and financial markets have done well over the years despite Washington’s meddling, which has been slowed but not stopped by recurring political gridlock. As investors, we’ve learned to tune out the noise and focus on the signal, which has been mostly bullish. We are likely to continue to need this skill in coming years.

We really need term limits so that old politicians find something else to do besides making a lifetime career out of running our lives.

T-Fed: Still Alive and Well. While Trump’s supporters and Progressives aren’t happy, stock investors are turning downright giddy. On Monday, November 23, we learned that former Federal Reserve Chair Janet Yellen (74) will head the US Treasury—and therefore that Senator Elizabeth Warren (D-MA) won’t get that job, as was widely feared by the banking industry. The S&P Financials jumped 1.9% on the news, outpacing the 0.6% rise in the S&P 500 last Monday. The sector gained 4.6% last week, ahead of the 2.3% increase in the S&P 500.

Melissa and I anticipated that Biden would pick someone with experience at the Fed on their resume. We thought he would pick Fed Governor Lael Brainard (58) to expand the Democratic party’s pool of relatively young up-and-comers. Nevertheless, Yellen is a great choice given her extensive policy experience and her stellar credibility. When she was Fed chair, I often fondly called her the “Fairy Godmother of the Bull Market.” (See Chapter 7 of my book Fed Watching for Fun and Profit.)

If the Democrats don’t win both of the contested seats in Georgia’s runoff for the state’s two US senators on January 5, Biden will face lots of resistance in the Senate to his fiscal spending ambitions. In this case, he undoubtedly would like to work with the Fed on alternative means to finance his plans. Outgoing Treasury Secretary Steve Mnuchin moved last week to checkmate that option by asking for his money back from the Fed. The Coronavirus Aid, Relief, and Economic Security (CARES) Act gave Mnuchin $450 billion to give to the Fed as capital to be leveraged up to $4 trillion in loans to help businesses and municipalities survive the pandemic. Mnuchin claims that the funds are no longer needed, as evidenced by the fact that the Fed hasn’t used the funds so far.

Indeed, in its November Financial Stability Report, the Fed boasted that its ZIRP (zero interest-rate policy) and QE4ever (apparently unlimited quantitative easing) combined with pledges to backstop the credit markets have been so successful in opening up the credit markets that the need for emergency credit facilities has been greatly diminished. Consider the following related developments:

(1) Emergency liquidity facilities. Since the March 23 week through the November 25 week, the Fed’s holdings of securities has increased by $2.7 trillion to a record $6.7 trillion (Fig. 3). Over the same period, the Fed’s liquidity facilities rose by $465 billion to peak at $1.2 trillion during the June 3 week and fell back down by $636 billion to $530 billion during the November 25 week (Fig. 4). The latest peak during the Great Virus Crisis was $566 billion below the peak of the Great Financial Crisis during the week of December 17, 2008!

(2) Corporate issuance boom. Record-low corporate bond yields and soaring stock prices have resulted in $2.7 trillion in new corporate security issues over the past 12 months through October (Fig. 5). That’s the fastest pace since October 2007. Undoubtedly, some of the proceeds were used to refinance bonds issued at higher yields, while some will be used to increase liquidity. The big surprise could be that some of the funds might boost capital spending on new technologies and reshoring. Seasoned equity offerings by nonfinancial corporations rose to a record $125 billion over the 12 months through June (Fig. 6).

(3) Booming mortgage financing. Record-low mortgage rates have driven mortgage applications to purchase homes to new cyclical highs, enabling a remarkable housing rebound this year (Fig. 7). The sum of new plus existing home sales plunged 27% from February through May, and then soared 67% through October to 7.1 million units (saar), the highest since December 2005. It’s been downright breathtaking to watch.

(4) Record liquid assets. From the last week of February through the July 6 week, the pandemic of fear caused a mad dash for cash that boosted liquid assets in the US by $2.6 trillion to a record $16.3 trillion (Fig. 8). Notwithstanding the easing of financial conditions, this series was still near its record high during the November 16 week, signaling that liquidity preference remains elevated. Joe and I reckon that $1 trillion to $2 trillion of this liquidity could pour back into the economy and the stock market once widespread inoculation occurs, restoring a semblance of normality.

With Yellen running the Treasury Department and Powell heading up the Fed, “T-Fed”—i.e., what we call the unconventional alliance between the two agencies formed to counter the economic effects of the pandemic—undoubtedly will survive Mnuchin’s attempt to end it. The symbiotic relationship developed during the week of March 23 when the Fed implemented QE4ever on that Monday and the CARES Act was signed on Friday of that week. In effect, that marked the adoption of Modern Monetary Theory by fiscal and monetary policymakers in the US. The genie is out of the bottle, and Mnuchin’s parting shot isn’t likely to stop T-Fed from flourishing. No wonder the stock market ignored his lame-duck effort to reverse course.

By the way, put this in the “what-could-possibly-go-wrong?” file for the stock market: If the Democrats do win the two Senate seats from Georgia in January, the party will have a majority in the Senate. So Mitch McConnell (78) would be replaced by Chuck Schumer (D-NY; 70) as the Senate majority leader, who would get to appoint the chairs of the Senate’s various committees. Elizabeth Warren (71) would probably get the Finance Committee. Bernie Sanders (D-VT; 79) would get the “Make America Socialist Committee.”

The Fed: Left Hand vs Right Hand. Apparently, the Open Market Desk at the Federal Reserve Bank of New York (FRB-NY) hasn’t informed the members of the Federal Open Market Committee (FOMC) that it has been buying lots of Treasury notes and bonds to keep the 10-year Treasury bond yield below 1.00%. Consider the following:

(1) The left hand (FRB-NY). From the last week of February through the last week of October, the Fed’s holdings of Treasury securities increased $2.1 trillion as follows by maturities: One year or less ($421 billion), 1-10 years ($1,281 billion), and over 10 years ($351 billion) (Fig. 9).

From the end of February to the end of October, the Treasury increased its outstanding marketable debt by $3.4 trillion as follows: bills ($2,420 billion), notes ($735 billion), and bonds ($284 billion) (Fig. 10). In other words, the Fed financed 62% of the Treasuries financing needs across all maturities, and purchased $613 billion more notes and bonds than were issued over that period!

No wonder the 10-year Treasury bond yield has remained below 1.00% since March 20.

(2) The right hand (the FOMC). The minutes of the November 4-5 FOMC meeting didn’t mention any of this despite much discussion about the Fed’s asset purchases: “Participants noted that the [Fed] could provide more accommodation, if appropriate, by increasing the pace of purchases or by shifting its Treasury purchases to those with a longer maturity without increasing the size of its purchases. Alternatively, the Committee could provide more accommodation, if appropriate, by conducting purchases of the same pace and composition over a longer horizon.”

US Economy: Miracle on Ice. Before Q3’s real GDP was released, we increased our estimate for its growth rate twice, from 20% to 25% to 30%. It turned out to be 33.1% (saar), causing us to lower our projection for Q4 growth from 10% to 5%. We might have to raise that estimate based on the latest reading of the Atlanta Fed’s GDPNow tracking model:

“The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2020 is 11.0 percent on November 25, up from 5.6 percent on November 18. After this morning’s releases from the U.S. Census Bureau and the U.S. Bureau of Economic Analysis, the nowcasts of fourth-quarter real personal consumption expenditures growth and fourth-quarter real gross private domestic investment growth increased from 2.6 percent and 28.4 percent, respectively, to 6.2 percent and 46.7 percent, respectively …”

Got that? Consumer spending growth remains strong, at 6.2% following Q3’s 40.6% rebound. Just as impressive is that capital spending growth is currently running at a 46.7% rate, up from 21.8% during Q3. This miraculous recovery could stall as a result of the latest wave of the pandemic. (See our Covid-19: Cases, Hospitalizations & Deaths.) Debbie and I do expect a slower pace of growth next year but no double-dip, especially now that vaccines will soon be available. Once they are widely distributed, the economic recovery should get a big boost from pandemic-challenged services that will no longer be hindered by social-distancing restrictions. The travel industry is likely to be booming next summer. For now, consider the following upbeat indicators:

(1) Consumer spending. In current dollars, personal consumption expenditures rebounded 20.9% from April through October and are just 1.6% below the record high during January (Fig. 11). Consumer spending on goods continued to rise to record highs, as it has been doing since June, but spending on services, which continues to recover, is still 5.6% below its record high during February. Housing-related spending edged up to another record high during October (Fig. 12).

Here are the laggards among consumer services categories, showing how much they have recovered so far and how much they remain below their highs prior to the pandemic: gambling (351.5%, -12.0%), admissions to specified spectator amusements (587.5, -77.9), amusement parks, campgrounds, & related recreation (380.3, -55.6), air transportation (904.8%, -36.4%), and hotels & motels (159.6, -58.2). They all should recover fully once most of us are inoculated. (See our Personal Consumption Expenditures.)

(2) Personal income. What about the coming fiscal stimulus cliff? If another round of such stimulus isn’t provided to boost incomes, won’t consumer spending double dip soon? The point of the first round was to bolster incomes during the lockdowns until they ended, allowing employment and earned incomes to recover. That scenario continues to unfold, as government social benefits in personal income has declined from a peak of $6.6 trillion (saar) during April to $3.8 trillion during October (Fig. 13).

Meanwhile, wages and salaries in personal income has recovered nicely, and is only 0.9% below its record high during February! Also, while personal saving has dropped sharply from the lockdown recession during March and April, during October it was still $1.1 trillion (saar) above where it was at the start of the year.

(3) Capital spending. Nondefense capital goods orders excluding aircraft has rebounded 14% since April through October, matching previous record highs in this category, which is a good indicator of capital spending (Fig. 14). As noted above, record-low bond yields have led to record issuance of nonfinancial corporate bonds. Some of the proceeds clearly are boosting capital spending.

(4) Regional business surveys. Four of the five business surveys conducted by the Federal Reserve Banks are available through November. The averages of their composite, new orders, and employment series dipped slightly during November but remain relatively high, auguring well for November’s M-PMI survey (Fig. 15).

Movie. “Let Him Go” (+) (link) starts real slowly, but gets better along the way. It stars Kevin Costner and Diane Lane as a couple living on a ranch in Montana during the early 1960s with their son, his wife, and their grandson. After their son falls off a horse and dies, his wife remarries into the evil Weboy family. Lesley Manville shines as the family’s sinister matriarch Blanche Weboy. Fearing for their grandchild’s safety in his new home, the couple mounts a suspenseful rescue attempt.

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Bibbidi Bobbidi Boo

November 25 (Wednesday)

US Politics: The Fairy Godmother of the Bull Market Is Back. President-elect Joe Biden has picked Janet Yellen to be the US Treasury Secretary. She also happens to be the subject of Chapter 7, titled “Janet Yellen: The Gradual Normalizer,” of my book Fed Watching for Fun and Profit.

In my book, I wrote: “Early on when Yellen became Fed chair (and even when she was vice chair), I noticed that the stock market often would rise after she gave a speech on the economy and monetary policy. She was among the most dovish members of the FOMC, and she now ruled the aviary, which also included a few hawks. So I remained bullish on the outlook for stocks, anticipating that under her leadership, the FOMC would normalize monetary policy at a gradual pace. Indeed, I often referred to Yellen as the ‘Fairy Godmother of the Bull Market.’”

When she was Fed chair, Yellen suggested that Congress should give the Fed the power to buy equities. Now as Biden’s Treasury secretary, she will continue to wave her magic wand.

Energy: The Canary Has Left the Coal Mine. Since October 30, the S&P 500 Energy sector has outperformed all other sectors in the S&P 500 in dramatic fashion. The sector is up 32.0% just for the month of November through Monday’s close, soundly surpassing the 15.9% return of the next strongest sector, Financials, and trouncing the S&P 500’s 9.4% gain over the same period (Fig. 1).

The Energy sector’s strong November performance has been fueled by the rebound in Brent crude oil futures, which are up 23% so far in November and up 138% since bottoming this year on April 21 (Fig. 2). Despite the rebound, both the S&P 500 Energy sector and the price of Brent crude futures have had a miserable 2020, down 37.3% and 30.2%, respectively, ytd. But that’s much better than where they stood in the spring. And recent positive vaccine trial results, indicating that life—and oil consumption—might return to normal by late next year, have spurred a rally in the price of crude and in the S&P 500 Energy sector. They’ve been helped on the supply side by the crude oil production cuts by US oil companies and OPEC+, i.e., the original 13 OPEC nations plus Russia and nine other oil-producing nations. OPEC meets on Monday and Tuesday, when it’s expected to extend current production cuts into Q1.

The Energy sector bounce is also positive news for the S&P 500 because the sector has been the most sensitive on the downside—and the upside—to the economic impacts of the Covid-19 pandemic. The top-three-performing industries in November to date among those we follow all are in the Energy sector: Oil & Gas Exploration & Production (43.3%), Oil & Gas Equipment & Services (43.2), and Oil & Gas Refining & Marketing (41.3)—with Integrated Oil & Gas (27.0) not far behind. Bulls should keep in mind that there’s plenty of excess crude oil production capacity around the world. Anytime the price of oil rises north of $50 a barrel, we’d assume that producers will turn on the taps again, which should keep a lid on oil prices. Let’s take a closer look at why this canary has left the coal mine and started singing once again:

(1) Production slowing. In addition to good vaccine news, a reduction in production has helped oil prices. Some of that reduction has come from OPEC+, which first cut output by 9.7mbd, then reduced the cut to 7.7mbd. OPEC producers were expected to increase production at the upcoming meeting, but the second wave of Covid-19 has put the production increases on hold, a November 23 Reuters article explained.

At home, production also has fallen, to 10.8mbd in November, down from 12.7mbd last year (Fig. 3). Production fell as US companies responded to low oil prices by slashing capital expenditures, merging, and going bust. The number of US oil rigs has fallen from 670 at the start of 2020 to 231 during the November 20 week. The decline in oil rigs is even more dramatic if you look back to 2018, when there were 888 rigs, or to 2014, when the figure peaked at 1,609 rigs. Only since the number of rigs bottomed in mid-August has it started to increase ever so slightly (Fig. 4).

The drop in oil prices has prompted a slew of mergers as companies have looked to cut costs and enjoy the benefits that size brings. The largest deals include Pioneer Natural Resources’ deal struck in October to buy Parsley Energy for $4.5 billion, ConocoPhillips’ agreement to buy Concho Resources for $9.6 billion, Devon Energy’s $2.6 billion planned merger with WPX Energy, and Chevron’s acquisition of Noble Energy in October.

“Devon Chief Executive Dave Hager said the move will accelerate plans to ditch the shale industry’s old strategy of pursuing rapid production growth at all costs and focus instead on generating income that exceeds drilling expense and returning excess cash to shareholders,” a September 28 WSJ article reported.

Many of the companies with no dance partners and no access to capital have opted to file for bankruptcy protection. Law firm Haynes and Boone notes that the stress in the oil patch dates back to Thanksgiving 2014, when Saudi Arabia declared it would no longer restrict its production to prop up world oil prices. The price of Brent, then north of $100, has fallen more or less ever since, with Covid-19 being the latest straw. Since Thanksgiving 2014, there have been more than 500 bankruptcies of North American oil producers and oilfield services companies, according to a tally by the law firm. The pace of new filings has slowed to only three in October, but the firm expects bankruptcy filings to continue.

(2) Watching for signs of demand revival. US demand for crude oil and related products has improved in some areas since it was decimated by Covid-19. US consumers have returned to the roads since lockdowns were lifted. Demand remains somewhat depressed because of all the folks working from home instead of driving to the office. However, retail sales at service stations jumped to $434.9 billion (saar) in October, up from its low of $312.6 billion in April. October’s level is still 15.4% below December’s level (Fig. 5).

As driving increased and production decreased, gasoline inventories went from excessively oversupplied this summer to more normal levels this fall (Fig. 6). What has only modestly improved is demand for jet fuel, with consumers keeping their feet on the ground for the most part. The number of people passing through TSA checkpoints has largely plateaued since rebounding from an April low of 87,534 to the 650,000 area for most of the summer (Fig. 7). The number of fliers is spiking for Thanksgiving, with up to 2.4 million expected, but that’s still a 48% drop y/y, according to AAA figures cited by a November 22 CNN article.

Put it all together, and world production has fallen from a peak of 102.3mbd in Q4-2018 down to an expected low of 91.0mbd in Q3-2020, according to US Energy Information Administration’s November short-term energy outlook. The agency expects world production to rebound to 99.9mbd in Q4-2021.

World consumption has fallen from a peak of 102.4mbd in Q3-2019 to a low of 85.3mbd in Q2-2020. The Energy Information Administration estimates demand will rebound to 96.8mbd by the end of this year and 100.2mbd by the end of next. If those estimates are correct, demand surged past supply in Q3-2020 and is expected to continue to eclipse supply through the end of 2021.

(3) Keeping an eye on the new administration. Expected actions by the incoming Biden administration could both increase the supply of oil on the world markets and decrease domestic demand for oil. President-elect Biden is expected to call for the end of fracking on federally controlled lands, push for the US to rejoin the 2015 Iran nuclear agreement, and encourage the development of renewable sources of energy.

The immediate impact of the potential fracking ban on federal lands is limited by the fact that fracking companies aren’t expanding their drilling given the depressed price of oil. The US’s return to the 2015 Iran nuclear agreement would have a more dramatic effect. The US would require Iran to resume compliance with the agreement and to agree to strengthen and extend the agreement, a November 22 Reuters’ article explained. The nuclear deal aimed to limit Iran’s nuclear program and prevent the country from developing nuclear weapons in return for easing economic sanctions. If the deal were to be reinstated, Iran would be able to bring a million barrels per day or more of oil production back into the global markets. President Trump abandoned the Iran nuclear deal in 2018, finding fault with the deal’s lack of restriction on Iran’s ballistic missile program and its militia in Iraq, Lebanon, Syria, and Yemen.

(4) Keeping the other eye on renewables. President-elect Biden is also expected to put forward a clean energy agenda that could accelerate the shift to solar energy and electric vehicles, which would reduce demand for natural gas and crude oil products. The global shift to electric vehicles could reduce global oil demand growth by 70% by 2030, according to the Carbon Tracker, a think tank referred to in a November 19 Reuters article. The study assumed that electric vehicles would represent 40% of China’s total car sales by 2030 and 20% of India’s and other emerging markets’ car sales.

In addition to the move toward electric vehicles, a growing movement is exploring the potential of hydrogen energy. Siemens Mobility and Deutsche Bahn have started developing hydrogen-powered fuel cell trains that they plan to test in 2024. They hope the trains can replace diesel engines running on German local rails, a November 22 Reuters article reported. The new trains would be fueled within 15 minutes, have a range of 600 km, and have a top speed of 160 km/hour. European Union and national climate targets require that railroads be decarbonized over the long term. How quickly the world adopts these alternative sources of power will have a large impact on the crude markets and the Energy sector.

(5) Expectations behind the Energy sector. The S&P 500 Energy sector’s revenues per share have been falling for much of the past seven years (Fig. 8). The sector’s revenue is again expected to fall by 34.3% in 2020, but then to climb 14.1% next year (Fig. 9). Earnings have also been falling in recent years, with the sector expected to post a sharp decline this year of -108.4%, but then to enjoy a sharp rebound next year (Fig. 10). In a positive sign, earnings net revisions were positive in the last four months after many years of downward revisions (Fig. 11).

While the price of Brent oil may increase, the improvement likely will be capped around $50 a barrel, because anytime it revives beyond that level, producers are likely to flood the market with the additional oil production that’s being held back. And if that flood becomes a tsunami, expect the canary to stop singing once again.

Disruptive Technologies: Bright Advancements in Solar. Theoretically, solar energy just makes sense. Sunshine is free and widely available. It doesn’t require drilling or mining. No country owns it. And assuming that we figure out soon how to harness it where it is needed, solar energy doesn’t need to be transported. To create this utopian solar world, producing solar energy needs to become more efficient and cheaper. Fortunately, scientists are on the job. Here are some of the advancements they’re working on:

(1) Meet perovskites. Most solar panels are made using silicon, and while they are increasingly affordable, their energy efficiency of only 7%-16% leaves room for improvement. Some of the most advanced silicon solar panels enjoy energy efficiency of 25%-30%.

Enter perovskites, a family of crystals. When made into thin-film photovoltaic panels, the material “can absorb light from a wider variety of wave-lengths, producing more electricity from the same” amount of sunlight, an October 20 OilPrice article reported.

The US Department of Energy’s National Renewable Energy Laboratory is working with the Advanced Perovskites Consortium to develop perovskite solar cells. The Department of Energy’s Oak Ridge National Lab announced the discovery of “hot-carrier perovskite solar cells” that would push efficiency up to 66% by harnessing the heat that’s generated.

Here’s how the lab explained its discovery: “When sunlight strikes a solar cell, photons create charge carriers—electrons and holes—in an absorber material. Hot-carrier solar cells quickly convert the energy of the charge carriers to electricity before it is lost as waste heat. Preventing heat loss is a grand challenge for these solar cells, which have the potential to be twice as efficient as conventional solar cells. The conversion efficiency of conventional perovskite solar cells has improved from 3% in 2009 to more than 25% in 2020. A well-designed hot-carrier device could achieve a theoretical conversion efficiency approaching 66%.” There was no word on cost or availability of the new solar product. But if its broad adoption is feasible and economical, its promise is great, since it would reduce the number of solar panels needed to generate a given amount of energy.

(2) Solar panels without the sun. One of the largest problems with solar energy is how to deal with cloudy days when the sun doesn’t shine enough to produce the energy needed. So far, the solution has been to install large batteries to store energy for a cloudy day. But a new invention aims to harness ultraviolet (UV) light that’s available whether the sun is shining or not.

Aurora Renewable Energy and UV Sequestration (a.k.a. AuREUS) turns fruit and vegetable crop waste into an organic luminescent material that absorbs UV light. The material is mixed with a resin and lined with a solar film to create glass-like panels, a November 23 Fast Company article reported. Unlike traditional solar panels, this material theoretically could be used as the outside coating on walls or windows of an entire building. The resin could also be used in threads to create power-generating fabrics. Now wouldn’t that be convenient on the ski slopes: a jacket that creates its own heat?!

(3) Solving for energy storage. Scientists from Linköping University in Sweden have developed a new molecule that can absorb energy from sunlight and store it in the molecule’s chemical bonds, according to an August 31 report in Science Daily. Such a molecule could be used to collect and store solar energy for future use, once the scientists figure out how to release the stored energy. That’s what they’re working on now.

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The First Thanksgiving Of the Roaring 2020s

November 24 (Tuesday)

Thanksgiving I: Comparative Roaring ’20s. First and foremost, we at Yardeni Research are thankful to all of you for supporting our research service. We wish you a very healthy, safe, and fulfilling holiday with your families. We would invite you all to my house for the traditional feast, but New York’s governor has limited the number of people we can have in our home for the holidays to 10. Don’t forget to keep the windows open to get good fresh air circulation wherever you’re feasting.

This should be the first and last Thanksgiving requiring us all to socially distance from one another. Apparently, we will have a cornucopia of vaccines and treatments available for mass distribution early next year. If so, then 2020 may mark the beginning of the Roaring 2020s. Let’s briefly compare the current situation to the one before and during the Roaring 1920s:

(1) World War I. Recall that the years leading up to the Roaring 1920s included World War I from July 28, 1914 through November 11, 1918. The total number of military and civilian casualties in World War I was about 40 million, with estimates ranging from around 15-22 million deaths and about 23 million wounded military personnel—ranking World War I among the deadliest conflicts in human history.

(2) Spanish flu. That was followed by the Spanish flu pandemic from February 1918 through April 1920. It infected 500 million people—about a third of the world's population at the time—in four successive waves. The death toll is typically estimated to have been somewhere between 17 million and 50 million, and possibly as high as 100 million, making it one of the deadliest pandemics in human history.

(3) Depression of 1920–21. There was a severe deflationary recession in the US, the UK, and other countries beginning 14 months after the end of World War I. It lasted from January 1920 to July 1921. How depressing! The Great War (as it was called back then) and the pandemic of 1918-20 killed between 32 million and 72 million people. That was followed by a global depression (as recessions were called back then). No one at the start of the decade could have anticipated the technology-led revolution of the Roaring 1920s or the resulting prosperity of that period. Thanksgiving during 1920 must have been extremely depressing indeed.

(4) The high-tech revolution of the 1920s. As we reviewed in the August 11 Morning Briefing, the 1920s was a decade of amazing technological innovations. Some of them sped up activities that were too slow when done by horses and automated activities that required lots of workers. Assembly lines required fewer workers, and their productivity increased. The revolution allowed for a greater division of labor. The focus was mostly on brawn.

The automobile produced on assembly lines revolutionized transportation. The bulldozer did the same for construction. The standard of living improved dramatically for everyone as electric grids provided clean, bright light without emitting smoke. Urban water networks supplied clean water, and sewer systems removed waste without the pungent odors of chamber pots and outhouses. Telephones allowed people to converse with distant friends. National food brands proliferated, as did restaurants. Department stores and mail order retailers provided goods to a rapidly growing consumer market. Penicillin was discovered.

(5) The trade wars of 2018-19. The 2020s was preceded by a trade war between the US and China. President Donald Trump started and escalated it during 2018 and 2019. The Biden administration is likely to deescalate the resulting Cold War. Nevertheless, as a consequence of both ongoing tensions between the two countries and the pandemic, manufacturers are likely to move more of their operations and supply chains to the US. That could be inflationary. More likely is that some of the technological innovations discussed below will boost productivity and reduce energy and transportation costs.

(6) The pandemic of 2020. So far, the Covid-19 virus has killed 1.4 million people worldwide including 263,000 in the US. That’s a terrible outcome, but nowhere near the Spanish flu’s lethal toll. The biotech revolution is likely to deliver effective vaccines against the Covid-19 virus this time.

(7) The high-tech revolution of the 2020s. Today’s “Great Disruption,” as Jackie and I like to call it, is increasingly about technology doing what the brain can do, but faster and with greater focus. Given that so many of the new technologies supplement or replace the brain, they lend themselves to many more applications than did the technologies of the past, which were mostly about replacing brawn. Today’s innovations produced by the IT industry are revolutionizing lots of other ones, including manufacturing, energy, transportation, healthcare, and education. My friends at BCA Research dubbed it the “BRAIN Revolution,” led by innovations in biotechnology, robotics, artificial intelligence, and nanotechnology. That’s clever, and it makes sense.

The current pandemic seems to be speeding up the pace at which these and other technologies are proliferating. Debbie and I believe that productivity growth has been heading toward a secular rebound during the post-pandemic Roaring 2020s. Even before the Great Virus Crisis (GVC), companies had been moving to incorporate into their businesses a host of state-of-the-art technologies in the areas of computing, telecommunications, robotics, artificial intelligence, 3-D manufacturing, the Internet of Things, among others. The GVC is accelerating that trend as companies rethink how to do business ever more efficiently in the post-pandemic era.

(8) One major difference. The one major difference between the 1920s and the early 2020s (post the November 3 election) is the political persuasion of the presidency. During the 1920s, the White House was occupied by two very conservative Republican Presidents: Warren G. Harding (March 4, 1921–August 2, 1923) and Calvin Coolidge (August 2, 1923–March 4, 1929). Coolidge advocated smaller government and laissez-faire economics.

Andrew Mellon was secretary of the Treasury from March 9, 1921 through February 12, 1932. One of his achievements was the Revenue Act of 1926, which reduced the top marginal rate to 25%. In addition to cutting taxes on top earners, the act raised the personal exemption for federal income taxes, abolished the gift tax, reduced the estate tax rate, and repealed a provision that had required the public disclosure of federal income tax returns.

The incoming Biden administration has promised to raise numerous taxes including on corporations and on taxpayers earning more than $400,000 annually. In the November 16 Morning Briefing, we reminded the incoming administration that trickle-down economics works both ways: “Higher taxes on the rich and on corporations inevitably trickle down to everyone else.”

Thanksgiving II: Earnings Rebounding. Joe and I are thankful that the rebound in S&P 500 earnings that we expected during the second half of this year is occurring on schedule and turning out to be stronger than we had predicted. As a result, we are raising our 2020, 2021, and 2022 S&P 500 earnings-per-share estimates by $10 to $135, $5 to $160, and $5 to $185, respectively (Fig. 1). For comparison, the consensus forecasts of industry analysts during the November 19 week were $137.45, $168.42, and $192.07. We tend to be optimists, but industry analysts tend to be too optimistic. Here are a bunch more observations on the earnings front:

(1) Remarkable rebound in 2020 earnings estimates. The rebound in 2020 consensus earnings expectations has been remarkable under the (pandemic’s) circumstances. They plunged from $174.44 when the pandemic was declared by the World Health Organization (WHO) on March 11 to a low of $124.80 during the week of July 10. As noted above, the consensus estimate is now back to $137.45.

(2) Revenues remain on targeted track. Our earnings estimate for this year has rebounded too, from $120 to $125, and now to $135. However, we aren’t ready to raise our S&P 500 revenues-per-share estimates, which remain on target, in our opinion, at $1,340 this year, $1,450 next year, and $1,525 in 2022 (Fig. 2).

(3) Surprisingly strong upturn in consensus expected profit margin. The analysts’ consensus estimates for revenues and earnings can be used to determine their estimated profit margin for the S&P 500. For this year, it plunged from 11.8% when the WHO declared the pandemic to a low of 9.3% during the July 16 week (Fig. 3). It was back up to 10.0% during the November 12 week.

 Our upwardly revised earnings estimates and unchanged revenues estimates imply that the profit margin will be 10.1% this year (up from our previous estimate of 9.3%), rising to 11.0% next year and 12.1% in 2022.

(4) Higher S&P 500 stock price index target. Joe and I continue to expect that the S&P 500 will be making record highs in 2021, with our target remaining at 3800 by mid-2021. We are now also aiming for 4000 by the end of next year (Fig. 4). To get to 4000 by the end of next year, we are assuming that S&P 500 forward earnings will be at $190 per share, or $5 above our earnings estimate for 2022 because of the optimistic bias of analysts (Fig. 5). That implies a forward P/E of 21.1, about the same as the current forward P/E (Fig. 6).

(5) Q3 S&P 500 earnings estimates. Industry analysts do turn pessimistic during recessions. They turned too pessimistic about the outlook for Q2 and Q3 earnings after the WHO pandemic declaration on March 11, resulting in significant “earnings hooks” when the actual results were reported (Fig. 7 and Fig. 8). At the start of the Q2 earnings season in early July, they expected a 43.9% y/y drop. The result turned out to be down 32.2%. In early October, they predicted a 21.9% y/y drop for Q3. Instead, the drop was 7.2%. Their Q4 estimate is currently down 11.7% y/y.

(6) Actual Q3 S&P 500 revenues and earnings. Our weekly analysis of forward revenues, earnings, and the profit margin accurately anticipated the V-shaped recovery in all three variables during Q3 (Fig. 9). On a q/q basis, quarterly revenues increased 8.1%, and earnings rose 41.0%. The profit margin jumped from 8.9% during Q2 to 11.5% during Q3. These numbers suggest a strong rebound in productivity during Q3.

(7) Actual Q3 S&P 500 sectors’ revenues. Among the S&P 500’s 11 sectors, only Financials shows a q/q decline during Q3, and it’s a small one (Fig. 10). At or near record highs were Consumer Staples, Health Care, and Information Technology.

Here is the y/y revenues-per-share growth derby of the 11 sectors through Q3: Health Care (6.5%), Information Technology (4.8), Consumer Staples (2.7), Communication Services (0.3), Consumer Discretionary (-1.8), Utilities (-2.4), S&P 500 (-3.9), Materials (-4.6), Financials (-5.3), Real Estate (-8.4), Industrials (-15.1), and Energy (-33.2).

(8) Actual Q3 S&P 500 sectors’ earnings. For the S&P 500 sectors’ operating earnings, we have data provided by Standard & Poor’s rather than I/B/E/S. The former is more conservative in accounting for write-offs than the latter. Making new highs for earnings during Q3 were Consumer Discretionary, Consumer Staples, and Health Care (Fig. 11).

Here is the y/y growth derby for the operating earnings per share of the 11 sectors through Q3: Consumer Staples (20.2%), Health Care (14.1), Financials (12.7), Information Technology (7.8), Consumer Discretionary (5.1), Communication Services (2.1), Utilities (-3.6), S&P 500 (-5.1), Materials (-9.0), Real Estate (-42.7), Industrials (-54.3), and Energy (-125.8).

(9) S&P 500 forward earnings by sectors. All 11 S&P 500 sectors are contributing to the rebound in S&P 500 forward operating earnings (using I/B/E/S data), which bottomed during the week of May 28 and rebounded 16.9% since then through the November 12 week (Fig. 12). At new record highs are Consumer Staples, Health Care, Information Technology, and Utilities.

(10) S&P 500 net earnings revisions by sectors. The Net Earnings Revision Index (NERI) for the S&P 500 had been in increasingly negative territory during the first five months of this year, bottoming at -37.4% during May (Fig. 13). It has turned positive over the past three months through October. Ten of the 11 sectors, all except Real Estate, have turned positive.

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Broadening Bull Market

November 23 (Monday)

YRI Study. We have reprinted our study titled S&P 500, Earnings, Valuation, and the Pandemic as a paperback and e-book. Both are available at Amazon here. This study focuses on the S&P 500 stock price index, examining how it is determined by the earnings of the 500 companies that are included in the index and the valuation of those earnings by the stock market. You can find the other books in our “Predicting the Markets” series on my Amazon author’s page here.

 US Politics: T-Fed on the Rocks? On Thursday, Treasury Secretary Steve Mnuchin announced that he will not extend the Fed’s emergency lending programs that used funds provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act beyond December 31, when they are set to expire. The programs cover corporate bond buying, loans to state and local governments, and the Main Street Lending Program to small and medium-sized businesses. They represent an unconventional collaboration between the Treasury Department and the Fed, which effectively turned the two agencies into the “Bank of the United States,” or “T-Fed,” as Melissa and I call it. Now T-Fed’s days may be numbered, though it could be revived by the incoming Biden administration.

Mnuchin explained: “With respect to the facilities that used CARES Act funding (PMCCF, SMCCF, MLF, MSLP, and TALF), I was personally involved in drafting the relevant part of the legislation and believe the congressional intent as outlined in Section 4029 was to have the authority to originate new loans or purchase new assets (either directly or indirectly) expire on December 31, 2020. As such, I am requesting that the Federal Reserve return the unused funds to the Treasury. This will allow Congress to re-appropriate $455 billion, consisting of $429 billion in excess Treasury funds for the Federal Reserve facilities and $26 billion in unused Treasury direct loan funds.”

Congress and the Treasury expected that the Fed would leverage the $455 billion into about $4 trillion in loans. But the Fed never got around to doing so, not in size, as we discussed last Wednesday.

After Mnuchin’s announcement, the Fed issued a statement urging that “the full suite” of measures be maintained into 2021. On Friday, Fed Chair Jerome Powell issued a statement matter-of-factly acknowledging Mnuchin’s decision. Democrats were outraged. Mnuchin countered that he is “following the intent of Congress.” He added that “we don’t need to buy more corporate bonds. The municipal market is working, people are able to borrow lots of money in the markets.”

This development is likely to convince President-elect Joe Biden to appoint someone from the Fed to be his Treasury secretary—specifically either Lael Brainard or Roger Ferguson, both Fed governors, or else former Fed Chair Janet Yellen. Last Monday, Melissa and I wrote: “If gridlock frustrates Biden’s plans to increase government spending significantly along with taxes, it would be good for him to have a Treasury secretary who could press the right buttons at the Fed to get more monetary stimulus.”

Strategy: Energetic Value Investment Style. November has been a very good month for the Value investment style so far, led by the cyclical sectors of the S&P 500/400/600, especially Energy. They were inoculated from the Covid-19 virus on Monday, November 9 when Pfizer announced that it had developed a very effective vaccine. The bad news is that it has to be stored at minus 90 degrees Fahrenheit. The Value stocks got a booster shot a week later, on Monday, November 16, when Moderna announced that its vaccine required normal refrigeration.

More vaccines are on the way. Love him or hate him, President Donald Trump deserves credit for making this happen by spending $10 billion on Operation Warp Speed. According to the HHS.gov website: “November 12: HHS [US Department of Health & Human Services] and DoD [US Department of Defense] announced partnerships with large chain pharmacies and networks that represent independent pharmacies and regional chains. Through the partnership with pharmacy chains, this program covers approximately 60 percent of pharmacies throughout the 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands. Through the partnerships with network administrators, independent pharmacies and regional chains will also be part of the federal pharmacy program, further increasing access to vaccine across the country—particularly in traditionally underserved areas.”

After Pfizer’s November 9 news, everyone seemed to have concluded that the bull market in stocks would now broaden. Joe and I agreed. On November 10, we wrote: “Roaring 2020s, here we come! Yesterday morning, Pfizer and partner BioNTech announced that they’ve developed a Covid-19 vaccine that is 90% effective. Stock prices soared on the news, led by all the pandemic-challenged businesses. Value outperformed Growth and may continue to do so as the bull market broadens and continues to rise in record-high territory.” So far, so good.

Here are selected performance derbies since Friday, November 6—which might have marked the start of the broadening of the bull market led by Value and SMidCaps—through Friday’s close:

(1) S&P 500/600/400 Value vs Growth. The outperformance of Value has occurred across the spectrum of market-cap indexes: S&P 500 Value vs Growth (5.2%, -1.0%), S&P 400 Value vs Growth (9.3%, 3.4%), and S&P 600 Value vs Growth (12.6%, 8.2%) (Fig. 1).

(2) S&P 500 sectors. Cyclical sectors in the S&P 500 with high concentrations of Value stocks have done well recently: Energy (22.3%), Financials (8.9), Industrials (6.4), Real Estate (3.5), Materials (2.5), Consumer Staples (2.1), S&P 500 (1.4), Communication Services (-0.1), Consumer Discretionary (-1.2), Health Care (-1.2), Utilities (-1.3), and Information Technology (-1.3) (Fig. 2).

(3) S&P 500 industries. Of the 122 industries we monitor, there was an equal number—38—of big outperformers with double-digit gains and big underperformers with losses, all of less than 10%. Among the top winners were Hotel & Resort REITs (35.0%), Oil & Gas Exploration & Production (31.5), Retail REITs (22.9), Office REITs (18.9), Airlines (15.8), and Hotels, Resorts & Cruise Lines (15.5).

Among the big losers were Gold (-9.5%), Home Improvement Retail (-6.8), Systems Software (-5.6), Internet & Direct Marketing Retail (-5.3), Systems Software (-5.6), and Household Appliances (-4.3). (See our Performance Derby S&P 500 Sectors & Industries.)

(4) LargeCaps vs SMidCaps. The market broadened out, favoring SMidCaps, as follows: S&P 500 (1.4%), S&P 400 (6.0), and S&P 600 (10.3) (Fig. 3). That makes sense given the following rebounds in the forward earnings of the S&P 500/400/600 from their lows during May and June through the week of November 12: 17.0%, 34.9%, and 57.2% (Fig. 4).

(5) Stay Home vs Go Global. The vaccine news gave a big boost to Go Global relative to Stay Home. Here is the performance derby for selected country and regional MSCI stock price indexes in local currencies: United Kingdom (8.0%), Europe (6.4), Taiwan (6.3), Australia (6.2), EAFE (5.9), All Country World ex-US (4.7), Japan (4.6), All Country World (2.8), EM (2.4), United States (1.4), and China (-1.4).

(6) Better breadth. The breadth of the bull market is broadening. The S&P 500 is 13.3% above its 200-day moving average, with 86.3% of the companies trading above their 200-day moving average (Fig. 5 and Fig. 6). We recognize that this might actually be a bearish signal in the short run. However, only 58.1% of the companies have positive y/y price comparisons, which is relatively bullish (Fig. 7).

US Economy: Housing Is Booming. Debbie and I are still forecasting that real GDP will increase 5% (saar) during Q4-2020, 3% per quarter next year, and 2% per quarter in 2022 (Fig. 8). The Atlanta Fed’s GDPNow tracking model showed a gain of 5.6% during the current quarter as of Wednesday, November 18. On that day, the Census Department released a strong housing starts number, causing the model to boost residential investment from a gain of 19.5% to 23.2%, versus 59.3% during Q3-2020. That’s consistent with our view that the housing-related boom is a major source of growth. Here’s some more on this subject:

(1) Starts. While multi-family starts have stalled near their cyclical highs this year, single-family housing starts jumped to 1.18 million units (saar) during October, the best pace since April 2007 (Fig. 9). The same can be said about single-family building permits, which rose to 1.12 million units during October, the highest since March 2007 (Fig. 10). Needless to say, single-family building permits are a very good leading indicator for residential construction and completions of single-family homes (Fig. 11).

(2) New home sales. Another useful leading indicator for new home sales is the “traffic of prospective home buyers” index compiled by the National Association of Home Builders and available since January 1985 (Fig. 12). It matched its record high of 58 during January of this year and went on to rise into record-high territory to 77 in November, following a Covid 19-related slump.

(3) Existing home sales. Existing home sales don’t directly impact GDP, but they do drive housing-related retail sales. The pending home sales index compiled by the National Association of Realtors dipped from a record high 132.9 during August to 130.0 during September, but still suggests that existing home sales will continue to soar, as they did in October to 6.85 million units (saar), the highest since February 2006 (Fig. 13). Sure enough, housing-related retail sales edged up to yet another record high during October (Fig. 14).

Wealth Distribution: Has Wealth Inequality Gotten Worse? The Fed introduced its new Distributional Financial Accounts (DFA) in a March 2019 working paper. It’s a treasure trove of information on household wealth distribution in the US. Melissa and I are finding lots of data that can provide insights into several controversial issues about this subject. They’ve been controversial mostly because claims on all sides of the debate have been supported with debatable data, with much of it inferred from tax statistics rather than directly measured. The Fed’s quarterly database is more comprehensive, frequent, and timely than others.

Has wealth inequality worsened significantly in recent years, as claimed by Progressives? They claim that the gains in real GDP and productivity over the past three decades have mostly gone to the rich, significantly increasing the income and wealth of the top 1% of wealth owners, a.k.a. the “One Percent.” The Fed’s DFA show that wealth inequality has worsened, but not significantly. Let’s review the data:

(1) Net worth by wealth percentile groups. From Q3-1989 through Q2-2020, the total net worth of households increased 450% from $20.4 trillion to $112.1 trillion (Fig. 15). Over the same period, nominal GDP increased 242% from $5.7 trillion to $19.5 trillion. So the ratio of the two rose from 3.6 to 5.7 (Fig. 16).

Here are the net worth levels of the four percentile groups shown in the Fed’s DFA as of Q2-2020 along with their growth rates since Q3-1989: Top 1% ($34.2 trillion, 612%), 90-99% ($43.1 trillion, 466%), 50%-90% ($32.6 trillion, 350%), and bottom 50% ($2.1 trillion, 174%) (Fig. 17). So the top two groups (i.e., the “Ten Percent”) grew much faster than GDP, while the third group also outpaced GDP but less so, while the change in the bottom 50% was inconsequential in the wealth derby (Fig. 18).

(2) Percentage shares of net worth by percentile groups. Here are the latest percentage shares of total net worth of the four groups and their readings at the start of the data during Q3-1989: Top 1% (30.5%, 23.5%), 90%-99% (38.5%, 37.2%), 50%-90% (29.1%, 35.5%), and bottom 50% (1.9%, 3.7%) (Fig. 19). There is apparent wealth inequality, but it hasn’t gotten significantly worse. The percentage share of the bottom 50% has never exceeded 4.3%. The percentage share of the 50%-90% group has dropped from a high of 36.4% during Q1-2003 to 29.1% currently. The percentage share of the top 10% has increased from a low of 59.5% during Q3-1992 to 69% now (Fig. 20).

(3) Age and education matter. It should be needless to say—but it needs to be said—that people are not serving life sentences in their percentile groups. The bottom 50% includes lots of young single people with not much education. Those who become better educated as they get older are likely to move into the higher income and wealth percentile groups (Fig. 21 and Fig. 22).

Movie. “The Crown” (+ + +) (link) is wonderful docudrama about Queen Elizabeth. It provides a sweeping view of her life and times. So far, her reign has coincided with the careers of 14 UK prime ministers. She has been through lots of good and bad times for her nation as well as for the royal family. My wife and I are still binge-watching the fourth season, which is about the sad lives of Prince Charles and Princess Diana, as well as the challenges faced by Prime Minister Margaret Thatcher. The latest season also features the antics of two intruders. One was an unemployed fellow who entered Buckingham Palace without permission and managed to have a brief conversation with the Queen in her bedroom. The other was a mouse that raced across the floor of Windsor Castle during the third episode.

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Looking Beyond the Pandemic

November 19 (Thursday)

Consumer Discretionary: More Than Meets the Eye. On the surface, it looks like consumer-related stocks are having a tough November. The S&P 500 Consumer Discretionary stock price index is up 7.0% mtd, making it the second-worst-performing of the S&P 500’s 11 sectors. Blame it on Amazon and its immense influence on the sector. Yet many of the industries in the Consumer Discretionary sector have been having a market-beating month as investors embrace the wonderful news about vaccines’ efficacy and bet on a return to some semblance of normal before the end of next year. Let’s take a look beneath the surface:

(1) Consumer Discretionary lagging behind. The performance derby for the S&P 500’s sectors mtd through Tuesday’s close clearly shows the Consumer Discretionary sector at the back of the pack: Energy (25.7%), Financials (15.5), Industrials (15.3), Materials (10.9), Real Estate (10.5), S&P 500 (10.4), Information Technology (9.7), Health Care (9.2), Communication Services (8.7), Consumer Staples (8.6), Consumer Discretionary (7.0), and Utilities (4.5) (Fig. 1).

Dragging down the Consumer Discretionary sector’s performance this month have been Internet & Direct Marketing Retail (4.7%), Distributors (4.5), General Merchandise Stores (4.2), Household Appliances (3.3), Automotive Retail (2.9), and Home Improvement Retail (1.9). The biggest dragger in the sector is Amazon, a member of the Internet & Direct Marketing Retail industry. Amazon has fallen 2.4% this month, trimming its ytd gain to 69.7%. As Joe mentioned in yesterday’s Morning Briefing, Amazon accounts for 47% of the sector’s market capitalization as of Friday’s close. So its performance has an outsized effect on the market—and of course on its sector.

The other industries dragging down the sector may be indicating that the surge of Covid-19-induced buying to fix up homes and buy washing machines and used cars has peaked. Optimistic news about successful vaccines has given investors renewed confidence to rotate out of the winners of the past year and start buying some of the retail stocks hardest hit by Covid-19. This willingness to look into the future is impressive given that the recent surge of Covid-19 cases across the country could mean a tough holiday season for retailers. No holiday parties means there’s no need to run out and buy new clothes or lay out a holiday feast. But those willing to look six months out, when a vaccine should start having an impact on our behavior, have renewed confidence that consumers will start living the good life again.

Which leads us to the many industries in the Consumer Discretionary sector that are among the best-performing industries in the S&P 500 so far this month: Hotels, Resorts & Cruise Lines is up 27.4%, Casinos & Gaming (24.4%), Apparel Retail (22.6), Apparel, Accessories & Luxury Goods (21.2), and Automobile Manufacturers (18.2). Looks like investors think Americans are ready again to book hotel rooms, go gamble in Vegas, and buy new clothes before our trips.

(2) A split reaction to retailers’ earnings. Investors’ willingness to bet on a future where Covid-19 is vanquished was evident in the retail stocks’ reaction to earnings news. Kohl’s reported fiscal Q3 (ended October) same-store sales fell 13%, and at TJX the figure is a decline of 5%. Yet shares of Kohl’s rose 7.8% after its earnings announcement, and TJX shares jumped 3.8%. For the month of November through Tuesday’s close, Kohl’s shares are up 33.9% and TJX shares are 18.2% higher.

The two retailers reaffirmed their financial stability. Kohl’s had more than $1.9 billion in cash at the end of the quarter and announced plans to reinstate its dividend during the first half of 2021. Likewise, TJX ended the quarter with $10.6 billion of cash and announced that it too would reinstate its dividend, in March and at a 13% higher rate than it last paid out in March 2020. Home Depot reported a 25% jump in US same-store sales for its fiscal Q3, and Walmart boasted a 6.4% increase, but those retailers’ shares have gained only 1.1% and 6.8% in November.

(3) Pressure building for stimulus. Investors appear to be betting that Congress will extend employment benefits beyond those offered by the Coronavirus Aid, Relief, and Economic Security (CARES) Act through December 31. The US unemployment rate remains elevated at 6.9% in October (Fig. 2). And spending has been supported by government benefits, which surged from $3.16 trillion (saar) in February to a record-high $6.55 trillion in April and subsequently fell to $4.11 trillion in September (Fig. 3). Government subsidies have helped bolster personal income, which was up 6.2% y/y in September even as wages and salaries were up only 0.5% y/y (Fig. 4 and Fig. 5).

The call to extend benefits is getting louder from those outside the Beltway. JP Morgan CEO Jamie Dimon put it ever so colorfully in a CNBC interview Wednesday: “I know now we have this big debate. Is it $2.2 trillion, $1.5 trillion? You gotta be kidding me. I mean just split the baby and move on. This is childish behavior on the part of our politicians. We need to help the citizens of America.”

Walmart’s CEO Doug McMillon put it a bit more diplomatically in the company’s Q3 conference call: “As various governments around the country tighten up to help keep people healthy, it will be imperative that elected officials in Washington work together to deliver the help so many small businesses need to get through this next phase of the pandemic.”

And former Food & Drug Administration Chief Dr. Scott Gottlieb has urged Congress to get a deal done as well: “We need to think about what temporary sacrifices we’re willing to make, including economically, with Congress stepping in for another round of [the Paycheck Protection Program] to support businesses that are going to be shut over the next two to three months because this may be the last time we have to do it,” he told CNBC on Wednesday.

(4) A look at forecasts. Kohl’s shares are no longer in the S&P 500, but TJX is a member of the S&P 500 Apparel Retail stock price index, which, as we mentioned above, is up 22.6% in November (Fig. 6). Analysts expect the industry to report a 20.8% drop in revenue this year, but post a 24.7% surge in 2021 (Fig. 7). Likewise, the industry’s earnings are forecast to fall 93.8% in 2020, only to rebound by 1,402.5% next year (Fig. 8).

That’s quite different than the S&P 500 Home Improvement Retail industry, which after posting a 22.7% earnings increase this year is expected to only grow earnings by 2.8% in 2021 (Fig. 9). Walmart and Costco make up the S&P 500 Hypermarkets & Super Centers industry in the Consumer Staples Sector. The industry is expected to have steady earnings growth--7.7% this year and 7.0% in 2021—but even that will be eclipsed by the earnings of retailers that were hurt the most by consumers staying out of the stores due to Covid-19 (Fig. 10).

Health Care: Moving at Warp Speed. The news about the spread of Covid-19 has been awful of late, with record numbers of people catching the disease. But thanks to the CARES Act, the US government is throwing $2.2 trillion at this ginormous problem, and improvements in science and manufacturing hopefully will result.

The CARES Act funded the expansion of unemployment benefits and research efforts toward understanding, preventing, and curing Covid-19. Less discussed is the funding it’s providing to help expand the manufacturing needed to produce items related to healthcare and a Covid-19 vaccine for 300 million Americans.

The CARES Act gives $27.0 billion to the Department of Health and Human Services to fund activities that include developing and purchasing vaccines and therapeutics, according to a June 25 Government Accountability Office report. At least $3.5 billion of the funding is earmarked for the Biomedical Advanced Research and Development Authority (BARDA). Public Citizen does a nice job of breaking out what companies are getting what grants. As we mentioned in last Thursday’s Morning Briefing, Becton Dickinson received $42.3 million from BARDA to expand its production of needles and syringes as part of the program.

Here’s a quick look at some of the BARDA’s grants relating to the manufacturing of goods needed to fight Covid-19. They hopefully will strengthen the domestic production of pharmaceuticals for years to come.

(1) Lots of needles and vials needed. In addition to Becton Dickinson’s funding, the agency is also giving $20.7 million to Smiths Medical and another $53.7 million to Retractable Technologies to fund the expansion of manufacturing of safety needles and syringes.

Corning was granted $204.0 million to expand its domestic manufacturing of Corning Valor Glass tubing and vials/cartridges. And Si02 received $143.0 to develop/establish three US-based manufacturing systems for durable, high-performance glass/plastic vials.

BARDA has also focused on the materials going into the vaccines. It gave $31 million to Cytiva to expand the company’s manufacturing capacity for products used to produce Covid-19 vaccines. The products include liquid and dry powder cell culture media, cell culture buffers, mixer bags, and XDR bioreactors, an October 13 press release states. BARDA has awarded Snapdragon Chemistry $691,878 to help develop an “innovative continuous manufacturing platform to produce ribonucleotide triphosphates (NTPs), a critical raw material for Covid-19 vaccines that use messenger RNA technology,” a June 11 press release states.

(2) Gotta fill the vials. Vaccine developers typically hire their own fill finish facilities for their vaccines. But the US government is reserving capacity to ensure that Covid-19 vaccine producers have access to this capacity. It’s also giving them money to expand their capacity.

Ology Bioservices received $106.3 million from BARDA to reserve production capacity to fill and finish about 15.6 million vials. Grand River Aseptic was given $1.6 million to expand capacity for filling and finishing vaccines and therapeutics. And Thermo Fisher Scientific received $49.2 million to expand its US facilities designed to fill individual vaccine doses under sterile conditions at high volumes.

Emergent BioSolutions won a $628 million contract with the government, most of which will be used to produce Covid-19 vaccines through 2021 and $85.5 million of which will be used to expand Emergent’s vial-filling contract development and manufacturing capacity for vaccines and therapeutics.

Similarly, BARDA gave $264.7 million to the Texas A&M University System’s Center for Innovation in Advanced Development and Manufacturing to reserve vaccine production capacity through 2021 and to “more rapidly expand production capacity for vaccine manufacturing” at their Texas facility, a July 27 press release stated.

(3) Planning beyond Covid-19. With many US drugs and drug ingredients made in China and other countries, the US government seems focused on beefing up US production. As we discussed in the May 7 Morning Briefing, politicians on both sides of the aisle understand that the ability to manufacture drugs domestically is a matter of domestic security.

Some of the funds earmarked to bolster the US manufacturing of pharmaceuticals is coming from BARDA. The agency entered into a $354 million contract with Phlow Corp. to build a generic medicine and API plant in Richmond, VA and to supply Covid-19 treatments produced there. The deal can expand to 10 years and $812 million.

BARDA also gave Paratek $285 million to build a second supply chain to make Nuzyra, an antibiotic, in the US. Its current supply line is in Europe. The funding will also go toward studying whether Nuzyra can be used to fight anthrax infection. The five-year agreement requires the company to give the US Strategic National Stockpile 10,000 treatment courses of Nuzrya.

“[T]he drug maker will onshore production of Nuzyra's active pharmaceutical ingredient (API) from U.S.-sourced raw materials,” a June 8 article in Fierce Pharma reported. “The move to build its U.S. supply will come with ‘incremental costs’ of doing business, including higher wages and more stringent demands from BARDA, but Paratek is aiming to mitigate those new costs with a more streamlined production network.”

“‘We probably would not have been able to go to the U.S. based on the incremental costs unless we had this public-private partnership with BARDA,” CEO Evan Loh told Fierce Pharma.

Disruptive Technologies: The Power of mRNA. The Covid-19 vaccine news has been decidedly positive in recent days, leading to speculation that vaccines could be available on an emergency basis to healthcare workers in the next month. The success of the vaccines and their rapid development owes much to a new technology for making vaccines based on messenger RNA (mRNA). It’s a technology that could be used to develop other vaccines and is being explored as a way to treat cancers.

We’ve been encouraged by the development of mRNA vaccines since our March 5 Morning Briefing, in which we explained how the new technology worked: “Messenger RNA (mRNA) instructs our cells to make proteins. Moderna has used COVID-19’s genetic code to create an mRNA that will instruct our cells to make a small amount of COVID19 proteins. These proteins trigger the production of COVID-19-specific antibodies that provide immunity to the virus. Since the mRNA never goes into the nucleus of cells, there’s no concern about it changing the cell’s genome.”

And in our April 23 Morning Briefing, we noted that the mRNA technology could help develop vaccines for many different diseases besides Covid-19: “‘We call mRNA the software of life,’ Moderna CEO Stephane Bancel said in an April 3 MIT Management article. ‘You can copy and paste the information into a lot of drugs by using the same technology.’” That speeds up vaccine development and reduces costs, because the same manufacturing processes and facilities can be used for different vaccines.

The company is already testing several other preventative mRNA vaccines in human studies. One aims to prevent cytomegalovirus, a virus that causes health problems in babies, a November 17 WSJ article reported. Moderna and BioNTech, which is working with Pfizer on the Covid-19 vaccine, are independently working on applying the mRNA technology to treat cancer. BioNTech is focused on using it to treat breast, skin, and pancreas cancers. It would be nice for something miraculous to emerge from the Covid-19 nightmare.

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The Fed’s Third Mandate

November 18 (Wednesday)

Strategy: Tesla Gets The Green Light From S&P. Standard & Poor’s announced after Monday’s close that Tesla (TSLA) will be added to the S&P 500 index in the Consumer Discretionary sector before the opening of trading on December 21. The stock soared 8.2% on the news to close at $441.61 on Tuesday. The company’s shares are up 428% ytd. Its market capitalization of $412 billion makes Tesla the largest-ever addition to the index and ninth biggest company in the index today.

The last exciting index addition occurred in 1999, when Yahoo soared 64% in the five trading days between its announcement and inclusion in the index. A similar drag race for Tesla would propel it to the sixth spot in the S&P 500, ahead of Berkshire Hathaway and behind the FAAMG (Facebook, Amazon, Apple, Microsoft, and Google) stocks. However, it would represent only about 1% of the S&P 500 index by size. Here are a few other relevant consequences:

(1) MegaCap. Tesla’s size eclipses fellow Consumer Discretionary sector constituents and automakers Ford and GM, which are worth about $95 billion combined. Given Tesla’s heft, its addition will have an Amazon-lite effect on the sector. Amazon accounted for 47% of the sector’s market capitalization at Friday’s close. Its share would fall to 42% after Tesla’s addition. However, both companies would account for more than half, or 52% of the sector’s market cap.

(2) Impact on valuation, etc. The addition of Tesla to the S&P 500 won’t affect the index price on the day it is included because S&P’s divisor adjusts for index changes. However, the divisor is not used to adjust the S&P 500’s revenues and earnings, and subsequently its valuation ratios. When an incoming company’s valuation is higher than those of the index and the company it is replacing, then the index’s valuation rises. This is also true for the profit margin.

While Tesla’s large size and relatively high valuation makes the addition to the index a big deal, it actually will have little impact on the S&P 500 index’s revenue, earnings, and profit margin. Our back-of-the-envelope calculation suggests that Tesla will account for 1.3% of the S&P 500’s market cap but just 0.2% of its total forward earnings and 0.4% of its total forward revenues. Based on Monday’s close, this would cause the S&P 500’s P/E to rise 0.2pts to 22.2 and its price-sales ratio to rise 0.02pts to 2.51. Tesla’s relatively low forward profit margin of 6.6% reflects its roots as an auto manufacturer rather than a technology firm. That will cause the S&P 500’s profit margin to dip slightly, but so slightly that rounded to the tenth place it remains the current 11.3%.

(3) Prequel to the Roaring 2020s. S&P has not announced which company will be removed from the index. However, it traditionally has removed companies from the index due to market-cap size considerations. At present, there are four S&P 500 Energy firms in the five lowest market-cap companies in the index, each worth around $4 billion. The removal of one of them, particularly from the Oil & Gas Exploration & Production sub-industry (which has 10 companies in the index), would further alter the new-age versus old-economy makeup of the S&P 500 index—keying us up for a Hollywood-style movie ending, with Tesla’s addition just the prequel. In other words, with more fast-growing tech firms filing to go public, Tesla’s addition may herald more exciting changes to the index in the new Roaring 2020s.

Fed I: Fed Says Fed Doing a Good Job. The pandemic could have triggered a financial meltdown and a depression. Thankfully, the monetary policy averted these calamities. Fiscal policy helped too. That’s the central message of the Fed’s November Financial Stability Report (FSR).

The Fed lowered the federal funds rate to zero on March 15 and announced QE4ever on March 23. When the President signed the CARES Act into law on March 27, the Federal Reserve and the US Treasury effectively became the “Bank of the United States,” or “T-Fed,” as Melissa and I call the duo. The CARES Act enabled the US Treasury to supply equity of up to $450 billion to special purpose vehicles to be established by the Fed and leveraged into up to $4.0 trillion in credit.

On April 9, the Fed announced emergency lending facilities to help pandemic-ridden corporations, municipalities, Wall Street, and Main Street with up to $2.3 trillion in credit. Let’s review how the Fed perceives that it saved the day, according to the latest FSR:

(1) Floating (mostly) all boats. The purpose of the FSR is to create transparency around and accountability for the resilience of the US financial system to shocks. The Fed notes in the FSR that financial stability is crucial to achieving its dual mandate of maximum employment and stable inflation. “In an unstable financial system, adverse events are more likely to result in severe financial stress and disrupt the flow of credit, leading to high unemployment and great financial hardship,” the report states. In other words, financial stability is really the Fed’s third mandate, though it’s not explicitly set by law as is the dual mandate.

The report is broken down into four key sections: the risk of outsized drops in asset prices (i.e., valuation), the risk of businesses and households cutting back on spending due to previously excessive borrowing (i.e., debt), the ability of the financial sector to absorb losses from the business and household sector (i.e., financial sector leverage), and the risk of runs and fire sales (i.e., funding, or liquidity, risks). While the pandemic put a major strain on each of these areas, the Fed says that it avoided or mitigated stability risks from materializing in nearly all of them.

(2) Fear not elevated asset prices. “Given the high level of uncertainty associated with the pandemic, assessing valuation pressures is particularly challenging, and asset prices remain vulnerable to significant declines should investor risk sentiment fall or the economic recovery weaken,” said the Fed (Fig. 1). Especially vulnerable sectors emphasized in the report include energy, travel and hospitality, and commercial real estate. (See our discussions of corporate bankruptcies and default risk, particularly in these sectors, here and here. Also see this recent Covid-19 bankruptcy list from AlphaSense.)

Nevertheless, asset prices should be supported by “a stronger than-expected economic recovery” thanks to “

rompt and forceful policy responses—including fiscal stimulus, lower interest rates, and various asset purchase and emergency lending programs,” the report added. Go, T-Fed! You rock!

(3) Corporate debt bomb avoided. Corporations took on more debt in a mad dash for cash as the pandemic spread to offset weakening cash flow, the report explained (Fig. 2). Even before the pandemic, business debt ran historically high, it observed. Declines in revenues weakened the ability of businesses to service their debts.

Not to worry, said the Fed: “So far, strains in the business and household sectors have been mitigated by significant government lending and relief programs and by low interest rates.” For example, spreads in corporate debt markets returned to historical norms as market functioning improved, and issuance resumed following the Fed’s bold actions. The FSR stated: “The announcement of a range of measures to support market functioning and the flow of credit in late March, particularly the corporate credit facilities, led to significant improvement in corporate bond market functioning and provided a backstop to support borrowing by corporations.”

(4) Household sector risk mitigated. Vulnerabilities arising from household debt had been modest before the pandemic (Fig. 3). While the risk of household delinquencies and defaults grew as jobs and incomes were lost, fiscal policies helped to avoid them. Household risk may increase as fiscal stimulus expires, affecting lenders throughout the financial system, warned the FSR.

Nevertheless, supported by low interest rates, housing prices have increased over the course of the pandemic. Mortgage debt accounts for roughly two-thirds of total household credit. Some risk remains in the household sector, such as for auto and credit card loans; but for now, lenders have provided Covid-19 related accommodations preventing delinquency and default status (Fig. 4 and Fig. 5).

(5) Banks relatively stress free. The pandemic pressured banks, but US banks remain well capitalized. Some non-bank financial institutions, however, “felt significant strains amid the acute period of extreme market volatility, declining asset prices, and worsening market liquidity earlier this year.” But the Fed eased these pressures with policy actions, said the report. Bank and broker-dealer leverage remains low, the FSR observed. In contrast, it found that measures of leverage at life insurance companies and hedge funds remain elevated.

Bank funding risk remained low throughout the pandemic, said the report. But “the large redemptions from money funds and fixed-income mutual funds, as well as the need for extraordinary support from emergency lending facilities, highlighted vulnerabilities in these sectors. While in place, those facilities substantially mitigate these vulnerabilities.”

(6) External vulnerabilities abound. Near-term risks associated with the virus and its effects on the global economy remain high, the report noted. It added that there “is potential for stresses to interact with preexisting vulnerabilities in dollar funding markets or those stemming from financial systems or fiscal weaknesses in Europe, China, and emerging market economies,” posing additional risks to the US financial system.

 Fed II: Regulators Focus on Non-Banks. Increased global regulations around non-bank financials are coming, as we discussed in our October 21 Morning Briefing, which covered the International Monetary Fund’s Global Financial Stability Report. Banks may be well capitalized, but non-bank financials remain vulnerable to risks according to the FSR as noted above.

In her statement, Brainard said: “The resurgence of fragility and funding stress in the same nonbank financial sectors in the COVID-19 crisis and the Global Financial Crisis highlights the importance of a renewed commitment to financial reform. We saw runs on prime money market funds—which had grown rapidly in the preceding couple of years—as large or larger than those in 2008. We also saw record outflows from open-ended funds that offer daily redemptions against less liquid underlying assets, such as the $1.7 trillion in corporate bonds held by mutual funds in the second quarter.”

A November 16 Reuters article titled “Regulators target money market funds after COVID-19 turmoil” reported that the Financial Stability Board (FSB), which coordinates financial rules for the Group of 20 Economies (G20), said in a Tuesday report that the Covid-19 turmoil in markets exposed vulnerabilities throughout the financial sector. “But further investigation is warranted into money market and open-ended funds, into how derivatives clearing houses vary margin or cash calls to cover trading positions, and into the structure of bond markets, the FSB said,” according to the article.

Chair of the FSB and Vice Chair of the Fed Randal Quarles told reporters that action needs to be taken on these issues. The FSB said that sectors like money market funds would have fared much worse in the “dash for cash” if it were not for “central banks doling out liquidity to maintain stability,” wrote Reuters. The FSB wants to avoid a “moral hazard” or an expectation that central banks would act again as a safety net for struggling funds in the next crisis.

Fed III: The Implications of Providing a ‘Backstop.’ On numerous occasions, Fed officials have characterized the Fed’s large lending facilities as “backstops” to the financial system. Because they are only backstops, the facilities have gone largely unused (as we detailed in Monday’s Morning Briefing), explained an August 17 Chicago Fed Insights note. As a backstop, the primary purpose of the facilities is to restore the confidence of the private markets rather than to incentivize lending through the facilities.

Specifically, backstops influence financial conditions “by providing a safety net and by influencing bargaining in private transactions,” wrote the Chicago Fed. It explained: “By regulation, lending facilities created under the Fed’s emergency powers are ‘backstops,’ charging a penalty interest rate that encourages borrowers to obtain funds in the market when possible.” As a result, “many of the Fed facilities have seen little borrowing, and total use has leveled off as financial stresses have diminished,” it said.

The Fed’s FSR indicated that its corporate credit facility purchases to date totaled just slightly more than 0.2% of the $5.5 trillion of outstanding non-financial corporate bonds. Its municipal facility has purchased only two issues totaling just more than $1.6 billion. It noted: “[S]ince the announcement of the backstop facilities and funding market stabilization measures, more than $1 trillion in new nonfinancial corporate bonds and more than $250 billion in municipal debt have been issued, purchased almost entirely by the private sector.”

Wealth Distribution: Who Owns Houses? Perhaps the biggest difference between the Great Financial Crisis (GFC) and the Great Virus Crisis (GVC) is that homeowners suffered substantial capital losses during and after the GFC but benefitted from substantial capital gains before, during, and after the GVC (so far). This time, homeowners have lots of equity in their homes, which can be used to cushion the shock of any economic and financial losses resulting from the pandemic.

Last week, Melissa and I started our examination of wealth distribution in America with a focus on corporate equities and mutual fund shares. Today, we continue it with a focus on real estate. Consider the following:

(1) The big picture. Table B.101 in the Fed’s Financial Accounts of the United States is titled “Balance Sheet of Households and Nonprofit Organizations.” It shows that the value of real estate held by households dropped 26% from Q4-2006 through Q1-2012 (Fig. 6). Over this same period, the 12-month average of the median existing single-family home price fell 22%. Owners’ equity dropped 42% over this period.

The recovery since the lows has been impressive, with all three series at new record highs during Q2-2020 as follows: residential real estate value ($30.8 trillion), median home price ($288,540 during the 12 months through September), and owners’ equity ($20.2 trillion). The level of outstanding mortgages has been remarkably flat around $10.5 trillion for the past few years, while real estate value has been rising to new highs since Q3-2016, resulting in more equity for homeowners (Fig. 7). Collectively, owners’ equity as a percentage of home values has recovered from a recent low of 45.8% during Q1-2012 to 65.6% currently (Fig. 8).

No wonder that the Fed’s latest Financial Stability Report views residential real estate and finance as among the most stable sectors in the economy.

(2) Residential wealth distribution by percentile groups. Here are the values and percentage shares of the $30.8 trillion in real estate value during Q2-2020 by household wealth percentile groups: top 1% ($4.5 trillion, 14.6%), 90%-99% ($9.3 trillion, 30.2%), 50%-90% ($13.3 trillion, 43.4%), bottom 50% ($3.6 trillion, 11.8%) (Fig. 9 and Fig. 10). The percentage shares have been relatively stable in recent years. The data suggest that lots of middle-class homeowners continue to benefit from rising real estate values.

Currently, roughly 80 million US households own their own home. This implies that the average home represents about $385,000 in real estate value, with owners sitting on an average of $252,500 in equity and holding an average mortgage of $132,500.

(3) The impact of age. Here are the real estate values and percentage shares owned by the major generations as of Q2-2020: Silent ($4.6 trillion, 14.9%), Baby Boomer ($13.4 trillion, 43.7%), GenX ($9.4 trillion, 30.4%), and Millennials ($3.4 trillion, 11.0%) (Fig. 11 and Fig. 12).

The share of the Silent Generation has declined steadily from around 65% during the early 1990s to about 15% now. Gaining the most market share during the 1990s were Baby Boomers and GenXers. The former peaked at 49% during 2010 and is down to 44%, while the latter remains on an uptrend. Coming from behind, with lots of catching up to do, is the Millennials.

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The Banks Of Last Resort

November 17 (Tuesday)

Central Banks: Lots More Free Money. While all eyes have been on the elections in the US, the major central banks continue to flood the financial markets with liquidity. Collectively, the assets of the Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ) rose to a record $21.8 trillion during the first week of November, up $7.2 trillion since the first week of March (Fig. 1). Here are the increases over this same period and the latest levels of the three central banks’ assets: the Fed ($3.0 trillion to $7.1 trillion), ECB ($2.9 trillion to $8.0 trillion), and the BOJ ($1.3 trillion to $6.7 trillion) (Fig. 2).

All three are pushing for their countries’ fiscal policymakers to provide more stimulus to offset the negative economic consequences of the pandemic. Meanwhile, they continue to do whatever they can on their own. Consider the following:

(1) Fed. The Fed’s balance sheet has been relatively flat in recent weeks as the Fed’s ongoing purchases of securities under QE4ever has been offset by a decline in the loans provided by the Fed’s emergency liquidity facilities (Fig. 3 and Fig. 4). In effect, the Fed has embraced Modern Monetary Theory (MMT) by financing the federal government’s spending on pandemic support programs, allowing them to soar without pushing interest rates higher.

Over the past 12 months through October, the 12-month sum of federal government outlays soared 49.7%, while revenues fell 1.2% (Fig. 5). As a result, the federal budget deficit swelled to a 12-month record sum of $3.3 trillion, up from $1.0 trillion last October (Fig. 6). Over the same period, the Fed’s holdings of US Treasuries jumped $2.4 trillion. That’s MMT on steroids.

To keep the 10-year Treasury bond yield under 1.00%, the Fed has been buying lots of bonds. Since MMT Day on March 23, when the Fed announced QE4ever, the yield has averaged 0.70%, remaining below 1.00% since then (Fig. 7). From February through October, the supply of US Treasury notes and bonds rose by $1.0 trillion. However, Treasury notes and bonds held by the public declined by $613 billion, as the Fed’s holdings of these securities jumped $1,632 billion (Fig. 8).

The result has been record-low mortgage rates. That has enabled a homebuying boom triggered by pandemic-related deurbanization, with the result that the sum of new and existing single-family home sales jumped to 6.83 million units (saar) during September, the highest since May 2006 (Fig. 9).

Corporations are refinancing their debts and raising funds at record-low corporate bond yields. Nonfinancial corporate bond issuance totaled a record $1.4 trillion over the 12 months through September (Fig. 10).

Also benefiting from the Fed’s largess is the stock market, with the S&P 500 hitting a new record high on Friday and again on Monday. There has been a close correlation between the Fed’s assets and the forward P/E of the S&P 500 (Fig. 11). The pandemic initially triggered a mad dash for cash. Although the Fed rushed to provide it to avoid a credit crunch, the precautionary demand for liquidity remains elevated, as evidenced by the record-high $16 trillion held in liquid assets and the 24% y/y increase in M2 (Fig. 12 and Fig. 13). A vaccine should reduce liquidity preference pushing asset prices higher, especially those of stocks and homes.

(2) ECB. As noted above, the ECB’s balance sheet now exceeds those of both the Fed and the BOJ. In euros, the ECB’s assets are up €2.1 trillion from the first week of March through the November 6 week, with securities held for monetary purposes up €0.9 trillion and longer-term refinancing operations (LTRO) up €1.2 trillion (Fig. 14). The LTRO program provides funds to banks to lend to nonfinancial corporations and households. The more loans that participating banks issue, the more attractive the interest rate charged by the ECB on those funds.

The LTRO program did seem to have boosted lending to businesses earlier this year and to households more recently (Fig. 15 and Fig. 16). Meanwhile, the Eurozone’s monetary aggregates rose at double-digit y/y rates during September, as follows: M1 (13.8%), M2 (10.3), and M3 (10.4).

The imposition in recent weeks of another round of tough lockdown restrictions in Europe increases the likelihood of a double-dip in economic growth in the region. Under the leadership of Christine Lagarde, the ECB has essentially pledged to do whatever it takes to cushion the financial and economic blows from the pandemic. That means that the ECB’s balance sheet will continue to swell.

(3) BOJ. Not to be outdone, the BOJ saw its assets soar 19% since the first week of March through the November 13 week; reserves are up 25%, resulting in a 15% increase in Japan’s monetary base using latest available data, through October (Fig. 17).

(4) Altogether now. The three major central banks continue to inject the global financial markets with big shots of liquidity. The hope is that by doing so, they will inoculate the financial markets from a world of troubles, most recently the pandemic. It’s working so far, as the All Country World MSCI stock price index (in local currencies) continues to trend higher in record territory along with the assets of the major central banks (Fig. 18).

Commodities, Bonds & the Dollar: A World of Hope. Our job is to forecast stock, bond, commodity, and currency markets. More often than not, we get important clues from market prices about the trends and inflection points in the fundamentals that drive them. Technicians study the price actions in financial markets but don’t bother with what they imply about the underlying fundamentals. For lack of a better term, our approach is a technical-fundamental one. The price action provides us with clues about the fundamentals, which we can use to predict the price action depending on our fundamental analysis of the fundamentals. Here are the latest insights we’ve gleaned from this approach:

(1) Commodities. Debbie and I are big fans of the CRB raw industrials spot price index for assessing the strength or weakness in the global economy. It has rebounded 16% from a low on April 21 through November 13, little changed from the November 9 reading, which was the highest reading since May 8, 2019 (Fig. 19). Leading the way higher has been its copper component, with the red metal’s nearby futures price up 40% over the same period.

The price of copper is especially sensitive to economic developments in China, which led the world into a brief but severe lockdown recession in January and February of this year followed by a remarkable V-shaped recovery since then (Fig. 20). Similarly, the US economy fell into a severe recession during March and April and has experienced a V-shaped recovery since then. As noted above, Europe’s economy may be about to double dip, but so far that’s not showing up in weaker commodity prices.

(2) Bonds. The US Treasury bond yield has risen from a record low of 0.52% on August 4 to 0.90% on Monday. It remains below 1.00% as a result of QE4ever. Despite the Fed’s intervention, the yield has risen on a better-than-expected V-shaped economic recovery and on hopeful vaccine news. On the other hand, the latest waves of the pandemic in Europe and the US are downers for yields. Furthermore, the latest core CPI inflation readings (y/y) remain low for the US (1.7%), Eurozone (0.2), and Japan (-0.3).

The ratio of the nearby future prices of copper to gold is widely followed as an indicator for the “correct” bond yield (Fig. 21). Its reading on Friday suggested that the yield should be above 1.00%, at 1.68% to be precise. On the other hand, the ratio of the S&P Goldman Sachs Commodity Index (GSCI) to the price of gold suggests that the yield’s current price is right (Fig. 22). The GSCI comprises 24 commodity prices including copper. Energy-related commodities account for roughly 60% of the index.

By the way, the copper/gold ratio works as a bond yield indicator because the copper price is highly correlated with the expected inflation rate in the spread between the 10-year nominal bond yield and the comparable TIPS yield, and the price of gold is inversely highly correlated with the TIPS yield (Fig. 23 and Fig. 24). In recent weeks, expected inflation has stabilized around 1.7%, while the TIPS yield has edged higher.

(3) The dollar. The trade-weighted dollar is inversely correlated with the GSCI (Fig. 25). When the global economy is weak relative to the US, so are commodity prices and the dollar tends to be strong. When the global economy is outperforming the US, commodity prices tend to be strong and the dollar tends to be weak. A strong/weak dollar tends to be bearish/bullish for the Emerging Markets MSCI stock price index (in local currencies) (Fig. 26).

(4) Bottom line. The current market action points to higher commodity prices, higher bond yields, and a weaker dollar. That suggests that Go Global should outperform Stay Home in global stock portfolios. Nevertheless, we aren’t convinced that there is much more upside in yields since we expect that the Fed will announce a target for the bond yield below 1.00% if it starts moving above that level. That would be bullish for commodities and foreign currencies. It would also be bullish for global stocks, especially in the US. So we are sticking with Stay Home for now.

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Biden’s Challenges & Choices

November 16 (Monday)

Strategy: Another Record High. Is the V-shaped recovery turning into the Nike swoosh? The four-week moving average of gasoline usage through the November 6 week suggests that might be happening, though its only 1.0mbd below usage at the same time a year ago. On the other hand, petroleum usage excluding gasoline continues to recover. (See our US Petroleum Products Supplied.)

The S&P 500 rose to a record high on Friday. The stock market correctly anticipated a V-shaped recovery. Now it may be looking past the resurging pandemic toward a vaccine early next year. Joe and I expect volatile frequent rotation between Work-From-Home and Pandemic-Challenged stocks for a while. Such action might actually feed and broaden the bull market.

US Politics I: Meet Joe Manchin. The latest election results show that the Republicans have 50 Senate seats, while the Democrats have 48. That leaves the two Senate seats from Georgia to determine control of the chamber in a rare double-barreled runoff election on January 5. If Democrats win both seats, they would take control of the Senate starting on January 20, as Vice President-elect Kamala Harris would have the power to break ties in the chamber. They would also get to chair the Senate committees. It is widely believed that the Democrats aren’t likely to win both seats, thus leaving Republicans in the majority.

A November 11 article posted on FiveThirtyEight observed: “It’s an off-cycle election that will no longer share the ballot with the presidential race. Now that Biden is the president-elect, many Democratic voters may feel that their mission has been accomplished and not bother to vote in the runoff. This is exactly what happened in previous Georgia runoffs—whether for Senate or other statewide offices. Since the late 1960s, the state has seen eight runoffs between a Democrat and a Republican for statewide office. … [I]n seven of the eight runoffs, Republican vote share margins improved, sometimes substantially so, as turnout fell sharply from the general election vote in November.”

On the other hand: “For the next eight weeks, Georgia will be the center of the political universe; expect both parties to spend tens of millions of dollars and dispatch big-name surrogates to get out the vote. That could minimize the drop-off in turnout, which in turn could minimize the drop-off in Democratic support. There’s also never been a Black candidate in a Senate runoff, either, which could help keep turnout high among a key part of the Democratic base.”

The article concludes: “[I]t’s best to treat both a Democratic or Republican victory as a serious possibility.”

If the Democrats pull an upset and get both seats, Joe Manchin could be the most important person in America. He is the Democratic senator from West Virginia. He is viewed as a conservative Democrat and has championed bipartisanship. On Monday, November 9, he was interviewed by Fox News. He said: “50-50 [control] means that if one senator does not vote on the Democratic side, there is no tie and there is no bill.” He added: “I commit to tonight and I commit to all of your viewers and everyone else that’s watching, I want to allay those fears, I want to rest those fears for you right now because when they talk about, whether it be packing the courts or ending the filibuster, I will not vote to do that.”

He continued saying that the “Green New Deal” and “all this socialism” was “not who we are as a Democratic Party.” He remarked: “We’ve been tagged if you’ve got a D by your name, you must be for all the crazy stuff and I’m not.”

US Politics II: Meet Lael Brainard. While President Donald Trump continues to contest the election results, President-elect Biden is working on picking his cabinet. For the financial markets, his pick to be the next Treasury secretary will be particularly important. Lots of names have been tossed around, including Larry Fink, Jamie Dimon, Elizabeth Warren, Stephanie Kelton, Janet Yellen, Roger Ferguson, and Lael Brainard.

Melissa and I think that the most logical choice would be Lael Brainard, who has been a Federal Reserve Board governor since June 16, 2014. If gridlock frustrates Biden’s plans to increase government spending significantly along with taxes, it would be good for him to have a Treasury secretary who could press the right buttons at the Fed to get more monetary stimulus.

While Biden prides himself on his ability to deal with Republicans, they are likely to block most of his policy initiatives if they keep their majority in the Senate. In recent months, Fed officials have been vocal in calling on Congress for another round of fiscal stimulus. They’ve implied that the Fed will conduct open-market operations to monetize the resulting debt, as the Fed has done since QE4ever was announced on March 23.

What more could the Fed possibly do? The Fed could lend out $4 trillion in a loan program that was funded by the Coronavirus Aid, Relief, and Economic Security Act (a.k.a. the CARES Act), on March 27, as we discuss below.

Republicans particularly have resisted calls by Democrats for funds to bail out state and local governments experiencing significant shortfalls in revenues as a result of the pandemic. Biden with Brainard’s support could lean on the Fed to loan money to the most distressed state and local governments, many of which are run by Democrats.

Here are highlights from Dr. Brainard’s bio, which is posted on the Fed’s website: During the Obama administration, Brainard served as undersecretary of the US Department of the Treasury from 2010 to 2013 and counselor to the secretary of the Treasury in 2009. During this time, she was the US representative to the G-20 Finance Deputies and G-7 Deputies and was a member of the Financial Stability Board. From 2001 to 2008, she was vice president and founding director of the Global Economy and Development Program at the Brookings Institution. She served as the deputy national economic adviser, deputy assistant, and personal representative to the G-7/G-8 for President Clinton. From 1990 to 1996, she worked as an associate professor of applied economics at MIT. Previously, Brainard worked in management consulting at McKinsey & Company. She received a BA from Wesleyan University and an MS and a PhD in economics from Harvard University.

The Fed: More Firepower. The lender of last resort hasn’t been doing the volume of lending during the pandemic that it had promised. If Dr. Brainard is picked to be Treasury secretary, then it’s possible that the Democrats may succeed in leveraging the Fed’s lending facilities to achieve some of their goals.

The Fed did respond to the Great Virus Crisis with QE4ever on March 23, purchasing $2.62 trillion in US Treasuries and mortgage-backed securities since then (Fig. 1). The Fed also provided several liquidity facilities, which jumped from $383 billion during the March 11 week to a recent high of $1.22 trillion during the May 13 week (Fig. 2). As the financial panic abated, the liquidity facilities’ loans fell to $589 billion during the November 11 week. Meanwhile, other emergency lending facilities have barely been used, mostly because QE4ever calmed the financial markets quickly and dramatically. Consider the following:

(1) T-Fed’s might. On March 27, President Trump signed the CARES Act, which gave the US Treasury $450 billion to invest in the Fed’s special purpose vehicles, which could be leveraged into as much as $4.0 trillion in loans, thus effectively converting the Fed into the “Bank of the United States,” or “T-Fed,” as Melissa and I call it. On April 9, the Fed announced the establishment of lending facilities to provide for up to $2.3 trillion in loans (see our April 15 Morning Briefing for a detailed explanation and breakdown of this lending capacity).

(2) Tiny utilization. If you want to see the Fed’s actual lending under these facilities, grab a magnifying glass. For some reason, the Fed does not make it easy to see the lending capacity of each facility compared to the current outstanding value cited in its update report. What we found, though, is that the $2.3 trillion in capacity stated in the updated term sheets compares with less than $100 billion in outstanding lending value—and is only about half of what the Fed has the power to lend under the CARES Act.

(3) Corporate facilities. Included in the $2.3 trillion are the Fed’s Primary and Secondary Corporate Credit Facilities (PMCCF and SMCCF), which are set up to purchase up to $750 billion combined in corporate debt, including exchange-traded funds. Eligible bonds include investment-grade corporate bonds as well as pandemic-impaired “fallen angels.”

Corporate debt purchases have picked up since early May but remain puny compared to the potential size of purchases. As of October 31, the PMCCF was operational but had not yet closed any transactions, according to the Fed’s credit facilities update dated November 6. As of May 19, the total outstanding amount of the Fed’s loans under the SMCCF was $1.3 billion. It grew to $13.3 billion as of October 31.

(4) Other facilities. The total outstanding loans under the Fed’s other facilities as of October 31 was about $78.0 billion (out of the $1.55 trillion in lending capacity), including the following (as of October 31 versus lending capacity): the Paycheck Protection Program (PPP) Liquidity Facility ($62.8 billion versus $350 billion), Term Asset-Backed Securities Loan Facility, i.e., TALF ($3.7 billion versus $100 billion), the Main Street Lending Program, or MSLP ($4.0 billion versus $600 billion), and the Municipal Liquidity Facility, or MLF ($1.7 billion versus $500 billion).

Of the facilities with trivial lending capacity relative to the total value, the outstanding value as of October 31 was as follows: the Money Market Mutual Fund Liquidity Facility, or MMF ($5.6 billion) and the Primary Dealer Credit Facility ($243.0 million). The Commercial Paper Funding Facility did not have any outstanding value as of October 31.

(5) Up slightly. On October 30, 2020, the Fed adjusted the terms of the MSLP to better target support to smaller businesses and nonprofit organizations, including to lower the minimum loan size and to update the transaction, loan origination, and loan-servicing fee terms for smaller loans. While the scale of MSLP lending increased by $1.8 billion from the previous month, the utilization is still nowhere near capacity.

Of note, according to the related transaction spreadsheet, the MLF continued to include loans to just two entities: the State of Illinois and the New York Metropolitan Transportation Authority.

(6) Dems’ critique. In response to questions from a congressional oversight panel overseeing the $500 billion in aid set aside for the MLF under the CARES Act, the Treasury department said on October 16 that it did not see a reason to extend the municipal lending facility beyond its December 31 expiration date and that the low utilization of the facility “reflects a recovered and functioning municipal securities market.”

Politico reported: “The [MLF] has faced criticism from Democrats, including oversight commissioners Rep. Donna Shalala (D-Fla.) and Bharat Ramamurti, for not offering generous enough terms for municipal entities. But Sen. Pat Toomey (R-Pa.) and Rep. French Hill (R-Ark.), who also sit on the commission, have said the program has served its purpose and should be wound down.”

Memo to Biden: Tax Hikes on the Rich Will Trickle Down. I had an interesting conversation with one of my firm’s vendors last week. He was upset about President-elect Biden’s plan to raise taxes on anyone earning over $400,000 a year. Biden has promised that anyone who earns less than that won’t have a tax increase. My friend observed that he doesn’t earn that much but expects that his customers who do so will have less money to pay him for his services. In other words, my friend clearly understands trickle-down economics: Higher taxes on the rich and on corporations inevitably trickle down to everyone else.

An October 21 Tax Foundation article observed: “The rich purchase items from others, some not as rich, and from businesses that employ workers across the income spectrum. The corporate tax falls partly on workers in the form of lower pay, acknowledged by the Congressional Budget Office [and] the U.S. Treasury[.] Likewise, the individual income tax that is paid by pass-through businesses falls partly on employees of those businesses.”

Many higher-income taxpayers own S corporations, which don’t pay a corporate tax. Instead, they pay their owners with dividends that are included in personal income and taxed as such. Proprietorships aren’t incorporated, and their owners’ incomes are also taxed as personal income. Mali and I have been doing lots of work on the data:

(1) Corporate profits & S corporations. On a pre-tax basis, S&P 500 aggregate reported net income has tended to account for 50%-70% of corporate book profits, which is included in the National Income and Product Accounts (NIPA) (Fig. 3 and Fig. 4). The difference between the NIPA and S&P profits series is mostly attributable to S corporations, and exceeded $1 trillion for the first time ever during Q2-2020 using the four-quarter sum (Fig. 5). This conclusion is confirmed by the difference between total corporate dividends paid and dividends paid by the S&P 500 (Fig. 6 and Fig. 7). Raising income taxes will reduce the after-tax income of owners of S corporations, which is bound to trickle down to the employees and vendors of S corporations, which account for 30%-50% of corporate profits.

(2) Proprietorships. During Q2-2020, pre-tax proprietors’ income in personal income equaled $1.5 trillion (saar) (Fig. 8). That’s almost as much as the $1.8 trillion in total pre-tax corporate profits.

(3) Bottom line. In other words, when income taxes are raised on the rich, that burden falls largely on owners of S corporations and proprietorships who collectively earn more than $2.5 trillion. No wonder Biden would like to tax them given the large pool of income they represent. However, these are mostly small businesses. ADP data show that small companies with 1-49 employees currently account for 31.2 million, or 26.1%, of private-sector payrolls (Fig. 9 and Fig. 10).

Trickle-down economics works both ways!

 Movie. “The Life Ahead” (-) (link) stars Sophia Loren in the Netflix movie directed by her son Edoardo Ponti about an elderly Italian woman who earns money by taking care of the children of working women (of ill repute).She plays an Italian Holocaust survivor known as Madame Rosa who takes in and eventually bonds with a Senegalese orphan, Momo. The movie is about tolerance and taking life one day at a time. It is slow paced without much drama. The dubbing in English is terrible. Watching it with subtitles might be a better experience.

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Ob-la-di, Ob-la-da

November 12 (Thursday)

Strategy: An Election and a Miracle Vaccine. The S&P 500 has risen 9.5% since bottoming on September 23 through Tuesday’s close. It’s truly an unusual market when the S&P 500 Automobile Manufacturers stock price index (34.3%) outperforms Internet & Direct Marketing Retail (2.3) and when Industrial Conglomerates (21.0) trounces Application Software (4.5). Most of the market’s recent gains occurred since Election Day, November 3, and continued after the announcement of a vaccine on Monday, November 9.

Since the market’s recent low on September 23, there has been a vicious rotation, with Financials, Utilities, Materials, and Industrials posting the strongest returns. Here’s the S&P 500 performance derby from September 23 through Tuesday’s close: Financials (16.8%), Utilities (15.9), Materials (14.1), Industrials (13.6), Energy (11.8), Communication Services (11.1), S&P 500 (9.5), Health Care (9.0), Real Estate (8.1), Information Technology (6.9), Consumer Staples (6.0), and Consumer Discretionary (5.3) (Table 1).

Optimism that our collective Covid-19 nightmare could end sometime next year may have given investors the confidence to peer into 2021, when y/y earnings comparisons show double-digit percentage growth starting in Q1 and continuing throughout the year. Here are analysts’ consensus forecasts for the S&P 500 sectors’ y/y earnings growth in 2021: Industrials (75.1%), Consumer Discretionary (59.3), Materials (29.0), S&P 500 (22.6), Financials (19.1), Communications Services (14.1), Information Technology (15.0), Health Care (12.8), Consumer Staples (6.4), Utilities (4.7), Real Estate (-5.5), and Energy (a return to profitability).

Joe reports that the S&P 500 Industrials’ earnings are inflated by the Airlines industry, which is expected to lose a huge amount of money this year ($29.7 billion) and lose only a bit of money next year ($3.8 billion). Excluding Airlines, earnings are slated to grow 22.9% for the Industrials sector and 19.8% for the S&P 500 in 2021. Such an outcome would certainly make for a happy New Year!

Industrials: Positive Trends. The convergence of some very large trends should boost American manufacturing in coming years. Covid-19 and the US-Chinese trade war have prompted manufacturers to explore moving their production back to the US. To remain competitive while doing so will mean running lean operations, using robots, and harnessing the Internet throughout the factory floor.

Companies’ focus on their manufacturing resiliency was discussed on Tuesday by Rockwell Automation’s executives in their fiscal Q4 (ended September) earnings conference call. If these trends come to pass, it will be good for employment and manufacturing.

Here’s Jackie’s look at some of the trends:

(1) Onshoring gaining momentum. The move to bring manufacturing back to North America is gaining momentum, according to a survey by Thomas, a company that helps manufacturers with product sourcing, supplier selection, and marketing. Almost 70% of 746 respondents said they were either “likely,” “very likely,” or “extremely likely” to reshore their manufacturing operations, according to the survey, which occurred from May 16 through June 17. That’s an improvement from the 54% of respondents in the February survey, the company’s July 14 press release states.

Rockwell CEO Blake Moret is also seeing companies moving toward reshoring their operations. “We continue to see our customers take steps to increase their resilience, agility, and sustainability. Resilience includes investments to reduce single points of failure, with a growing list of companies announcing plans to build or expand North American operations,” he said. “Other measures to increase resilience include increased automation, traceability, and remote monitoring, which are all Rockwell strengths.”

The pandemic has pushed manufacturers of medical goods to increase their manufacturing capacity in the US. Becton Dickinson announced a joint partnership with the Biomedical Advanced Research and Development Authority (BARDA) to develop new manufacturing lines for injection devices. It will provide priority access to the US government for hundreds of millions of syringes and needles to support vaccination efforts, a July 8 company press release stated. As part of the partnership, BARDA will invest about $42 million into a $70 million capital project to expand Becton Dickinson’s operations and manufacturing capacity in Nebraska. The capacity was expected to come on line within 12 months.

(2) Electric vehicles and semis growing. Rockwell highlighted a number of other industries that were helping its business. The move to produce electric vehicles and batteries has meant companies are rolling out new or adjusted manufacturing lines. Rockwell’s automotive organic sales, which fell 20% y/y in fiscal Q4, is expected to grow 10% in fiscal 2021. Likewise, the semiconductor industry is benefitting from the adoption of smart devices, faster data centers, and 5G wireless technology. That segment’s sales rose by “high single digits” last quarter and are expected to climb by “mid-single digits” in fiscal 2021. And finally, the expansion of e-commerce has filled distribution facilities with advanced technology and automation.

(3) Internet of Things on the factory floor. In addition to becoming more automated, manufacturing floors are also increasingly connected to the cloud. Microsoft and Rockwell extended their partnership by five years to “deliver edge-to-cloud-based solutions that connect information between development, operations and maintenance teams through a singular, trusted data environment. This will allow development teams to digitally prototype, configure and collaborate without investing in costly physical equipment,” a October 6 Microsoft press release states. It also allows teams to securely access and share data across the organization and with business partners.

(4) Cost cutting. Like many other companies, Rockwell cut costs when the pandemic hit. Some cuts will be reversed, but others will remain and help improve the bottom line. Rockwell plans to reverse wage cuts and restore 401(k) matches at the end of November. However, other cuts are expected to result in $15 million in additional annualized cost savings starting in fiscal 2021. At the end of the day, Rockwell was confident enough about the future to provide an earnings forecast—a 10% increase at the midpoint of the range--and to increase its dividend. The shares sold off almost 3% on Wednesday, but they’re up almost 20% ytd.

(5) The numbers. Rockwell Automation is a member of the S&P 500 Electrical Components & Equipment stock price index. After moving sidewise for much of 2018, 2019, and the first half of this year, the index rallied sharply. It’s up 13.8% ytd and up 19.5% since the market’s September 23 low (Fig. 1). Revenues and earnings peaked in 2019 and are expected to bottom this year before growing once again. Revenues are forecast to tumble 12.3% in 2020 and rise by 3.3% in 2021 (Fig. 2). Likewise, earnings are expected to fall 15.0% this year only to bounce 8.4% in 2021 (Fig. 3). After being negative for much of the past year and change, net earnings revisions have turned positive, rising to 19.2% in August, 23.9% in September, and 27.4% last month (Fig. 4). Investors are optimistic, with the industry’s forward P/E at 22.6, near the highest levels of the past 25 years (Fig. 5).

Disruptive Technologies: Fintech Making Inroads. The recent demise of the planned Ant Financial IPO made us wonder just how large the fintech players in the US would have to be before US regulators enacted tougher rules on the burgeoning industry. Fortunately, the thought hit just as the Federal Reserve Bank of Philadelphia held its fourth Fintech Conference this week.

Loretta Mester, president of the Federal Reserve Bank of Cleveland, described how quickly the industry has grown: “According to the U.S. Treasury, from 2010 to the third quarter of 2017, more than 3,330 new technology-based firms serving the financial services industry have been founded. The global market capitalization of fintech firms grew to $22 billion in 2017, 13 times what it was in 2010. Lending by these firms accounts for over 36 percent of personal loans in the U.S., up from under 1 percent in 2010.”

But the US fintech market remains much more fractured than the Chinese one. Chime is considered the most valuable US fintech company, valued at $14.5 billion in its September private fund raising. While that’s up 900% since its March 2019 fundraising, it’s still far smaller than $313 billion valuation Ant would have enjoyed if its IPO had been successful. The fractured nature of the US fintech market may have kept the regulators at bay so far. But the sum of the parts is getting large enough that regulators are sure to become more proactive.

Here’s a quick look at some of the largest areas of the fintech market:

(1) Fintech in mortgage lending. Fintech companies have made major inroads into mortgage lending. In 2015, Quicken Loan’s Rocket Mortgage introduced the ability to apply for a mortgage online in less than 10 minutes. By Q4-2017, Quicken was the largest US mortgage originator by volume, surpassing Wells Fargo, a January 2 Business Insider article reported.

Here’s the Consumer Financial Protection Bureau’s list of originators of all mortgages, whether made online or in person, during 2019: Quicken Loans, United Wholesale Mortgage, Wells Fargo, JPMorgan Chase, LoanDepot, Caliber Home Loans, Bank of America, Freedom Mortgage, and US Bank, according to a June 25 HousingWire article.

Some of the private mortgage companies are using the strong housing market to go public. United Wholesale Mortgage is merging with Gores Holdings IV, a special purpose acquisition company, in a deal that values the lender at $16.1 billion. The merger follows Rocket Companies’ IPO in August and precedes an expected IPO from Caliber Home Loans and LoanDepot.

(2) Fintech in personal loans. Fintech lenders have also made headway in the personal loan market, according to a 2019 report by DBRS. Their share jumped from just 5% in 2013 to 38% in 2018 as a percentage share of all personal loans outstanding. Conversely, banks’ market share has decreased from 40% in 2013 to 28% in 2018. Similarly, traditional finance companies’ share has decreased from 24% to 13%, and credit unions’ share has declined from 31% to 21% over the same time period.

Some online lenders use their own capital to make loans, but many don’t have a banking license and depend on banks that do have licenses to actually make the loans. As they grow, some of the online lenders are looking to become more like traditional banks. This summer, Varo Money was the first fintech company to be granted a national bank charter by the US Office of the Comptroller of the Currency (OCC). It was followed by Social Finance’s (SoFi) application for a national bank charter, which received preliminary, conditional approval from the OCC last month. If SoFi Bank receives a license, it will be able to hold customer deposits and make loans without relying on a bank partner. And earlier this year, Square’s application for an industrial loan company bank charter received FDIC approval. It’s expected to lend to small and medium-sized business and offer deposit products.

“With a [banking] charter, a fintech can lower its funding costs, gain access to Federal Reserve payments systems, and operate more uniformly on a nationwide basis with federal preemption of many state laws, including state licensing requirements,” an August 4 article in McGuire Woods’s Consumer FinSights blog explained.

(3) Fintech in auto loans. Fintech providers of personal loans have been branching out into auto loans. Upgrade, which offers personal loans and credit cards, announced in August plans to enter the auto financing market. With more than 10 million users and originations exceeding $3 billion, Upgrade uses Cross River Bank to underwrite, originate, and service the loans. Another fintech company, Upstart, is also expanding from personal loans into the auto loan market.

Many fintech players have partnered with auto manufacturers’ captive lenders. For example, Ford dealerships are working with AutoFi, and Motor Acceptance works with Modal, a car shopping and financial platform.

As online auto sales grow, so should online auto lending. Carvana offers online auto loans to customers looking to purchase new or used cars online. And Chase Auto partnered with online used-car retailer Vroom to create Vroom Financial Services Powered by Chase.

(4) Fintech in credit cards. The traditional credit card business is still dominated by large banks. The top five are Chase, Citi, AmEx, Bank of America, and Capital One, a September 1 Cardrates.com article reported. Goldman Sachs broke into the top 25 issuers with the launch of the Apple Card in August 2019. Apple Card works as a physical card or as a part of Apple Pay, the iPhone’s digital wallet.

A number of private fintech startups are looking to expand into the world of credit cards. Brex is a corporate credit card for tech companies that allows them to access much higher credit limits, automate expense management, eliminate receipt tracking, and integrate with accounting systems, according to a March 26, 2019 article on Crunchbase. Zero offers a debit card that gives users cash back (or other rewards) like a credit card. Extend allows business cardholders to share their credit card with employees and freelancers without exposing the card number or losing control.

Cred.ai offers a full banking platform that includes a credit card with Visa. It targets the Millennial and Gen Z generations with offers to help raise credit scores via its artificial-intelligence-enabled credit optimizer tool. In the same category is online bank Chime’s Credit Builder Visa credit card. Chime shares on-time payment information with credit bureaus, which helps improve its customers’ credit scores.

“Unlike traditional banking players, cred.ai is foregoing fees, interest, and rewards. For revenue, the platform relies on merchant transactions and deposits, as well as its plans to license its underwriting system and compliance infrastructure technology to small banks and other fintechs in the future,” an August 13 CNBC article reported. We don’t expect the disruption to end anytime soon.

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It Ain’t Over ’Til It’s Over

November 11 (Wednesday)

US Politics I: Georgia on My Mind. I might have declared victory for gridlock too soon on Monday. “Georgia on My Mind” is a 1930 song written by Hoagy Carmichael and Stuart Gorrell. It was first recorded that year by Hoagy Carmichael. Ray Charles, who was born in Georgia, recorded the song for his 1960 album. In 1979, the State of Georgia designated Ray Charles’s version the official state song. Georgia will be on America’s collective mind until the runoff elections occur on January 5 for the state’s two Senate seats.

On Monday, I wrote: “The Republicans seem to have held onto their Senate majority, though the final outcome depends on a couple of Senate seats in Georgia that won’t be decided until early January. On November 6, The Hill reported: ‘Democrats are pinning their hopes on being able to force a 50-50 Senate on a narrow, uphill path that requires them to win both seats in the typically red state. If Democratic nominee Joe Biden wins the White House, a 50-50 margin would hand them the majority because Vice President Kamala Harris could break a tie.’”

In politics, nothing is a slam dunk. By some estimates, Georgia is about to be inundated with as much as $1 billion from the rest of the country to influence the two elections. What’s at stake is worth much more than a measly billion dollars. An editorial in the November 8 WSJ explained:

“If incumbents in North Carolina and Alaska hold their current leads, Republicans will have 50 Senate seats in the next Congress. But they need 51 for a majority to organize the body because Vice President-elect Kamala Harris will preside over the Senate. She would cast the deciding vote in a 50-50 Senate. What difference would a single vote make? Republicans would lose their committee chairmanships and thus the power to serve as a check on the Biden Administration. Joe Biden deserves the Cabinet he wants in most cases, but a GOP Senate could deter appointments like Elizabeth Warren at Treasury. Oversight Chairman Ron Johnson’s probe of FBI and other abuses would cease.

“Or consider the Democrats poised to run key committees if they organize the Senate. Bernie Sanders would run Budget, which means a squeeze on the Pentagon. Sherrod Brown of Ohio would run Banking, and Ms. Warren would run the financial institutions subcommittee. Have fun, bankers. Oregon’s Ron Wyden would run Finance. He supports the $4 trillion Biden tax increase plus he wants to tax even unrealized capital gains as ordinary income. That means taxing the appreciation in the value of assets even if they aren’t sold during the year. He isn’t kidding.”

On Saturday, Chuck Schumer (D-NY), the Senate Minority Leader, gloated: “Now we take Georgia, then we change the world. Now we take Georgia, then we change America.” Also on Saturday, Georgia Secretary of State Brad Raffensperger (R) announced that he was sending a team of investigators to State Farm Arena in Fulton County to “secure the vote and protect all legal votes” after a ballot “issue” was discovered. The county is one among those most responsible for giving former Vice President Joe Biden the lead over President Donald Trump.

US Politics II: Scorched Earth? We might have seen the year’s Santa Claus rally on Monday. The January 5 runoff elections in Georgia could weigh on the stock market as they approach. If the Democrats pull upset wins in both, James Madison’s constitutional system of “checks and balances” will be broken for at least the next two years through 2022 mid-term elections. The Democrats will have the unchecked power to raise taxes, increase federal spending, provide a universal basic income, nationalize healthcare, pack the Supreme Court, implement their Green New Deal, and so on.

Meanwhile, despite recounts and legal challenges, President Trump probably lost the election. However, he will be slow to concede and will proceed during his remaining days in the White House to do what he can to prove that the election was stolen from him, or at least to raise doubts about the voting system.

Furthermore, Senator Lindsey Graham (R-SC), the chairman of the Senate Judiciary Committee, said on Sunday that US Attorney John Durham will release a report on his inquiry into the Russia investigation that will warrant indictments. Here is what he said on Fox News to host Maria Bartiromo:

“We’ve learned there was Russian collusion, but it was between the Clinton campaign, and it was between Russia. … Clinton and Russia, not Trump and Russia, and we learned that Crossfire Hurricane was the most corrupt investigation, maybe in the history of the FBI. Durham is all over this. After the election, you’re going to get a report, and I’ll be shocked if people are not indicted.”

Our friends at The Political Forum yesterday observed: “Add to all of this the fact that Trump still has 71 days to order the declassification of anything he thinks might be of interest, and it’s not outside the realm of possibility that the President, coming to grips with the fact that he’ll be unable to change the outcome of the election, has decided to burn Washington to the ground on his way out. Between the ‘proof’ of voter fraud that everyone admits is out there, whatever damaging information might be contained in the Durham report, and whatever else we might not know about other matters, like the content of Hunter Biden’s hard drive or Hillary Clinton’s emails, Trump could make an enormous mess out of a great many people’s lives if that’s what he chooses to do.”

As Yogi Berra famously once said, “It ain’t over ’til it’s over.” Sadly, deranged partisanship is probably here to stay. Gridlock would allow the stock market to tune out the noise. The alternative might not be so easy for the stock market to ignore.

Strategy: Better Breadth? Monday’s announcement by Pfizer that a vaccine may soon be available for Covid-19 was a shot in the arm for S&P 500 Value stocks (4.0%), while the S&P 500 Growth stocks (-0.5%) took a hit because they’ve mostly benefitted from the Work From Home (WFH) impact of the pandemic (Fig. 1). SMidCaps had a good day on Monday: S&P 500 (up 1.2%), S&P 400 (2.8), and S&P 600 (4.9) (Fig. 2).

The market capitalization of the Magnificent Five stocks (AAPL, MSFT, AMZN, GOOGL, and FB) fell 2.8% on Monday (Fig. 3). The Mag-5 are the five S&P 500 stocks with the biggest market capitalizations. They still had a market-cap share of 24.4% on Monday, down from the record high of 26.5% on September 1 (Fig. 4). They’ve accounted for most of the outperformance of Growth relative to Value and LargeCaps relative to SMidCaps since 2017.

Bears have been warning that the market’s narrow breadth was setting the stage for a nasty correction if not a bear market. Monday’s action showed that the S&P 500 could move higher even as investors rotated out of Growth and into Value. Indeed, there is enough cash on the sidelines to allow market breadth to broaden without taking down the Mag-5 down much (if at all) and allow the S&P 500 to climb into record-high territory over the rest of the year. Liquid assets jumped from $13.6 trillion at the beginning of the year to $16.2 trillion by the end of May, remaining around there through the end of October (Fig. 5). Consider the following:

(1) Sectors. Here is Monday’s performance derby for the 11 sectors of the S&P 500: Energy (14.2%), Financials (8.2), Industrials (3.3), Real Estate (2.6), Materials (2.2), Utilities (1.8), S&P 500 (1.2), Health Care (0.7), Communication Services (-0.3), Consumer Staples (-0.5), Information Technology (-0.7), and Consumer Discretionary (-1.6). (See Performance Derby: S&P 500 Sectors & Industries, Monday, November 11.)

The outperformance of Energy and Financials boosted the Value stock price index Monday, while the Mag-7 weighed on Growth in Communications Services (FB, GOOGL, NFLX), Technology (AAPL, MSFT, NVDA), and Consumer Discretionary (AMZN).

(2) WFH stocks underperform. The vaccine news also weighed on the performance of the following WFH stock industries on Monday: Household Appliances (-10.4%), Computer & Electronics Retail (-9.8), Homebuilding (-6.9), Food Retail (-6.5), Home Improvement Retail (-6.2), Interactive Home Entertainment (-4.3), Internet & Direct Marketing Retail (-3.8), Household Products (-3.7), General Merchandise Stores (-3.7), Hypermarkets & Super Centers (-3.3), Air Freight & Logistics (-3.1), and Trucking (-2.5).

(3) Laggards starting to catch up. The pandemic-challenged companies rallied Monday on expectations that the vaccine will revive employment, travel, leisure, and amusement activities once social distancing is no longer required to reduce the spread of the virus. Here is a selection of Monday’s winning S&P 500 industries: Hotel & Resort REITs (30.1%), Retail REITs (21.3), Hotels, Resorts & Cruise Lines (18.6), Food Distributors (16.8), and Casinos & Gaming (14.9).

(4) Breadth of fresh air. Joe and I track the percentage of S&P 500 companies with positive y/y stock price comparisons (Fig. 6). At the end of last year, this measure of breadth suggested that the index was extremely overvalued when it rose to 90.2% during the week of December 20. It then indicated extreme undervaluation when it fell to 11.8% during the March 20 week. In recent weeks, it’s been around 50%, suggesting that there is plenty of room for better breadth.

(5) Broad-based forward earnings recovery. Since early June through the November 5 week, forward earnings continued to trace out V-shaped recoveries for the S&P 500/400/600 (Fig. 7 and Fig. 8). The forward earnings of Growth continued to outpace that of Value, as it has since the beginning of the year (Fig. 9 and Fig. 10).

(6) Valuations. The Mag-5 has been boosting the relative forward P/Es of LargeCaps and Growth since early 2018. Here are the latest as of Monday’s close: S&P 500 (21.7), S&P 400 (18.8), S&P 600 (18.9), S&P 500 Growth (27.9), and S&P 500 Value (17.1) (Fig. 11 and Fig. 12).

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The Distribution of Corporate Equities Among US Households

November 10 (Tuesday)

Vaccine I: Speeding Along. Roaring 2020s, here we come! Yesterday morning, Pfizer and partner BioNTech announced that they’ve developed a Covid-19 vaccine that is 90% effective. Stock prices soared on the news, led by all the pandemic-challenged businesses. Value outperformed Growth and may continue to do so as the bull market broadens and continues to rise in record-high territory. Yesterday, I wrote: “Joe and I still have a target of 3800 for the S&P 500. We just aren’t sure whether that happens by mid-2021 or by the end of this year.” Now we think it could happen well before mid-2021.

According to the “Fact Sheet: Explaining Operation Warp Speed” posted on HHS.gov, the website of the US Department of Health and Human Services (HHS), on July 22 “HHS announced up to $1.95 billion in funds to Pfizer for the large-scale manufacturing and nationwide distribution of 100 million doses of their vaccine candidate. The federal government will own the 100 million doses of vaccine initially produced as a result of this agreement, and Pfizer will deliver the doses in the United States if the product successfully receives FDA EUA or licensure, as outlined in FDA guidance, after completing demonstration of safety and efficacy in a large Phase 3 clinical trial, which began July 27th.”

The Fact Sheet also outlines the plans for manufacturing and distributing the vaccine. Congress directed almost $10 billion to this effort through supplemental funding, including the CARES Act. Congress also appropriated other flexible funding. The almost $10 billion specifically directed includes more than $6.5 billion designated for countermeasure development through BARDA (the Biomedical Advanced Research and Development Authority, an office of the HHS) and $3 billion for National Institutes of Health research.

Operation Warp Speed (OWS) certainly seems to be operating at warp speed thanks to the funding provided by Congress and the efforts of the Trump administration.

STAT covered the Pfizer news yesterday in an article titled “Covid-19 vaccine from Pfizer and BioNTech is strongly effective, early data from large trial indicate.” Here are the key points:

(1) Crossing a safety threshold. “In keeping with guidance from the Food and Drug Administration, the companies will not file for an emergency use authorization to distribute the vaccine until they reach another milestone: when half of the patients in their study have been observed for any safety issues for at least two months following their second dose. Pfizer expects to cross that threshold in the third week of November.”

(2) Missing pieces of information. “There is no information yet on whether the vaccine prevents severe cases, the type that can cause hospitalization and death. Nor is there any information yet on whether it prevents people from carrying the virus that causes Covid-19, SARS-CoV-2, without symptoms.”

(3) Important unknown details. “Because the vaccine has been studied for only a matter of months, it is impossible to say how long it will protect against infection with the virus. The vaccine does cause side effects, including aches and fevers, according to previously published data. …

“The results have not been peer-reviewed by outside scientists or published in a medical journal, and even Pfizer and BioNTech have been given no other details about how the vaccine performed by the independent monitors overseeing the study.”

(4) Distribution challenges. “Initial supplies of the vaccine, if authorized, will be limited. Pfizer says up to 50 million doses could be available globally by the end of the year, with 1.3 billion available in 2021. There are also expected to be distribution challenges. The vaccine must be stored at super-cold temperatures, which could make it extremely difficult to deliver to many places. Pfizer has said it is confident those issues can be managed.”

(5) Bodes well for other vaccines. “Although the estimate of the efficacy of the vaccine could change as the study is completed, it is close to a best-case scenario. That also bodes well for other vaccines in the late stages of testing, including those developed by Moderna, AstraZeneca, and Johnson & Johnson.”

(6) A big diverse sample. “The study has enrolled 43,538 volunteers the companies said, and 38,955 have received their second dose. About 42% of global participants and 30% of U.S. participants have racially and ethnically diverse backgrounds.”

Vaccine II: More Silver Bullets. Some 170 Covid-19 vaccine candidates are in development globally, according to yesterday’s update of the WSJ vaccine roundup, citing World Health Organization information. Ten are in Phase 3 of the five phases of development and testing. But just a handful of frontrunners are sponsored by reputable US and European-based teams and backed by OWS—including Pfizer & BioNTech, Moderna & National Institute of Allergy and Infectious Disease, AstraZeneca & University of Oxford, Johnson & Johnson’s Janssen, and Novavax.

Huge swaths of the population would need to be vaccinated to eradicate the virus, especially if the protection lasts less than a year or so. But even if a vaccine doesn’t put a swift end to the pandemic, it should end the pandemic of fear gripping high-risk populations and their families. Here is more background and an update on the other vaccine candidates:

(1) Naturally waiting. Phase 3 involves injecting people with the candidate vaccine or a placebo, then evaluating the severity of any Covid-19 symptoms and vaccine reactions they exhibit, according to Johnson & Johnson’s website. Now that Pfizer has shown that it has sufficient naturally occurring confirmed cases in its sample for an initial analysis, we can assume that preliminary efficacy results for other manufacturers’ vaccine candidates will not be far behind.

(2) Unprecedented speed. To get at enough early infections to trigger an analysis, sponsors have amped up the scale of testing to tens of thousands of volunteers; frontrunners’ studies range from 30,000 to 60,000 volunteers, many of whom already have received the presumed necessary two doses of a vaccine candidate.

Two Covid-19 vaccine trials (AstraZeneca’s and Johnson & Johnson’s) were put on a short pause not long after the initial shots were administered due to the possible identification of adverse reactions, but those issues have since been resolved and testing has resumed. Sponsors remain hopeful that initial efficacy analysis may be completed sometime before the end of the year. Pfizer just proved that the hope is warranted with its interim analysis of 94 confirmed cases. As noted in yesterday’s press release, 164 cases are targeted for final analysis.

(3) Low bar. After the initial stages of Phase 3, sponsors will need to seek either emergency-use authorization or formal approval and licensure from regulatory bodies such as the European Commission or the US Food & Drug Administration (FDA). Requirements include minimum standards of effectiveness, such as at least 50% under the FDA. But based on Pfizer’s promising headline, that’s an awfully low bar! The FDA is also recommending a minimum two-month waiting period to monitor for side effects, Reuters recently noted, but that’s a lot faster than the typical timeline of several years. The post-approval manufacturing and distribution phases involve ongoing monitoring of production and testing of vaccines for potency, safety, and purity.

(4) Promising technology. Pfizer’s early better-than-expected efficacy results are promising not only for Covid-19 but also for the future of vaccine technology. Three main types of vaccinations are in the final stages of testing: gene, virus, and protein based. Pfizer’s and Moderna’s candidates use the gene-based technology to synthetically instruct the body’s cells to make a virus component protein and induce an immune response through mRNA. Virus-based vaccines like AstraZeneca’s and Johnson & Johnson’s use either a weakened or modified form of a virus or else a viral component to trigger an immune response. Novovax’s protein-based vaccine injects a protein from the virus to generate a response. There is a long history of proven vaccinations using virus and protein-based techniques, while an mRNA vaccine has never been approved before.

(5) Large capacity. OWS set out to produce and deliver tens of millions of doses of a safe and effective Covid-19 vaccine for the US population by the end of 2020, with 300 million doses available and deployed by mid-2021, an unprecedented timeline, observed the New England Journal of Medicine. It looks like that incredible goal may be reached. Significant doses from one or more vaccine candidates could be available for distribution this year. Pfizer expects to deliver up to 50 million vaccine doses before the end of this year and up to 1.3 billion doses in 2021.

(6) Take rate. An October 19 STAT news report raised concerns that the share of folks willing to take an initial vaccine was falling. But a new survey by STAT and The Harris Poll suggests that more than half of the population would get vaccinated as soon as a shot becomes available. Vaccinating nursing home populations alone would significantly lower hospitalization and death rates, in our opinion.

 Strategy I: New Fed Database on Household Wealth. A large team of the Fed’s researchers have been busy constructing a new database containing quarterly estimates of the distribution of US household wealth since 1989. They launched it with the release of a March 2019 working paper titled “Introducing the Distributional Financial Accounts of the United States.” Melissa and I reviewed it in the July 31, 2019 Morning Briefing. The Distributional Financial Accounts (DFA) is an impressive accomplishment combining quarterly aggregate measures of household wealth from the Financial Accounts of the United States (FA) and triennial wealth distribution measures from the Survey of Consumer Finances (SCF).

We believe that the new database can be used to resolve lots of controversial issues about wealth distribution in the US. The DFA’s balance sheet of the household sector is much more comprehensive and timely than previously existing sources. The Fed’s researchers observe that their “approach produces rich and reliable measures of the distribution of the Financial Accounts’ household-sector assets and liabilities for each quarter from 1989 to the present.” The data can be used to study the distribution of wealth in America by wealth and income percentiles, education, age, generation, and race. Melissa and I intend to do just that in coming months with the goal of assembling a comprehensive Topical Study tentatively titled “Income & Wealth in America: Myths & Realities.”

Strategy II: Who Owns Equities in America, According to FA? Our October 27 Morning Briefing was titled “Who Owns Stocks in America?” We based it on the aggregate data available in Table L.223 in the FA for corporate equities held by each of the major sectors in the accounts. Unlike the DFA, the household sector in the FA includes nonprofit organizations, and this sector’s data are calculated residually from the other accounts. Let’s review our findings:

(1) The supply side of equities. The total market value of equities held in the US during Q2-2020 was $52.0 trillion, with domestic issues totaling $43.5 trillion and foreign issues totaling $8.5 trillion (Fig. 1). Domestic issues included $33.5 trillion of nonfinancial issues and $10.0 trillion of financial issues and consisted of $37.2 trillion of publicly traded and $6.3 trillion of closely held equities (Fig. 2 and Fig. 3). The $6.3 trillion of closely held equity consisted of $4.7 trillion in S corporations and $1.6 trillion in C corporations (Fig. 4).

(2) Ownership by sectors. During Q2-2020, of the $52.0 trillion in equities, the major sectors directly held the following amounts and percentage shares: household sector ($19.5 trillion, 37.6%), mutual funds and exchange-traded funds (ETFs) ($14.5 trillion, 27.8%), rest of the world ($8.2 trillion, 15.8%), and institutional investors ($7.0 trillion, 13.4%) (Fig. 5 and Fig. 6).

(3) Directly and indirectly held by households. The FA includes a Table B.101e titled “Balance Sheet of Households and Nonprofit Organizations with Debt and Equity Holdings Detail.” It provides extraordinary insight into the indirect equity holdings of households through life insurance companies, private and public pension funds, and mutual funds. During Q2-2020, households and nonprofits directly held $19.5 trillion (37.6% of all equities) and indirectly held $12.4 trillion (23.8% of the total) (Fig. 7). In other words, their direct and indirect holdings of equities totaled $31.9 trillion, or 61.4% of all equities (Fig. 8). Interestingly, this percentage has been remarkably stable around 65% since the early 1980s.

Strategy III: Which Households Own Equity, According to DFA? The link between the household sector in the FA and in the DFA is Table B.101.h titled “Balance Sheet of Households,” which unlike Table L.223 excludes nonprofit organizations from the household sector. On the other hand, this balance sheet shows the household sector’s combined holdings of corporate equities and mutual fund shares, which include bond funds but not money market mutual funds or ETFs. The assets and liabilities in this version of the household balance sheet are the ones for which the DFA provides all the data needed for analyzing the distribution of household net worth. (See “Household Balance Sheet” from our forthcoming study on income and wealth in America.)

Now, let’s analyze the distribution of the DFA’s various series for corporate equites and mutual fund shares held by households, sliced and diced by wealth percentile, generation, and education:

 (1) DFA by wealth percentiles. We repeat: The DFA is based on the FA’s Table B.101.h, which is the “Balance Sheet of Households” excluding the assets and liabilities of nonprofit organizations. It shows only annual data and reveals that corporate equities and mutual funds held by households at the end of 2019 totaled $29.1 trillion (Fig. 9). In the DFA, this series is shown on a quarterly basis. By the way, we can derive a similar quarterly series as the sum of corporate equities held by households and nonprofits plus mutual fund shares held by them, as reported in FA Table L.224, which excludes money market funds and ETFs (Fig. 10).

The DFA shows that corporate equities and mutual fund shares held by households was down slightly to $26.8 trillion during Q2-2020, with the following ownership and percentage shares of the total among wealth percentile groups: top 1% ($14.1 trillion, 52.4%), 90%-99% ($9.5 trillion, 35.8%), 50%-90% ($3.0 trillion, 11.2%), and bottom 50% ($0.2 trillion, 0.6%) (Fig. 11 and Fig. 12).

The bottom 50% never owned more than 1.6% of this asset category. The 50%-90% crowd’s share peaked at 21.4% during Q3-2002 and since has fallen to 11.2% currently. The 90%-99% group has held a fairly steady share around 35% since the early 1990s. The top 1% has ranged between a low of 40.2% and a high of 52.8%.

The widespread notion that the very rich own a disproportionate share of corporate equities is true, but their collective share is more like 50% of the total held by households than the urban legend of 80%-90%.

(2) DFA by generations. The DFA allows us to compare the amount of an asset or liability held and the percentage shares by four generations: Silent (born before 1946), Baby Boomer (1946-1964), GenX (1965-1980), and Millennial (1981-96).

Here are the values of corporate equities and mutual funds held by the four generations and their percentage shares during Q2-2020: Silent ($5.1 trillion, 19.0%), Baby Boomer ($14.8 trillion, 55.3%), GenX ($6.3 trillion, 23.4%), and Millennial ($0.6 trillion, 2.2%) (Fig. 13 and Fig. 14).

Since the start of the data in 1989, the percentage share held by the Silent generation has dropped from around 80%-90% to 19% currently, while the percentage share of the Baby Boom generation increased from 10%-20% to 55% currently. The GenX share was close to zero in early 2009 and has been trending up; it’s around 23% currently. The Millennials’ share remains close to zero.

(3) DFA by education. Finally for today, let’s have a look at the impact of education on the ownership of corporate equities and mutual fund shares. The DFA data show that households headed by college-educated persons held 82.9% of corporate equities and mutual fund shares during Q2-2020 (Fig. 15 and Fig. 16). That percentage has been trending higher since Q1-1995, when it fell to a series low of 60.2%. Households with heads who had some college, high school, and no high school owned only 9.9%, 6.3%, and 0.8%. Education is clearly a vitally important determinant of financial well-being.

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God Bless James Madison

November 09 (Monday)

US Politics: And the Winner Is . . . Gridlock! The good news is that my candidate won! His name is James Madison. He was the Founding Father who wrote the US Constitution. He designed our nation’s system of checks and balances, otherwise known as “gridlock.” I was rooting for gridlock, and gridlock apparently won. In the October 21 Morning Briefing, I wrote:

“I agree with the widely held view that gridlock is bullish for the stock market. In our civics classes in high school, gridlock was called ‘checks and balances.’ The Founders created this constitutional system to reduce the risk of political extremism. They designed the system so that more often than not, politicians on either side of the aisle wouldn’t have unchecked power. In the past when one party ruled the White House and both houses of Congress, the electorate had the choice of depriving them of that power every two years, which is what it did on a regular basis, though not necessarily every two years.”

I also wrote that Joe and I “still have a target of 3800 for the S&P 500. We just aren’t sure whether that happens by mid-2021 or by the end of this year.” The S&P 500 rose to a record high of 3580.84 on September 2 (Fig. 1). It then dropped 9.6% from September 2 through September 23, to 3236.92, before rebounding 9.2% through October 12 to 3534.22. Then it swooned again to 3269.96 on Friday, October 30. That seems to have been the end of Panic Attack #67, which was mostly about election jitters. The market rallied 7.3% since then to close at 3509.44 on Friday, with most of the gain occurring since Election Day.

Joe Biden won, but he certainly didn’t hang 10 on a Blue Wave. The Republicans seem to have held onto their Senate majority, though the final outcome depends on a couple of Senate seats in Georgia that won’t be decided until early January. On November 6, The Hill reported: “Democrats are pinning their hopes on being able to force a 50-50 Senate on a narrow, uphill path that requires them to win both seats in the typically red state. If Democratic nominee Joe Biden wins the White House, a 50-50 margin would hand them the majority because Vice President Kamala Harris could break a tie.”

If they don’t win both races, Democrats won’t have the unchecked powers they had hoped to achieve with the election—so, no tax hikes, no massive fiscal spending programs, no bailouts for states run by Democrats, no Green New Deal, and no packing of the Supreme Court. Having a divided Congress also rules out the prospect of nationalizing the healthcare system, though now we may all be required to wear masks. No wonder that the Health Care sector of the S&P 500 has outperformed the S&P 500 since the October 30 retest of the September 23 low.

Here is the performance derby of the 11 sectors of the S&P 500 since then through Friday’s close: Information Technology (9.7%), Health Care (8.3), Materials (7.6), Communication Services (7.6), S&P 500 (7.3), Industrials (7.2), Consumer Staples (4.6), Financials (4.5), Real Estate (4.4), Utilities (2.8), and Energy (0.8). The Communication Services and Technology sectors also outperformed, mostly because they are less likely to be regulated under Biden than they might have been under Trump. The tech titans contributed millions of dollars to this year’s political campaigns, mostly to Democratic candidates. (See our Performance Derby October 30-November 6, 2020.)

The bad news is that gridlock guarantees another two years of deranged partisanship in Washington at least until the mid-term elections of 2022 and most likely longer. Most of us have learned how to tune out the noise; investors are no exception: The stock market has done well since March 2009 despite the increasing rancor among our political class. It should continue to do so.

The immediate question ahead is whether the Democrats and Republicans can look past their differences and agree on another fiscal stimulus program to support pandemic-challenged businesses and unemployed workers. I expect that they will but that the package will likely be half the size of the $2.2 trillion CARES Act.

One more thing: Our gridlock-challenged politicians need to avert a government shutdown in December. The lame-duck Congress, in business until early January, has been working since October 1 under a temporary budget that expires on December 11, with the Senate having failed to pass any of the 12 spending bills needed to run government activities. At stake is the approximately $1.3 trillion in discretionary spending for defense and non-defense activities. This does not include huge programs operating on automatic pilot, such as the Social Security retirement plan and federal healthcare programs for the poor and elderly. It also does not include “emergency” funds for natural disasters, pandemic relief, and other unexpected events.

A government shutdown is either a utopian or dystopian outcome of gridlock depending on how you feel about our government when it’s open for business. In any event, God Bless America, and James Madison too!

I’m assuming that when the time comes, Donald Trump will leave the White House peaceably. Love him or hate him, he will remain a powerful political force and undoubtedly will continue to fight with the political and media establishment whether banned by Twitter or not.

US Economy I: Labor Market Recovering. Americans clearly want to go back to work, and employers are rehiring them. The labor market recovery still looks mostly V shaped. Fears that the Payroll Protection Program would provide only temporary support to employment seem unfounded so far. Generous unemployment insurance benefits might have discouraged some workers from going back to work earlier in the pandemic, but they’re doing so now that the benefits are reduced or running out. Let’s have a closer look at the latest labor market stats, which Debbie discusses in even greater detail below:

(1) ADP payrolls. First, the bad news. Last Wednesday, ADP reported a disappointing increase of 365,000 in October’s private payrolls to 119.4 million (Fig. 2). That puts it 9.7 million above the April low but still 10.0 million below February’s record high of 129.4 million. During October, employment in service-providing industries increased 348,000, while employment in goods-producing ones rose only 17,000 (Fig. 3).

(2) BLS payrolls. Then on Friday, the Bureau of Labor Statistics (BLS) reported that payroll employment rose 638,000, with private payrolls up 906,000 during October and the previous two months revised higher by 15,000 and 21,000, respectively, thus continuing to trace out a V-shaped recovery. That puts total payrolls up 12.1 million above the April low but still 10.1 million below February’s record high of 152.5 million. During October, employment in private-sector service-providing industries increased 783,000, while employment in goods-producing ones rose 123,000 (Fig. 4).

(3) Earned Income Proxy. The 0.8% m/m gain in private payrolls—combined with the average workweek unchanged at 34.8 hours and average hourly earnings up 0.1%—caused our Earning Income Proxy (EIP) for private-sector wages and salaries to rise 0.9% during October (Fig. 5 and Fig. 6). Both aggregate weekly hours and our EIP continued their V-shaped recoveries that started in May through the latest data, in October.

(4) Household employment & unemployment. The payroll employment data compiled by the BLS counts the number of jobs. The household employment data count the number of people with both full-time and one or more part-time jobs. Household employment soared 2.24 million during October. That well exceeded the 724,000 increase in the labor force, causing the number of unemployed workers to drop by 1.5 million to 11.1 million (Fig. 7). The unemployment rate dropped to 6.9% from the recent high of 14.7% during April (Fig. 8). That’s the fastest drop in the jobless rate ever, following the fastest increase ever earlier this year!

US Economy II: Productivity Soaring. Nonfarm business productivity always rebounds during economic recoveries as output increases faster than labor input (Fig. 9). This time, it actually recovered during Q2, which was the worst of the two-quarter recession, with a gain of 10.6% q/q (saar). That was followed by an increase of 4.9% during Q3, when nonfarm business output soared 43.5% (saar) while hours worked increased 36.8%. (Recall that real GDP increased 33.1%, saar, during Q3.)

Debbie and I believe that productivity growth has been heading toward a secular rebound during the post-pandemic “Roaring 2020s.” Even before the Great Virus Crisis (GVC), companies had been moving to incorporate into their businesses a host of state-of-the-art technologies in the areas of computing, telecommunications, robotics, artificial intelligence, 3-D manufacturing, the Internet of Things, among others. The GVC is accelerating that trend as companies rethink how to do business ever more efficiently in the post-pandemic era.

The 20-quarter average annual growth rate in productivity dropped from the most recent secular peak of 4.0% during 2003 to just 0.6% during 2015. It rose to 1.8% during Q3 of this year. A secular rebound in productivity would certainly help to offset any inflationary pressures as a result of the likely move away from just-in-time supply chains operating on a global basis, wherever labor costs were lowest, to just-in-case onshore supply chains. This shift is partly attributable to the lessons learned from the pandemic as well as the worsening Cold War between the US and China.

US Economy III: The Productivity-Pay Gap Myth. While Debbie and I are rooting for a secular rebound in productivity growth in coming years, Progressives have been quick to point out that productivity gains haven’t trickled down to workers for decades. They observe that there has been a widening gap between productivity and pay since the mid-1970s. This myth has been promoted by the Economic Policy Institute (EPI) in Washington, DC for a long time.

 The EPI’s website states that the “nonprofit, nonpartisan think tank” was created in 1986 “to include the needs of low- and middle-income workers in economic policy discussions. EPI believes every working person deserves a good job with fair pay, affordable health care, and retirement security.”

That’s certainly a worthy cause that is always at the top of the agenda for any partisan Progressive organization. However, as happens all too often, Progressives are too quick to seize upon misleading data that seemingly support their case for new policies to achieve their goals. They are never satisfied with what they have already accomplished with the New Deal, the Great Society, and Obamacare.

The EPI has plenty of top-notch economists and researchers who spend their days looking to improve the lot of workers. The website states: “To achieve this goal, EPI conducts research and analysis on the economic status of working America. EPI proposes public policies that protect and improve the economic conditions of low- and middle-income workers and assesses policies with respect to how they affect those workers.”

The website brags that “[i]n the 1990s EPI researchers were the first to illustrate the decoupling of productivity and pay in the U.S. economy, a trend now widely recognized as a key element of growing economic inequality.” This claim was most recently updated by the EPI in a July 2019 post titled “The Productivity–Pay Gap.” It features a compelling chart showing that inflation-adjusted hourly compensation tracked productivity very closely from the late 1940s through the 1960s. But since the 1970s, the former has lagged the latter, resulting in a widening gap between the two. The conclusion is obviously disturbing: “This means that although Americans are working more productively than ever, the fruits of their labors have primarily accrued to those at the top and to corporate profits, especially in recent years.”

Not surprisingly given the EPI’s partisan approach to research, their supporting data are seriously flawed. They made a rookie’s mistake: using the wrong price deflator to adjust hourly compensation. They are using the Consumer Price Index (CPI), which long has been recognized as having an upward bias; doing so weighs misleadingly on real hourly compensation, creating a totally bogus gap!

To be fair, they are following the lead of the Bureau of Labor Statistics (BLS), which releases the production and compensation data on a quarterly basis in a report titled “Productivity and Costs.” Table footnote (2) states that real hourly compensation—which includes wages and salaries of employees plus employers' contributions for social insurance and private benefit plans—is deflated by “the Consumer Price Index for all urban consumers (CPI-U). The trend from 1978-2019 is based on the Consumer Price Index research series (CPI-U-RS).”

So here is the true story:

(1) In theory. In a market economy, competitive forces tend to cause inflation-adjusted pay to be commensurate with labor’s marginal productivity. The motto of many labor organizers in the past and now is: “A fair day’s wage for a fair day’s work.” A competitive economy tends to make that ideal happen without any policy intervention.

(2) In practice. We can close more than half of the productivity-pay gap simply by dividing hourly compensation by the personal consumption expenditures deflator (PCED) instead of the CPI (Fig. 10). We can close it even more by using the nonfarm business price deflator (NFBD). During Q3-2020, the gap was 50.0% using the CPI, 26.1% using the PCED, and only 12.8% using the NFBD.

(3) Deflator roulette. It’s bizarre that BLS still uses the CPI to deflate hourly compensation. It’s even more bizarre since the BLS reports the NFBD in the same quarterly release. From Q1-1947 through Q3-2020, the CPI is up 1,112%, while the PCED is up 864% and the NFBD is up 772% (Fig. 11).

(4) The logical price. But why does it make more sense to use the NFBD than the PCED? NFBD is the price level that actually matters to employers when they do their explicit or implicit calculations of the marginal cost of labor. Workers’ purchasing power obviously depends on the prices of items—such as rent, gasoline, and healthcare—that are included in the PCED but not in the NFBD. However, in a competitive market economy, employers pay for a fair day’s work, not for the cost of living.

I am ready to debate that last point and will do so in coming commentaries on this subject. However, for now, there is no debating that the productivity-pay gap is too small to play as large a role in income inequality as the folks at the EPI and other Progressives believe. Our market economy works just fine. Since Q1-1971 through Q3-2020, real hourly compensation using the NFBD is up 415%, in line with the 468% increase in productivity and well above the 371% and 312% increases using the PCED and CPI. The data confirm that the purchasing power of workers has kept pace with their productivity. There has been no stagnation in the standard of living. Period.

Movie. “The Queen’s Gambit” (+ + +) (link) is a binge-able Netflix miniseries about a fictional young lady by the name of Beth Harmon who learns to play chess from a janitor in her orphanage at the age of nine. She becomes the world’s greatest chess player by the age of 22. Along the way, she struggles with emotional issues and drug and alcohol dependency. The cast is incredible, with Anya Taylor-Joy starring as Beth. Her intense obsession with winning the game is mesmerizing. This is a must-see. If we get locked up again, I’m going to work on my chess game for sure.

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Back to the Future

November 05 (Thursday)

Technology: Leading a Post-Election Meltup. Investors’ appetite for tech shares revived in the wake of the election, after a month-long selloff took some of the froth out of the sector’s valuation. The election brought good news from voters in California who exempted the rideshare and food-delivery companies—including Uber Technologies, Lyft, and DoorDash—from having to reclassify their drivers as employees. And more good news arrived in the form of September data that showed semiconductor sales remained strong.

Let’s take a look at the market’s largest sector as it enters the year’s home stretch.

(1) The selloff that refreshes? The S&P 500 Technology sector enjoyed an amazing run from March 23 through September 2, gaining 38.6% and leading all other S&P 500 sectors. Since the market’s peak on September 2 through the market’s low last week on October 30, the sector fell 12.7%. From last week’s low, it’s up 2.2% through Tuesday’s close (Fig. 1).

Here’s the S&P 500 sectors’ performance derby from the September 2 peak through Tuesday’s close: Utilities (7.7%), Industrials (0.7), Materials (0.2), Financials (-2.4), Consumer Staples (-3.5), Real Estate (-3.9), Health Care (-4.0), S&P 500 (-5.9), Consumer Discretionary (-6.5), Communication Services (-7.6), Information Technology (-10.9), and Energy (-15.2) (Table 1).

The S&P 500 Tech sector has had a banner 2020 so far. Here’s the performance derby for the S&P 500 ytd through Tuesday’s close: Information Technology (23.5%), Consumer Discretionary (21.6), Communication Services (9.8), Materials (8.0), S&P 500 (4.3), Health Care (3.0), Consumer Staples (2.1), Utilities (0.1), Industrials (-1.4), Real Estate (-8.3), Financials (-19.3), and Energy (-51.1) (Fig. 2). It continued its recent winning ways yesterday, rising 3.8%, trailing only the gains of Health Care (4.5%), and Communication Services (4.3).

(2) Semis sending good signals. The strength in semiconductor sales continued through September, according to the Semiconductor Industry Association. The three-month moving average of global semiconductor sales rose 4.5% m/m and 5.8% y/y in September (Fig. 3).

Sales were strong across most geographies m/m, rising by 7.9% in China, 3.3% in both Europe and Asia Pacific/Other, 2.2% in the Americas, and 1.5% in Japan. Year-over-year comparisons were only a touch softer: Americas (20.1%), China (6.5), Asia Pacific/Other (2.9), Japan (-1.8), and Europe (-9.8).

The strength in the US semiconductor market was confirmed by data on US industrial production of semiconductors & other electronic components. It rose by 19.3% in September, based on a three-month average (Fig. 4).

The S&P 500 Semiconductors stock price index didn’t escape this fall’s market selloff. It declined by 6.5% from the market’s September 2 peak through Tuesday’s close (Fig. 5).

That leaves the industry’s ytd gain at a still-impressive 23.2%. Analysts remain optimistic about the industry’s growth next year, with forecasts for 2021 revenue growth of 7.3% and earnings growth of 11.5% (Fig. 6 and Fig. 7). The only thing to keep an eye on is the industry’s forward P/E, which even after the recent selloff remains elevated relative to the past decade at 19.4 (Fig. 8).

 Geopolitics: China Takes Off the Gloves. China’s leadership showed over the past week just how controlling and aggressive it can be. On Monday, the leadership called Jack Ma—perhaps the county’s greatest entrepreneur—onto the carpet and squashed his company’s IPO plans, presumably in retaliation for Ma’s criticism of China’s banking regulators. That followed the unveiling of the Chinese Communist Party’s (CCP) latest five-year plan, which made clear that the country intends to focus on its technological independence and military strength.

These actions follow other aggressive moves, including recent arrests of Hong Kong opposition leaders and the imposition of sanctions on US defense companies because they supply Taiwan with weapons. US officials did little to bring down the temperature between the two countries. US Secretary of State Mike Pompeo toured Asia, encouraging countries to stand up to China. The cold war got just a bit chillier. Let’s take a deeper look.

(1) Ma gets schooled. China’s leadership telegraphed this week that no one, not even China’s richest man, is allowed to talk ill about Chinese institutions. “Today’s financial system is the legacy of the Industrial Age,” Ma said according to a November 3 CNBC article. “We must set up a new one for the next generation and young people. We must reform the current system.” He also referred to the big state-owned banks’ “pawnshop mentality.”

Ma, Ant Group’s controlling shareholder, its executive chairman Eric Jing, and CEO Simon Hu were summoned before Chinese regulators on Monday. The same day, the Chinese banking regulator issued new draft rules on microlending, which if implemented could slow Ant’s growth and reduce its profitability. Shortly thereafter, the Shanghai and Hong Kong stock exchanges pulled the IPO.

Ant Group issued a mea culpa: “We will overcome the challenges and live up to the trust on the principles of: stable innovation; embrace of regulation; service to the real economy; and win-win cooperation.”

It was amazing—shocking even—that regulators were willing to squash such a high-profile deal. The Ant IPO was considered evidence of China’s growing financial maturity and heft. It allowed China and Ant to snub the US stock exchanges. The IPO’s squashing not only gives China one less thing to crow about but also serves as a reminder that, while China might have a stock exchange, it certainly does not believe in capitalism or freedom of expression.

(2) Following the Chinese roadmap. The CCP announced its economic and political goals for the next five years. Atop the list: achieving “technological self-reliance.” Perhaps this shouldn’t come as a surprise given the Trump administration’s recent sanctions against Huawei Technologies and efforts to ban Bytedance’s TikTok and Tencent Holding’s WeChat. And most likely, technological self-reliance has been the party’s longstanding intention. It’s just jarring to read of the news in black and white.

Hong Kong is intertwined in this plan, as the party intends to build the city into an “innovation and technology center.” And in general, the CCP intends to build its own domestic market, creating domestic demand for the products it produces.

The CCP five-year plan also noted that China will “comprehensively strengthen military training and preparation for war,” a November 1 Reuters article reported. The goal is to “turn the People’s Liberation Army into a modern military force by 2027, by which time, analysts say, China aims to build an army on par with that of the US,” an October 29 article the South China Morning Post reported. An analyst told the paper that the country’s aim was to build an army that could “deter interference by the US army around the Taiwan Strait.” Again, China’s aggressive stance isn’t a surprise given recent US defense companies’ sales of weapons of Taiwan.

Notably, the five-year plan lacked a GDP growth target, though one could be added later. Over the past five years, the target was 6.5% annual growth. The plan did target boosting per-capita GDP to about $30,000 a year by 2035, up from $10,262 last year. The goal was accelerated from the previous time target of 2050.

(3) Pompeo pokes the tiger. Meanwhile, during a tour of Asia, Secretary of State Pompeo encouraged Indonesia’s Muslims to criticize China’s treatment of the Muslim Uighurs in Xinjiang.

“The atheist Chinese Communist Party has tried to convince the world that its brutalization of Uighur Muslims in Xinjiang is necessary as a part of its counterterrorism efforts or poverty alleviation,” he said, according to an October 29 WSJ article. “We know that there is no counterterrorism justification for forcing Uighur Muslims to eat pork during Ramadan or destroying a Muslim cemetery.”

When meeting with reporters in Sri Lanka, Pompeo called the Chinese Communist Party a “predator” and warned the country against tightening its ties with China. And while in India, Pompeo and Defense Secretary Mark Esper signed a defense pact on satellite-data cooperation, the October 30 WSJ article reported. None of that could have made Chinese officials happy.

Disruptive Technologies: Are Hydrogen Cars in the Future? This week, Toyota introduced the 2021 Mirai, a hydrogen-powered sedan for the US market. The latest version of the car (yes, there was an older version) will be available only in California and Hawaii, where there are hydrogen refueling stations. Hyundai and Honda also have US offerings, but the market remains small, with only about 7,900 hydrogen-powered vehicles sold or leased in the US at the start of this year, according to a February 23 CNBC article.

There are serious pros and cons involved with hydrogen vehicles, including their cost (a con) and refueling convenience (a pro). Here’s a look:

(1) Pricier… for now. Hydrogen-powered cars and the fuel they run on are more expensive than gas- and electric-powered vehicles and their fuels. The new Mirai is expected to cost more than its predecessor, which starts at $59,545, according to a November 2 Car and Driver article. Scientists are working to bring down the cost of hydrogen tanks and fuel cells. The price is also expected to drop as sales volumes increase, just as happened for Tesla’s electric vehicles.

The cost of hydrogen is also more expensive than that of alternative fuels. The CNBC article estimates that the cost of hydrogen fuel in California is the equivalent of about $5-$6 per gallon of gasoline. So the car companies offer customers hydrogen-fuel rebates. Toyota offers $15,000 or three years of free hydrogen to purchasers of its current car, and it’s expected to make that offer again with the new model.

Another problem is the lack of hydrogen refueling infrastructure. There are only about 45 hydrogen fuel pumps in the US, and they’re primarily in California. Electric charging stations have multiplied rapidly in the US, and every house has electricity that electric cars can use for charging.

One advantage that hydrogen-powered cars have over electric cars is their ability to be refilled in minutes at a pump, just like gasoline-powered cars. It still takes too long for electric cars to be refilled at stations to make them convenient for long road trips.

(2) Greener than gasoline. Like electric cars, hydrogen-powered cars are considered better for the environment IF the hydrogen is made using renewable sources of energy, like solar or wind power. When hydrogen is burned, it produces only water. When gasoline is burned in a car’s engine, carbon dioxide is produced.

(3) Elon’s not a fan, but the Pope is. Tesla’s Elon Musk has been vocal in his belief that hydrogen-fueled vehicles cannot be successful. Not one to hold back, Musk has said that hydrogen fuel cells are “mind-bogglingly stupid,” “fool cells,” and a “load of rubbish.” Part of his argument hinges on the fact that electricity can be produced, transmitted, and used in cars more efficiently than hydrogen.

Nonetheless, Pope Francis has given hydrogen his blessing. The Pope will use Toyota’s Mirai as his official “popemobile,” according to an October 20 article in The News Wheel. The article states that Francis rode a Mirai during a visit to Japan and ordered one on the spot.

Many Japanese citizens live in apartment buildings that lack plugs to charge electric vehicles. So Japan sees hydrogen-powered cars as an interesting alternative to electric- and gasoline-powered vehicles. The country and three private companies unveiled earlier this year one of the world’s largest hydrogen plants. The plant, which runs on solar power, produces enough hydrogen to fill 560 fuel cell vehicles a day, a March 8 article in Nikkei Asia reported. However, Japan is likely to import most of its hydrogen from countries like Australia, where it can be produced less expensively.

(4) Trucks coming too. While batteries are considered a good option for smaller trucks that recharge at the same place every night, hydrogen is being developed for large, long-haul trucks that are at a different stop every night.

Newcomers Nikola and Hyliion Holdings have made headlines recently as they develop hydrogen-fueled trucks. But traditional players are also getting involved. General Motors is supplying Nikola with the hydrogen fuel cells for its trucks. Daimler and Volvo Group are jointly developing fuel cells for trucks. And Toyota and Hyundai have hydrogen-powered trucks under development.

The impediment to making hydrogen-fueled trucks commonplace is the added cost and the need for refueling infrastructure. We’ll be watching the progress.

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World Tour

November 04 (Wednesday)

Global Strategy: No Place Like Home. The third wave of the pandemic is intensifying as hospitalizations soar along with new cases in Europe and the US. That’s caused Europe to implement renewed lockdown restrictions, which increases the chances that the US will have to do the same—though I expect that the restrictions here will be more targeted, not entailing a shutdown of the economy broadly as occurred during the first wave.

When the second wave hit the US during the summer, Europe seemed to be making more progress in combatting the virus. That’s clearly no longer the case. On the other hand, China and a few other Asian nations seem to have responded so quickly and effectively to the first wave that life for them is back to normal. Apparently, that’s because their citizens are more willing to continue to practice social distancing and universal mask wearing than are Americans and Europeans.

During the summer, global investment strategists recommended overweighting Europe because the pandemic seemed to be abating there. Joe and I were skeptical. The Europeans went on their one-month vacations during July and August and came back home with the virus. On the other hand, China’s stock market and economy have performed well, reflecting its progress containing the virus.

Nevertheless, Stay Home continues to outperform Go Global. Consider the following:

(1) Forward earnings, revenues, and margins. We continue to see an upward trend in the ratio of the US MSCI stock price index to the All Country World (ACW) ex-US MSCI stock price index (in both local currencies and in dollars) (Fig. 1 and Fig. 2). The uptrend has been intact since the start of the bull market in 2009. It can be largely explained by the outperformance of the forward earnings of the US relative to the ACW ex-US (Fig. 3 and Fig. 4). Here is the forward earnings performance derby of the major MSCI stock market indexes around the world from March 1, 2009 through October 22 of this year: Japan (179.0%), US (141.1), China (79.0), Emerging Markets (40.7), ACW ex-US (27.6), UK (-4.2), and EMU (-7.0).

In the forward revenues performance derby, only the Emerging Markets MSCI has outpaced the US since 2009, though they are now neck-and-neck (Fig. 5). Here is the forward revenues performance derby over the same period: US (54.1%), Emerging Markets (52.1), China (36.8), ACW ex-US (5.8), EMU (-4.6), Japan (-7.0), and UK (-10.6).

The US beats the rest mostly because the forward profit margin has been much higher here than over there (Fig. 6). Here are the latest readings as of the October 22 week: US (11.0%), UK (7.7), ACW ex-US (7.1), Emerging Markets (6.5), EMU (6.3), Japan (5.8), and China (4.7).

(2) Valuation. The outperformance of Stay Home comes at a price. The ratio of the forward P/Es of the US MSCI to the ACW ex-US has increased from around 1.00 at the start of the bull market to 1.39 currently (Fig. 7 and Fig. 8). During the October 22 week, the former was 22.3, while the latter was 16.1.

The widening valuation differential can be explained by the outperformance of the forward P/E of the S&P 500 Growth stock price index (Fig. 9). It recently peaked at 30.2 on September 2. It was down to 26.2 on Monday.

It turns out that the forward P/E of the ACW-ex US MSCI tends to track the comparable P/E for the S&P 500 Value index (Fig. 10).

(3) Mag-5. The outperformance of Stay Home relative to Go Global has been especially strong when the Magnificent Five components of the S&P 500 have been gaining market-capitalization share (Fig. 11). The Mag-5 are the top five stocks in the S&P 500 based on market cap. In other words, the US stock market appears overvalued relative to markets abroad mostly because of Growth stocks, particularly the Mag-5 in the US. Excluding them shows that foreign stocks in general are priced like Value stocks in the US.

In a world of zero interest rates, Growth stocks should be more highly valued than Value stocks. Growth stocks are scarce in the US and even scarcer on a global basis.

Global Economy: Fighting the Virus. The third wave of the pandemic is likely to weigh on global economic growth, but Debbie and I don’t expect a double dip. There could be one in Europe, where strict lockdown restrictions have been re-imposed. We don’t expect that will happen in the US, though that may depend on who was just elected president. Asian economies are also likely to continue to recover. The latest global indicators are turning mixed as a result:

(1) Commodity prices. The nearby futures price of copper has rebounded 45% from this year’s low of $2.12 per pound on March 23 to $3.07 on Monday (Fig. 12). Copper is one of the 13 components of the CRB raw industrials spot price index, which is up 12% over this same period.

(2) Purchasing managers indexes. There certainly has been a V-shaped recovery in global M-PMIs since they bottomed during April (Fig. 13). Here is where they stood during October for the global economy as well as advanced and emerging ones: global economy (53.0), advanced economies (52.8), and emerging economies (53.4).

Here is the performance derby by selected countries comparing October to April: Brazil (66.7, 36.0), US (59.3, 41.5), India (58.8, 27.4), Germany (58.2, 34.5), Eurozone (54.8, 33.4), UK (53.7, 32.6), Vietnam (51.8, 32.7), China (51.4, 50.8), Korea (51.2, 41.6), Malaysia (48.5, 31.3), and Japan (48.7, 41.9).

(3) Economic sentiment. The Eurozone’s Economic Sentiment Indicator stalled during October at 90.9 (Fig. 14). It’s up from this year’s low of 64.9 during April, but still well below the reading of 102.6 during January. It could slip in coming months as a result of renewed lockdown restrictions. It is highly correlated with the y/y growth rate in the region’s real GDP, which could experience a double dip.

 Global Financial Stability: Averting a Zombie Apocalypse. In Chapter 3 of its October 2020 Global Financial Stability Report, the International Monetary Fund (IMF) called on policymakers to stay the course, providing lots of fiscal and monetary stimulus to offset the economic and financial damage caused by the Great Virus Crisis (GVC). The IMF warned against cutting back on policy support prematurely. The report is titled “Bridge to Recovery.”

Exactly a year ago, only a few months before the GVC, the IMF titled its October 2019 Global Financial Stability Report “Lower for Longer.” Melissa and I at the time observed that it should have been titled “Is a Zombie Apocalypse Coming?” given the report’s disturbing conclusion: “In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.’”

In my recently released book Fed Watching for Fun & Profit, I defined the “Zombies” as living dead firms that continue to produce even though they are bleeding cash. In a purely capitalist system, they should go out of business and be buried. However, these firms survive only because they are kept on life support by government subsidies, usually because of political cronyism, which corrupts and undermines capitalism. In recent years, the Fed’s ultra-easy monetary policies have created and exacerbated the Zombie problem. I wrote:

“And why are lenders willing to lend to the Zombies? Instead of stimulating demand by borrowers, historically low interest rates incite a reach-for-yield frenzy among lenders. They are willing to accept more credit risk for the higher returns offered by the Zombies. Besides, if enough Zombies fail, then surely the central banks will come up with some sort of rescue plan.”

So far so good: The unprecedented global financial support unleashed by central bankers during the pandemic has successfully averted a Zombie Apocalypse. The major central banks flooded the financial markets with liquidity, allowing corporations around the world to refinance their bonds at record-low interest rates. The Zombies live to die another day!

The IMF’s recently released report reveals that signs of liquidity strain among vulnerable entities remain, especially among those showing signs of vulnerability before the pandemic outbreak. In the Group of Seven (G7) economies overall, nonfinancial corporate debt remains elevated after a surge of borrowing earlier this year. However, the global appetite for risker debt instruments has fallen as the demand for higher-quality debt has increased, the IMF report suggests. Nevertheless, policymakers need to prevent “still-solvent firms facing liquidity strains from turning into insolvent entities or being forced to significantly curtail their activities,” said the report’s authors. Consider the following:

(1) Loans. Overall, the y/y growth rate of listed firms’ total debt through the end of June, generally exceeding 10% (see the report’s Figure 3.3.8). Loans represented the major source of corporate debt funding in the G7 economies in a range of 58% in the US to 90% in Germany, according to the latest available financial accounts data for Q2 cited in the IMF’s report, with debt securities composing the remainder.

Above-trend bank credit growth through Q2 was largely attributable to bank drawdowns that occurred at the start of the pandemic as corporations dashed for cash. Listed firms’ drawdowns increased more than 40%, on average, compared with the H1-2019 level. Investment-grade syndicated loan issuance surged in Q2-2020. But the activity was much stronger in Europe and Japan than in North America. Leveraged loan activity generally fell as underlying asset quality deteriorated.

(2) Bonds. “The characteristics of new debt in the high-yield bond market reveal a shift toward higher quality,” noted the report. Nearly 60% of high-yield new issues in the G7 economies during the first half of the year were BB rated, and more than 30% of the bonds were secured (see the IMF’s Figure 3.3.3). That represented the highest levels in at least the past 15 years. More than 80% of issues this year were for refinancing existing debt. Issuances intended to raise capital for acquisitions, buybacks, or dividends were at their lowest share in a decade (see the report’s Figure 3.3.4).

(3) Spreads. Yet default risk remains as corporate spreads, especially in the high-yield sector, remain wider than the start of the year. The “sharp deterioration in corporate fundamentals and concerns about default risk” in the G7 economies contributed to the widening spreads. Specifically, the report observed in a footnote: “As of September 10, 2020, US investment-grade (high-yield) credit spreads had widened 33 basis points (125 basis points) since the beginning of the year. In Europe, investment grade (high-yield) spreads had widened 9 basis points (101 basis points) on a net basis.”

(4) Vulnerable. Looking ahead, a key issue for financial stability will be the deterioration in corporate solvency resulting from pandemic-related declines in profitability and corporate credit quality, noted the IMF. Firms with three issues may be particularly vulnerable to future liquidity strains—i.e., those with: i) limited access to credit markets, such as small firms; ii) impaired liquidity because of low cash reserves or high short-term debt; and iii) high leverage. The IMF doesn’t suggest policies that directly target those most vulnerable to “adverse funding liquidity shocks” but policies that benefit these firms indirectly by supporting the economy.

(5) Policy. The good news for the Zombies is that global central banks—including the Federal Reserve, Bank of Japan (BOJ), and European Central Bank (ECB)—appear to be in no rush to change policy course. Fed officials have committed to holding interest rates near zero until at least 2023. The Fed is expected to maintain its current pace of bond purchases as long as Covid-19 menaces the economy, observed a November 1 WSJ article.

BOJ Governor Haruhiko Kuroda recently said that his bank could extend the March 2021 deadline of its crisis program if “necessary and appropriate” to aid struggling corporates, according to Reuters. “There’s also plenty of room to expand the scale of easing for each element of our crisis-response programme,” he added. ECB officials are expected to expand the scope and duration of their pandemic policy package at their December meeting, reported CNBC.

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Viral Stress Test

November 03 (Tuesday)

US Economy I: GDP vs the Virus. The initial estimate of Q3-2020 real GDP growth released by the Bureau of Economic Analysis (BEA) on October 29 was 33.1% (saar), 3.9ppts below the final GDPNow model “nowcast” released on October 28 by the Federal Reserve Bank of Atlanta. The initial GDPNow model estimate for real GDP growth in Q4-2020 is 3.4%, made on November 2.

As a result of the remarkable rebound in real GDP last quarter, Debbie and I are cutting our estimate for the current quarter from 10% to 5% but sticking with our forecasts of 3% per quarter next year and 2% per quarter in 2022 (Fig. 1). Our key premise is that real GDP will fully recover from the lockdown recession that occurred during the first half of this year by the end of next year.

We assume that there will be another round of fiscal stimulus of $1.5 trillion to $2.0 trillion after the election no matter who wins the White House, the House, and the Senate. We aren’t convinced that the economy needs it to continue to recover given that ultra-easy monetary policy is likely to continue to support the boom in housing-related industries. Then again, the third wave of the pandemic is underway. However, we don’t expect another round of lockdown restrictions as severe as the ones that caused the recession during the first wave.

We are encouraged to see that the weekly data on credit/debit card consumer spending continued to recover during the October 9 week from the April lows (Fig. 2). We are also glad to see that both total petroleum usage and gasoline usage remained on their recovery paths during the October 23 week (Fig. 3 and Fig. 4).

That’s the good news, so far. The bad news is that the third wave of the pandemic could be worse than the first wave. Based on the 10-day moving average of COVID Tracking Project data through October 30, the number of new positive test results rose to a record 73,403 (Fig. 5). That’s mostly because the number of new tests rose to a record 1.17 million over this period; but the positivity rate has increased from a recent low of 4.2% on October 6 to 6.3% currently.

The number of new positive cases tends to lead the number of current hospitalizations, which is up from a recent low of 29,755 on September 28 to 42,478 on October 30 (Fig. 6). In turn, current hospitalizations leads the number of deaths, which is up from a recent low of 978 on October 16 to 1,103 on October 30 (Fig. 7).

US Economy II: Consumers Consuming. On Friday, the BEA reported that personal income rose 0.9% m/m during September, while personal consumption expenditures increased 1.4% during the month. Both were stronger than expected. They shouldn’t have been surprising given the strength in September’s personal income and payroll tax receipts reported by the federal government (Fig. 8 and Fig. 9). The 12-month sum of personal income tax receipts shows a remarkably fast rebound since June (Fig. 10). On the same basis, payroll tax receipts hasn’t even flinched but rather has continued to rise to new record highs since the start of the year!

How is this possible given that the number of unemployed workers soared from 5.8 million during February to 23.1 million during April (Fig. 11)? It has come down since then, but remained very high at 12.6 million during September. This is quite puzzling. Could it be that many of the unemployed had received a significant portion of their pay in unreported cash? Perhaps the Paycheck Protection Program has done a surprisingly good job of keeping workers on payrolls. Maybe, but we don’t know. Let’s have a closer look at September’s personal income and spending numbers:

(1) Wages, salaries, supplements, and government benefits. Pre-tax personal income excluding government social benefits is up 8.2% since its recent trough during April, but has remained 1.6% below its record high during February (Fig. 12). Leading the recovery has been labor compensation, which is up 8.4% since April but still 2.6% below its record high during February.

Government social benefits provided a huge boost to personal income from February through April, more than offsetting the drop in personal income excluding these benefits (Fig. 13). As the pandemic-related benefits has dissipated in recent months, it’s been good to see that personal income excluding them has recovered. The third wave of the pandemic suggests that Washington might very well provide another round of emergency benefits after the election.

(2) Other sources of personal income. Receipts on assets has been declining since early this year as both interest income and dividend income have decreased (Fig. 14). Rental income has been remarkably flat at a record high all year so far considering that lots of tenants have stopped paying their rent. However, this component of personal income includes imputed rent on owner-occupied housing, which accounts for roughly 70% of the total. The big surprise was the big recovery in proprietors’ income, which plunged 18.0% from February through April but soared 32.3% since then through September to a new record high!

(3) Taxes. The personal income release confirms that both individual income taxes and payroll taxes have held up surprisingly well this year, having reversed in recent weeks most of the decline earlier this year (Fig. 15 and Fig. 16). The BEA data for these two series includes taxes paid to the federal government as well as to state and local governments.

(4) Saving. One of the main reasons that we believe that the economy can continue to recover over the rest of this year even if a second round of fiscal stimulus doesn’t happen is that consumers haven’t spent all of the first round of cash provided by the government. Personal saving totaled $2.5 trillion (saar) during September, down from an all-time record high of $6.4 trillion during April but still well above the $1.3 trillion at the start of the year (Fig. 17). The personal saving rate started the year at 7.6%, jumped to 33.6% during April, and was back down to 14.3% during September.

(5) Spending. Another reason we believe that the economy can continue to recover absent another fiscal stimulus package is that monetary policy remains very stimulative, boosting home sales and housing-related retail sales. Personal consumption expenditures rose in September, with spending on goods rising further into record-high territory, led by housing-related consumption (Fig. 18 and Fig. 19). Still lagging behind are the pandemic-challenged services, including air transportation, hotels & motels, spectator amusements, and amusement parks (Fig. 20 and Fig. 21). Gambling has made a big comeback. So has spending on food services, suggesting that many restaurants are staying in business thanks to takeout orders.

(6) Housing. With mortgage rates near record lows and the pandemic causing many urban renters to become suburban owners of homes (especially Millennials), the housing industry is booming. The Housing Market Index compiled by the National Association of Homebuilders rose to a new record high in October (Fig. 22). The Pending Home Sales Index compiled by the National Association of Realtors edged down ever so slightly during September from its record high the prior month.

Strength in residential construction spending should continue to offset the weakness in nonresidential and public construction (Fig. 23).

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And the Winner Is . . . ?

November 02 (Monday)

Politics I: What If Gridlock Wins? I’ve often observed that the US economy has performed remarkably well over the years despite Washington. Presidents like to take credit for the millions of jobs they have created or boast about the number of jobs they will create. Presidential candidates make similar promises about how their policies will boost employment by millions if they are elected or re-elected.

The reality is that it is businesses that create jobs, not politicians. Businesses tend to do a better job of creating jobs when they aren’t burdened by Washington’s meddling in their affairs. Since Washington almost always meddles to varying degrees with the economy, it’s amazing how so many businesses in so many industries continue to be profitable and to expand their capacity and payrolls, with only recessions briefly tripping them up.

This line of thinking leads to the widely held notion that the economy and the stock market do best when Washington’s politicians are stymied from meddling as much as they would like by political gridlock, i.e., when the party of the president doesn’t have majorities in the House and/or the Senate. Divided government is bullish, while unified government is bearish, or less bullish.

Our governing system of “checks and balances” is the core principle that guided the nation’s founders when they wrote the US Constitution. In addition, many of them signed the Declaration of Independence, which declared: “Governments are instituted among Men, deriving their just powers from the consent of the governed.” They were mostly lawyers, and they designed a system that worked best when it didn’t allow any majority party to have too much power for too long.

By the way, Abraham Lincoln, who was a lawyer as well as a president, famously restated the founding principle in his Gettysburg Address: “that these dead shall not have died in vain—that this nation, under God, shall have a new birth of freedom—and that government of the people, by the people, for the people, shall not perish from the Earth.”

Today, many investors fear that a Blue Wave on Election Day could happen, giving the Democrats’ unfettered power to implement their expansive and expensive agenda, including increasing federal spending, raising federal taxes, imposing more regulations, packing the Supreme Court, and so on. Wall Street strategists, including yours truly, countered that the bearish impact of higher taxes and more regulations should be offset by more spending in the Blue Wave scenario.

I asked Debbie to analyze the performance of the S&P 500 under unified and divided government since FDR took office (Fig. 1). She calculated the percentage increases in the index from January-through-December periods during the two alternative regimes. She found that during the previous six Blue Waves, the S&P 500 increased 56% on average. During the previous three Red Waves, the index rose 35% on average. During the seven periods of divided government, the S&P 500 rose 60% on average.

This suggests that gridlock is more bullish than the two unified alternatives, which are also bullish, but less so with Blue Waves more bullish than Red Waves. Perhaps the market figures that government spending is less likely to increase more than taxes when the government is divided rather than unified. In any event, the government has been getting bigger and more meddlesome for years, as evidenced by ever-widening federal budget deficits and mounting federal government debt (Fig. 2). (The founders generally disapproved of debt and believed that the amount the country owed should be limited.)

Alternatively, could it be that the White House and the Congress don’t matter as much to the stock market as does the Fed? I think so, and so does Barron’s, which chose to run a cover story on Fed Chair Jerome Powell with the title “This Is Jerome Powell’s Moment, No Matter Who Wins” this week. The article, written by Nick Jasinski, observed: “Tuesday’s election will be a critical one for the nation. But for those nervous about the economy, the Fed’s chairman may just be the most important man in Washington.”

I was quoted in the piece as follows: “He’s a pragmatic pivoter. He’s done what he set out to do, and [shown a willingness to] change his mind depending on what the situation demands, but not be totally inconsistent.” Chapter 8 of my book Fed Watching for Fun & Profit is titled “Jerome Powell: The Pragmatic Pivoter.”

I previously have observed that no matter who wins the White House on Tuesday (or before Inauguration Day), he won’t be as important as Powell, whose first term doesn’t end until early 2022. Powell has made it very clear that he intends to keep the yield curve close to zero. The federal funds rate was lowered to zero on March 15 (Fig. 3).

The 10-year US Treasury bond yield has been below 1.00% since March 20 (Fig. 4). From February through September, the Treasury issued $670 billion in notes and $259 billion in bonds (Fig. 5 and Fig. 6). Over the same period, the Fed purchased $1,223 billion in notes and $338 billion in bonds. Previously, I’ve argued that if the bond yield rises above 1.00%, the Fed will most likely announce an official target range below 1.00%, a.k.a. “yield-curve targeting.”

Finally, since Halloween coincided with a full moon this weekend, all the more reason to fear the front cover curse. What could possibly go wrong for Powell?

Politics II: What If Trump Wins? The polls suggest that Trump will lose to Biden in the key battleground states. The polls were wrong about Trump four years ago. The country is so bitterly divided that many Trump supporters are “shy” Trump voters and hang up the phone when a pollster calls them. An October 29 Politico Magazine article observed:

“In 2016, months of national polls confidently showed Hillary Clinton ahead, and set many Americans up for a shock on Election Night, when the Electoral College tilted decisively in Trump’s favor. Two pollsters who weren’t blindsided by this are Arie Kapteyn and Robert Cahaly. …

“This year, both men believe that polls could again be undercounting Trump’s support. The reason is ‘shy’ Trump voters—people reluctant to share their opinions for fear of being judged. Though the ‘shy voter’ idea is thrown around a lot by both Trump supporters and Democratic skeptics, Kapteyn and Cahaly have specific insights into why, and how, Trump support might be going undetected.”

Hillary Clinton disparaged Trump supporters as “deplorable” when she campaigned in 2016. Joe Biden recently called them “chumps.” Cahaly observed that the “soccer mom doesn’t want to say she’s for Trump because she doesn’t want you to think she’s one of them. … [T]here are a lot more people who like professional wrestling than admit it. There are lots of fans who don’t want you to think they’re like the other people who like professional wrestling.”

Cahaly concluded: “There’s a lot of hidden Trump votes out there. Will Biden win the popular vote? Probably. I’m not even debating that. But I think Trump is likely to have an Electoral College victory.”

If Trump wins, it might be because shy voters mostly agree with Trump’s conservative policies and either like his swaggering personality or look past it. What about the pandemic? Shy voters may fear another lockdown under Biden more than they fear the virus. Biden has recently been saying: “I’m going to shut down the virus, not the country.” He has been walking back his August 21 statement in an ABC “World News Tonight” interview in which he said that he would shut the country down to stop the spread of Covid-19 if the move was recommended to him by his health experts: “I would shut it down; I would listen to the scientists.”

Trump repeatedly has vowed to keep the economy open. That promise will be easier to fulfill if one or more vaccines are available for widespread distribution during the first half of next year. Progress on the economic front requires that the latest wave of the pandemic is managed with selective rather than widespread social-distancing restrictions until enough people are inoculated against the virus. Until that happens, another round of fiscal stimulus is likely under either Trump or Biden. While Biden will press for much more spending than Trump and raise taxes, Trump has promised to lower taxes on the middle class.

Politics III: What If Biden Wins? In a Blue Wave scenario, government spending is likely to increase more than if Trump is re-elected. Taxes would also go up a lot for anyone earning over $400,000. So would taxes on corporations. The only question is when. I asked Jim Lucier, our good friend and a managing director at Capital Alpha Partners, to comment on this issue. Here is his erudite answer:

“Democrats will raise taxes in 2021, but the tax increases will become effective in 2022. As for raising taxes in 2021, there is really no option but to raise them in 2021 if you want to raise them at all. Raising taxes is a heavy lift, and it needs to be done when a president has maximum juice, starting as soon as possible in his first year. Members of Congress will be less interested in raising taxes during a midterm election year. Also, when the economy is weak and unemployment is high, the logical time to raise taxes is to do so as part of a much larger fiscal stimulus bill, which Biden wants Congress to pass early in the year.

“As a matter of custom, Congress does not raise taxes retroactively. Legally speaking, Congress can raise taxes retroactively, and there has been litigation over a couple of instances in the past century starting with the Revenue Act of 1913. This includes a technical case when Congress did not intend to raise taxes retroactively but did so accidentally.

“However, the fuss associated with retroactive tax increases is so great that in the modern era Congress almost never does. What Congress will do, on occasion, is announce in advance that some policy will take effect as of the date of announcement. For instance, Chuck Grassley announced that he had a provision against corporate inversions that would take effect as of the date he announced it, even if the bill it was part of was not likely to be enacted for some time. Ron Wyden has done the same thing a couple of times. If Wyden or Grassley wants to shut down a tax shelter immediately, they put the world on notice that sooner or later, the tax shelter will be prohibited as of that date. It may take them another year or two to actually pass the bill.

“In 1992, when Congress raised taxes mid-year, they did adopt a blended tax rate that reflected a rate increase as of mid-year. That’s because having a tax rate that changes mid-year is a pain in the rear.

“I have had the opportunity to pursue this question with people who have had the appropriate tippy-top tax counsel jobs on the Hill, and they assure me that the tax increase will be prospective, to 1/1/2022 or to corporate tax years beginning after 1/1/22.

“Another thing to consider is that Biden could raise the corporate tax rate in stages, perhaps spreading a 7-percentage-point increase in the corporate tax rate over seven years at 1 percentage point per year. The same logic about prospective tax increases would also apply to capital gains tax increases, which is actually the topic investors ask about most frequently.”

Politics IV: Electoral College Scenarios. What if there is no clear winner after the polls close on Election Day? It may take a few days to count all the ballots, creating lots of suspense and angst. The winner might not be known until the Electoral College meets on December 8. Along the way, both sides might ask the Supreme Court to intervene on contested issues that will decide the outcome. Here’s is a brief crib sheet on some of the possible scenarios:

(1) Not a popularity contest. A useful article explaining the Electoral College appeared in the October 22 NYT. It observed: “When Americans cast their ballots, they are actually voting for a slate of electors appointed by their state’s political parties who are pledged to support that party’s candidate. (They don’t always do so.)”

So the outcome of the vote in the Electoral College mostly depends on the key battleground states, as the winner needs at least 270 votes of the total 538. Several past presidents achieved that even though they lost the popular vote, including D.J. Trump, G.W. Bush, B. Harrison, and J.Q. Adams.

(2) Counting states. A tie is possible. In that event, the newly elected House of Representatives gets to decide the winner, with each state voting as a unit. The NYT article explains: “If there is a tie vote in a state’s delegation, the state’s vote would not count. A presidential candidate needs at least 26 votes to win. Currently, Republicans control 26 state delegations, while Democrats control 22. Pennsylvania is tied between Republican and Democratic representatives, and Michigan has seven Democrats, six Republicans and one independent. That could all change on Nov. 3 of course, because all House seats are up for election. … Ultimately, any disputes about the procedure could land everything in the Supreme Court.”

(3) Faithless electors. The Supreme Court unanimously ruled in July that states may require electors to abide by their promise to support a specific candidate. Currently, 33 states and the District of Columbia have laws that require electors to vote for their pledged candidate. Some states replace electors and cancel their votes if they break their pledge. In 2016, seven electors—five Democrats and two Republicans—broke their promises to vote for their party’s nominee, the most ever in history. They voted for various candidates who were not on the ballot. These renegades did not change the outcome.

(4) Head-spinning scenarios. Now if you really want to read a head-spinning article on this subject, have a look at “Navigating a Contested Election, the Electoral Count Act and 12th Amendment: How to Ensure a Fully Counted Outcome” by two former officials in the Clinton administration. The outcome could be a free-for-all constitutional crisis involving state governors, the Insurrection Act of 1807, the US Attorney General William Barr, Vice President Mike Pence, and House Speaker Nancy Pelosi (D-CA).

Movie. “Away” (+) (link) is a binge-able Netflix series about an American astronaut, played by Hilary Swank, embarking on a dangerous mission to Mars as commander of an international space crew with representatives from China, India, Russia, and Ghana. The first season spends more time on the emotional toll of being away from family and loved ones on a three-year roundtrip to the Red Planet than on the actual journey, which obviously doesn’t go so smoothly with plenty of technical and interpersonal problems along the way there. So it’s a touchy-feely Mars movie. Meanwhile, here on Earth, Elon Musk is planning on colonizing Mars. According to a Friday report, the would-be Martian King ruled that his colony won’t be ruled by any “Earth-based government”—and will instead adhere to its own “self-governing principles.” May the force be with Elon. Let’s see how far Elon gets. Netflix hasn’t renewed for a second season.

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Trick or Treat?

October 29 (Thursday)

Strategy: Panic Attack #67 Isn’t Over. Halloween, which falls on Saturday this year, dates back to the Celtic festival of Samhain, according to History.com. The night before their new year began on November 1, the Celts believed the ghosts of the dead returned to earth. They would build huge bonfires, where people wearing costumes burned crops and animals as sacrifices to the gods.

Investors have been easily spooked since the S&P 500 peaked at a record high of 3580.84 on September 2 (Fig. 1). It dropped 9.6% through September 23, finding support at the level at the start of this year. It then rebounded but failed to make a new high. After yesterday’s rout, it is down 8.7% from the September 2 peak and ready to test the September 23 low. We characterized September’s selloff as Panic Attack #67, mostly attributable to the market’s overvaluation and triggered by jitters about the coming election (Fig. 2). It has continued into October. (See our Table of S&P 500 Panic Attacks Since 2009.)

The question is will it end once we know who will be in the White House? We should know that by the end of November 3. The market’s recent selloff may reflect jitters about a contested election. In recent weeks, investment strategists, including yours truly, have argued that the market should move higher no matter who wins. The common notion was that another round of fiscal stimulus will be delivered under either Trump or Biden. There might be even more government spending under Biden, which should offset some of the negative consequences of more taxes under him.

However, the latest wave of the pandemic may be raising concerns that Biden would be more likely to reimpose severe lockdown restrictions if so advised by his health experts than would Trump. The resurgence of Covid cases is leading to renewed business restrictions in Europe. France is returning to full lockdown mode, with residents allowed to leave their homes only for school, to buy essentials, seek medical attention, or exercise. Italy is closing restaurants and bars at 6 pm for a month. Germany is closing bars, restaurants, gyms, discos, theatres, and concert venues for four weeks. And Sweden, which eschewed restrictions during the first Covid wave, is expected to invoke restrictions similar to its neighbors next week.

Here’s a look at the market’s recent price action and what analysts are expecting for earnings growth in the first half of 2021.

(1) Utilities beat out Tech. You know the market gods want human sacrifices when the widely owned Technology sector gets hit, while the Utilities sector shines. Here’s the performance derby for the S&P 500 sectors from September 2 through yesterday’s close: Utilities (4.5%), Industrials (-6.1), Consumer Staples (-6.3), Health Care (-6.3), Materials (-6.5), Consumer Discretionary (-6.7), Financials (-7.2), Real Estate (-8.3), S&P 500 (-8.7), Communications Services (-10.6), Information Technology (-12.2), and Energy (-20.3) (Fig.3).

That’s vastly different than the action that has propelled the S&P 500 by 60% from March 23 through September 2: Information Technology (80.2%), Consumer Discretionary (79.8), Materials (72.1), Industrials (63.4), S&P 500 (60.0), Communication Services (56.7), Health Care (46.2), Energy (45.3), Real Estate (44.5), Financials (44.0), Consumer Staples (36.7), and Utilities (34.1).

(2) 2021 comparisons: So much easier. The only good thing about a recession is that a year later earnings comparisons so are much easier. The virus-induced recession of this spring torpedoed earnings, but it means that 2021 is setting up for a year of earnings growth, thanks in part to much easier comparisons.

While S&P 500 earnings started to tumble in Q1-2020, the biggest earnings decline occurred in Q2. Here’s a look this year’s miserable quarterly earnings declines for the S&P 500, with Q3 and Q4 representing estimates from Refintiv: Q1: -12.8%, Q2: -30.6%, Q3: -16.7% and Q4: -12.4%.

Starting in the first quarter next year analysts are optimistic that earnings growth for the S&P 500 will resume. Here are the 2021 quarterly forecasts: Q1: 14.2%, Q2: 44.4%, Q3: 23.3%, Q4: 23.6%.

Estimates going out more than six months are notoriously suspect, but the forecasts in the first half of the year should be right directionally if nothing else. Add the quarters together and 2020 earnings appear on a path to fall 18.1%, only to rebound by 24.5% next year (Fig.4).

(3) Most sectors’ earnings improve too. By Q1-2021, earnings growth for all of the S&P 500 sectors—except Energy and Real Estate—turn positive. And by Q2-2021 even those laggard sectors post positive earnings growth, according to analysts’ estimates.

Here is the performance derby for the S&P 500 sectors’ Q1-2021 estimated earnings growth: Consumer Discretionary (73.4%), Financials (43.0), Materials (25.6), S&P 500 (14.2), Health Care (12.6), Information Technology (10.8), Communication Services (6.7), Utilities (3.4), Industrials (0.9), Consumer Staples (0.6), Real Estate (-2.0), and Energy (-59.1). It’s a welcome change to see some of the more cyclical sectors earnings doing well, with Materials, Industrials, and Financials posting stronger earnings growth than Technology and Communication Services.

Financials Q1-2021 earnings estimates have improved sharply since October 1 when the industry began reporting Q3 results. Q1-2021 estimates for the Financials sector have improved from 26.5% on October 1 to 43.0% now. The earnings growth estimate for the Materials sector also improved nicely, by 4.8ppts since October 1.

With the easiest comparisons, Q2-2021 earnings growth is the strongest of any quarter next year. Here’s the performance derby for the S&P 500 sectors’ earnings forecasts for Q2-2021: Industrials (419.1%), Consumer Discretionary (186.7), Energy (152.1), Financials (55.7), Materials (52.7), S&P 500 (44.4), Communication Services (29.5), Real Estate (13.4), Information Technology (13.0), Consumer Staples (9.7), Health Care (6.7), and Utilities (2.8).

Estimates for the Financials sector also improved nicely for Q2-2021, as they only stood at 47.4% on October 1 and they’re now 55.7%. Estimates for Q3 and Q4 of 2020 have also improved since the start of the month. On October 1, Financials was supposed to see earnings growth fall by 21.6% in Q3-2020 and fall 22.1% in Q4-2020. The sector is still expected to see earnings fall, but by much less: -3.7% in Q3-2020 and -10.3% in Q4-2020. With nearly two-thirds of the Financials sector’s results in for Q3, 86% of companies have exceeded analysts’ expectations and only 14% have disappointed.

Other sectors haven’t had as many members report as Financials. But primarily thanks to the improvement in the Financials sector’s earnings estimates, the entire S&P 500’s earnings estimate has improved. It now stands at a 16.7% decline in earnings for Q3, up from the 21.4% decline expected back on October 1.

Disruptive Technologies: Gene Therapy Evolution Continues. Among the most exciting advancements in science are occurring in the development of gene therapies. Two recent developments caught our eye. First, Crispr technology is now being tested in the treatment of cancer and second Bayer announced this week its acquisition of gene therapy pioneer Asklepios BioPharmaceuticals. Here are some of the details.

(1) Crispr targets cancer. Researchers at Madrid’s National Center for Cancer Research used Crispr technology to correct mutations in cancer cells in mice to slow or stop the growth of those cancer cells, the folks at ARK Investment Management reported in this week’s newsletter.

Spontaneous gene mutations in cancer cells drive tumor growth. The scientists in Madrid focused on gene fusions, “when two genes, often from different chromosomes, collide inside a cancer cell. Fusions create highly dangerous proteins, called chimeras, that drive tumor growth,” the ARK explained.

Scientists used RNAs to bind to the mutated cancer genes in mice and delete the fusion. Fusions only occur in cancer cells, so this therapy would not affect healthy cells. And it allows cancer cells essentially to repair themselves.

Tumors in the mice that were treated with the Crispr technology were smaller than the tumors in the untreated mice. In addition, the treated mice lived longer, according to the study, which appeared in Nature Communications on October 8. Results were even more positive when Crispr technology was combined with chemotherapy.

(2) Big pharma buys in. Bayer became the latest large pharmaceutical company to purchase a gene therapy company. It will pay $2 billion to purchase Asklepios BioPharmaceuticals and up to an additional $2 billion if milestones are met.

Known as AskBio, the company is conducting trials of gene therapies to treat Pompe disease, Parkinson’s, and congestive heart failure. And, according to its website, the company is also in preclinical trials for treatments of Angelman Syndrome, Huntington’s disease, and Methylmalonic acidemia.

AskBio has sold two gene therapy subsidiaries in the past. Bamboo Therapeutics, which focused on Duchenne muscular dystrophy, was sold to Pfizer in 2016 for $645 million and Chatham Therapeutics, focused on genetic solutions for hemophilia, was sold to Baxter International for an initial $70 million in 2014.

Financials: The ABCs of PPP Loans. US banks provided $525.0 billion of loans under the Paycheck Protection Program (PPP) overseen by the Small Business Administration. The impact on the financials of large money center banks, like JPMorgan, was modest and few details were given. Asset management, capital markets, and huge loan books made the impact of even large volumes of PPP loans barely material.

The impact on smaller banks is more notable, however. Zion Bancorporation did an admirable job of disclosing just how PPP loans affect the bank’s financials. Zion, like most large banks, is donating any profits from the loans to charity. The PPP loans do boost the bank’s loan growth, a fact that the bank clearly points out. And the impact of the loans will be temporary. The loans will be forgiven by the government or they’ll mature in five years. Here’s a look at some of the details.

(1) Big banks yawn. JPM made $28 billion of PPP loans by the end of Q2. While seemingly large, the PPP loans represent just 2.9% of the banks $978.5 billion Q2 total loan book. Its Q2 quarterly filing states that the “impact on interest income was ‘not material’” and because the loans are guaranteed by the government, the bank doesn’t hold regulatory capital against them.

PPP loans have a 1% interest rate and the processing fees are deferred and accreted into interest income over the life of the loans, JPM reported. But expenses will offset much of that income.

“We don’t intend to profit from PPP,” said Jennifer Piepszak, chief financial officer in the company’s Q2 conference call. “[Y]ou’ll have some revenue and then you’ll have expenses, and the profit will be near zero. It is an immaterial amount this quarter, given these fees are recognized over the lives of the loans. …[W]e’ll see more of that probably in the third and fourth quarter. Again, they — it will still be zero on the bottom line.”

(2) Zion offers up details. Zion’s was the ninth largest PPP originator, an outsized market share given it’s the nation’s 37^th largest financial institution. As of Q3 the bank made $6.8 billion of PPP loans.

PPP loans meant the bank’s loan book grew. Zion’s Q3 net loans and leases were $54.7 billion, up $5.9 billion, or 12%, including PPP loans. If the PPP loans are excluded, loans fell by $0.9 billion.

Like many other banks, Zion is contributing profits from the loans to charity. In Q3, the bank made a one-time $30 million contribution to the bank’s charitable foundation, related to the origination fees earned on the PPP loans. The donation was deemed a noninterest expense and it lifted the bank’s adjusted noninterest expense to $440 million in Q3, up from $415 million in Q3 2019. If the donation is backed out, noninterest expense was down 1% y/y.

The PPP loans brought down the yield on Zion’s loan portfolio. The yield on average interest earning assets was 3.2%, down 21bps q/q and down 95bps y/y. It was dragged down by the yield on PPP loans, 3.03%, compared to the non-PPP loan portfolio, 3.77%.

The yield on PPP loans will fall even further this quarter because the PPP loans’ maturity dates were extended to five years and in October the Small Business Administration began the PPP loan forgiveness process. In its Q3 conference call, Zion CFO Paul Burdiss noted that after extensions, the yield on the PPP loans falls to about 1.7% or less. As loans mature or are forgiven, fees attached to the PPP loans, which would have been amortized over the life of the loans, accelerate into net interest income. The bank has received an application for or granted forgiveness on about 25% of its PPP loans.

The bank incurred expenses related to the PPP program. It paid out $3 million of PPP-related bonuses and spent $3 million on advertising expenses in its effort to retain new PPP lending clients.

The PPP loans improve the bank’s credit statistics. The loans are guaranteed by the federal government and banks aren’t holding regulatory capital against them. With the PPP loans, the ratio of total allowance for credit losses to loans and leases outstanding was 1.68%, but without the PPP loans that ratio deteriorates slightly to 1.91%. Conversely, it hurt the bank’s efficiency ratio, which was 62.2% in Q3, up from 57.3% in Q3 2019. Without the PPP-related charitable contribution, the efficiency ratio would have been 58.0%.

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Leaning Out

October 28 (Wednesday)

US Economy: Voom. The latest batch of economic indicators confirms that the US economy bottomed in April and has been in a “Voom” through October. A Voom is a V-shaped boom. Of course, past performance is no guarantee of future results if the latest wave of the pandemic leads to renewed widespread lockdown restrictions. That could happen nationwide if Joe Biden is the next President and his medical experts tell him to shut it down. It is less likely to happen if Donald Trump is reelected since he mostly ignores the experts. In any event, at least one vaccine is likely to be ready for distribution early next year and so is another round of fiscal stimulus after the election no matter who wins the White House.

For now, we take comfort in October’s regional business surveys conducted by five of the Federal Reserve district banks (Fig. 1). As Debbie discusses below, the averages of their composite, new orders, and employment indexes were very strong. Also vooming through September are durable goods orders, especially nondefense capital goods orders excluding aircraft (Fig. 2). That augurs well for capital spending. All these indicators surpassed their February pre-pandemic levels.

Labor Force I: Dropping Out. Considering the many challenges for working parents as a result of the pandemic, it is not surprising that those who have the option and can afford it would have one parent leave the workforce to manage the home front. Some parents, especially single ones that could not really afford it, may have been forced to do the same for lack of other options. That’s a major reason why it is important to look at those that have decided to leave the workforce in addition to those counted among the ranks of the employed and unemployed to fully understand the impact of the pandemic on the labor market.

The unemployment rate fell dramatically from a record high of 14.7% during April to 7.9% during September (Fig. 3). Over this same period, the unemployment rate for women fell from a peak of 15.5% to 7.7%, while for men it fell from 13.0% to 7.4% (Fig. 4).

But these dramatic improvements in the labor market partly resulted from people dropping out of the labor force and giving up looking for work rather than finding jobs. From January through September, the labor force fell 4.5 million with 25-54 year-old women in the labor force down 1.7 million and 25-54 year-old men down 972,000 million (Fig. 5). Over the same period, 25-54 year-old women not in the labor force rose 1.6 million, while 25-54 year-old men not in the labor force rose 953,000 million (Fig. 6). Over this same period, the labor force participation rate is down from 63.4% to 61.4%, with declines from 77.0% to 74.2% for working-age women (25-54 years old) and from 89.3% to 87.7% for men (Fig. 7 and Fig 8).

Now consider the following related developments:

(1) Mom’s opt out. In an October 6 virtual speech for the National Association for Business Economics, Federal Reserve Chair Jerome Powell said that measures broader than unemployment may better capture current labor market conditions “by adjusting for mistaken characterizations of job status, and for the decline in labor force participation since February.” Powell also noted in the same speech that the burdens of the downturn have been uneven with the overwhelming burden of childcare during quarantine and distance learning falling mostly on women. Lean In’s founder Sheryl Sandberg recently told CNBC that many working mothers were doing a “double double shift” during the pandemic.

That’s likely why a staggering 865,000 women ages 20 and over left the workforce in September compared to 235,000 men in that group, according to a National Women’s Law Center analysis referenced in the CNBC article. Lean In and McKinsey & Company’s recent annual “Women in the Workplace” report found that for the first time in the previous five years of the study, women are leaving the workforce at higher rates than men.

The drop in the female labor force participation rate during the pandemic has been concentrated among the 35 to 44 year-old age-group, which is the most likely group to have multiple young children at home as pointed out by Betsey Stevenson, a professor of public policy and economics at the University of Michigan in a 10/23 article for the New Yorker. Stevenson anecdotally said that “Zoom” school for parents of three children ages 4, 6, and 9, for example, would be difficult for anyone to manage even if both parents were available and working-at-home.

(2) Childcare constraints. The childcare issue seems to be paramount. McKinsey recently found that one-quarter of women were considering fewer hours, less demanding work, or leaving the workforce due to Covid-19. A Northeastern survey conducted between May 10 and June 21 referenced in the New Yorker article noted that 13.3% of working parents had lost their job or cut back on their working hours because of a lack of childcare options. The Federal Reserve’s 10/21 Beige Book regional summary for Atlanta stated: “Employers remained concerned about workers’ abilities to balance workloads with the demands of childcare and the return to school, in person or virtual.”

(3) Dads cut back too. Many working parents, including men and women, have had trouble keeping up with work over the course of the pandemic. Anecdotally, Melissa’s local car service repair shop told her during September that repairs to her car would take longer than usual. That was because they were understaffed recently having had lost several dads to remote learning.

A 10/22 Pew study observed that fewer parents were working and more parents had cut their hours this year versus last. Pew found that the shares of both mothers and fathers (with children under 18-years-old living at home) who were employed and at work fell, by 5.6ppts and 4.9ppts, respectively from September 2019 to September 2020. Many more moms than dads recently dropped out of the labor force, however, Pew noted. But dads cut back more on their working hours than moms did.

(4) Long-term damage. The long-term economic burden resulting from the pandemic may be most significant for the prime-aged individuals who have left the workforce whether by choice or not. Stevenson told the New Yorker that the childcare crisis may continue long after the pandemic. The industry is structured among many small providers that are unable to absorb large losses as incurred during the pandemic. Some may close. For others, charging a higher cost of care may be necessary, causing parents to make different decisions about care.

Many working dads have had to cut-back on their hours to take care of the kids, but it seems that the larger burden may fall on working moms who have already left or are considering leaving the workforce. Their professional skills may weaken, causing the loss of relevancy in a fast-paced high-tech world the longer they are out of it. They may miss months, years, or even a lifetime of opportunities for earning income, saving for retirement, and getting promoted. It’s not just these women that will be financially impacted, but their families too.

Labor Force II: Melissa’s Story. The pandemic has upset everyone’s lives. It’s particularly tough for working parents with children. I asked Melissa to relate her experience as the working mother of two little girls and the wife of a self-employed businessman. Here is her story:

I understand firsthand why so many working parents, especially women, are dropping out of the labor force as discussed above. Our local school was closed due to the pandemic outbreak during March when our daughter was in kindergarten. Initially, remote learning for kindergarten consisted of learning packets whereby parents were expected to walk children through up to two hours of learning per day in addition to special activities including Music, Art, and Physical Education. The lessons were not too challenging and could be done at any time during the week, which was helpful for my preexisting remote work schedule.

Nevertheless, entertaining and meeting the routine daily needs of a six-year old and her six-month old baby sister at the time, has been challenging. I no longer felt comfortable turning to Grandma for extra support given that the virus has more serious consequences for older folks. The nursery school in which we had enrolled our youngest daughter also closed due to the pandemic and remains closed to infants.

Unfortunately, my husband’s commercial sign business took a major pandemic hit as his retail, gym, and restaurant clientele stopped all projects. Thankfully, however, he was available to help at home as school started up after summer break for full-time remote learning in mid-August. But even with two adults at home, albeit one working and one aiming to reestablish a business, the situation has been challenging:

(1) Tight schedule. Remote school started out better than expected, but quickly became draining for me and my daughter. Remote classes taught by live teachers are scheduled to the minute in 20-minute-or-so intervals. The classes are all on Microsoft Teams. The kids were taught how to turn the camera on and off, how to use the mute button, and how to raise a virtual hand for a question.

Both the teachers and the children participate as well as they can, but many of the first graders, including my daughter, don’t possess the skills to keep track of their schedules and determine what class they needed to join and how.

(2) Dependent work. As a result, I have been constantly doing so during the school day. I also found that I needed to sit with my daughter most of the time to aid her understanding and keep her on task. Like many of the kids, she already had fallen behind at the end of the previous school year at the onset of the pandemic.

Interspersed during live instruction, the first grader was instructed to do independent work on a software platform but doing so completely independently was a challenge. My daughter and I were not the only ones challenged by remote school as many other children and parents in the class shared the same frustrations. The school and the teachers were giving remote learning their best effort, but the format just does not lend itself well to teaching young kids.

(3) Groundhog Day. From about 7:30 am until 2:00 pm during the week from mid-August to mid-October, I managed remote elementary school while my husband cared for our infant. Then from about 2:00 pm until 5:00 pm, we juggled the kids, the household chores, and my work before preparing dinner, facilitating bath time, and bedtime.

After the kids went to bed, I found myself exhausted, but working as late into the night as possible to keep on top of my work. Before the pandemic, I found that time for leisure, health, or personal growth pursuits was limited, but it became nonexistent with my added pandemic-era responsibilities. It was all about school, the children, and work in a routine-driven mode every day.

(4) Lucky one. Thankfully, my boss is very understanding. Also, I already worked remotely on a flexible schedule. I also had the help from my husband. My older daughter also learned to entertain herself after school hours with virtual playdates over FaceTime. Despite being completely wiped out, I consider myself very lucky. I am still relatively able to manage my major responsibilities, while many other family scenarios undoubtedly make that impossible.

I wonder: How must single parents of grade school children with in-person jobs be faring? How about parents of children with disabilities, or health problems? How about parents who are both working full-time from home and juggling the school schedules of multiple children? These situations seem completely unmanageable.

Some parents may have opted to send their child to daycare centers that have reopened since the lockdowns and created programs for older children to plug into their respective classrooms through “virtual learning lounges.” But these programs are expensive and may not seem to make financial sense for many families. That’s especially true for those that have either recently lost their jobs, or income due to the pandemic.

Some families understandably are fearful of contracting the virus because of vulnerable individuals in their households or close family circles. Many continue to play it safe despite the challenges of remote learning even with the option to send their kids back to physical school. In my daughter’s school district, parents were given the opportunity to send their children back to school for face-to-face learning in mid-October. We opted for our daughter to return with masks and social distancing required, but the school reported that 40% of families had opted to continue with remote learning at least for the rest of the semester.

(5) Once again. Some families, expecting that the school doors would not remain open for long, may have opted for at-home learning for continuity’s sake. Many parents that sent their kids back to in-person school worry too that their child’s school may close again. It’s already happened at a local high school that had recent Covid cases in my area.

What are parents to do if these closures arise again with no warning and they already have returned to in-person work? Or, if a parent lost their previous job due to the pandemic, would it be worth it for them to find a new one just now given the uncertainty around the virus and childcare?

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Who Owns Stocks in America?

October 27 (Tuesday)

Global Economy: Winter Is Coming. The V-shaped recovery in the US may start to swoosh in coming months if the latest wave of the pandemic leads to renewed lockdown restrictions. Housing-related businesses should continue to boom even during the winter months, but another round of voluntary and enforced social distancing would likely weigh hard on many services businesses that were especially hard hit during the initial wave of the pandemic. Consider the following:

(1) Another wave. The 10-day moving averages of new positive tests compiled by the Covid Tracking Project has moved up sharply in recent weeks through October 23 (Fig. 1). That’s mostly because new tests continue to increase, reaching a record high of over a million. The positivity rate remains relatively low at 6%, but it has been edging higher recently. Current hospitalizations are also moving higher again in recent weeks, and could lead to rising new deaths before long (Fig. 2).

(2) Weighing on Europe’s economy again. So far, the latest flash PMIs for the US show that the V-shaped recovery continued during October, led by the NM-PMI, which rose to 56.0 this month, the best reading since February 2019 (Fig. 3). The bad news is that the latest wave of the pandemic in the US could follow the lead of the one in Europe, where another wave of lockdown restrictions is causing the Eurozone’s V-shaped recovery to stall. That’s the implication of October’s flash PMIs for the region, where the NM-PMI dropped to 46.2 from 48.0 last month (Fig. 4).

(3) Fauci weighs in. On Sunday, Dr. Anthony Fauci, the director of the US National Institute of Allergy and Infectious Diseases, said, “We will know whether a vaccine is safe and effective by the end of November, beginning of December. The number of doses that will be available in December will not certainly be enough to vaccinate everybody—you’ll have to wait several months into 2021.” On Friday evening, he said, if “people are not wearing masks, then maybe we should be mandating it.” That’s been my position since early on. Requiring everyone to wear masks makes more sense than lockdowns, in my opinion.

 (4) A shot in the arm. Yesterday, the WSJ reported that “a Covid-19 vaccine being developed by the University of Oxford and AstraZeneca showed a promising immune response and low levels of adverse reactions in the elderly and older adults, according to an interim analysis that the drugmaker said was encouraging.

“The vaccine, now in late-stage human trials aimed at showing its efficacy and safety, is a front-runner in the global sprint for a shot to protect lives and jump-start economies hobbled by the pandemic. Trials in the U.K. could produce results before year-end, fueling hopes among scientists and government leaders that a vaccine might be available for high-risk groups here by early 2021.”

(5) Weighing on stocks. Joe and I have been rooting for the S&P 500 to consolidate its 60.0% meltup gain from March 23 through September 2, when it hit a closing record high of 3580.84. Yesterday, it closed 5.0% below that peak. We would like to see the market give earnings a chance to catch up. It’s been doing that since September 2. The market also needs to see that we are winning the world war against the virus on all three fronts. We’ve made tremendous progress on the financial and economic fronts. But we are on the defensive again on the health front. And, of course, the market needs to see who wins the White House, the House, and the Senate on November 3. Joe and I remain bullish with our target of 3800 for the S&P 500 by the middle of next year.

 Strategy I: The Fed’s Quarterly Data. The Fed’s quarterly Financial Accounts of the United States is a treasure trove of information on the balance sheets and income statements of the major sectors of the US economy. Today, I would like to focus on answering a simple question with the Fed’s data: “Who owns stocks in America?” The answer isn’t as simple. Nor are the Fed’s data detailed enough to assess the extent of wealth inequality based on equity holdings. Nevertheless, here are some interesting insights:

(1) Market capitalization. The total market value of all corporate equities held by US residents was $52.0 trillion at the end of Q2-2020 (Fig. 5). That was down just 5.5% from the record high at the end of Q4-2019. The Fed slices and dices the total into a domestic sector, which includes nonfinancial and financial corporations, and the rest of the world. Data are also available showing publicly traded and closely held equities of corporations in the domestic sector.

The total market cap comprised $33.5 trillion in equities issued by nonfinancial corporations, $10.0 trillion issued by financial corporations, and $8.5 trillion issued by the rest of the world and held by US residents. The $43.5 trillion issued by the domestic sector’s corporations included $37.2 trillion of publicly traded equities and $6.3 trillion of closely held equity (Fig. 6).

Of the $6.3 trillion closely held equities, $4.7 trillion was in S corporations and $1.6 trillion was in C corporations (Fig. 7).

(2) Equities directly held by sectors. The Fed’s data can be used to calculate the percent of the total market cap of all equity issues directly held by the major sectors as follows: household (37.6%), mutual funds & ETFs (27.8), institutional investors (13.4), the rest of world (15.8), and all others (5.4%) (Fig. 8). Institutional investors include property-casualty insurance companies, life insurance companies, private pension funds, federal government retirement funds, and state and local government retirement funds.

(3) Equities directly and indirectly held by households. The Fed’s data show equities held by households both directly and indirectly through life insurance companies, mutual funds, private pension funds, federal government retirement funds, and state and local government retirement funds. (Equities held by defined contribution plans are included in the three retirement funds. Assets held by defined benefit pension funds are not considered assets of the household sector. However, defined benefit pension entitlements are included in the “other” category of household assets.)

The percent of the total market value of US equities held directly and indirectly by households was 61.4% during Q2 (Fig. 9). It’s been hovering between 60% and 65% since the early 1980s. It had been as high as 90% in 1960.

(4) Another piece of equity puzzle. Both S and C corporations are included in the Fed’s accounts and their earnings are included in the profits measure of the National Income & Products Account (NIPA). In NIPA, proprietors’ income is included in personal income (and taxed as such), not in corporate profits. Proprietors’ income is significant, tending to be roughly 80% as much as pre-tax corporate profits since the mid-1960s (Fig. 10 and Fig. 11). In the Fed’s account, there is a table for “proprietors’ equity in noncorporate business.” It rose to a record high of $12.4 trillion at the end of Q2.

The NIPA Handbook explains: “Nonfarm proprietors’ income measures the income, before deducting income taxes, of sole proprietorships, partnerships, and other private nonfarm businesses that are organized for profit but that are not classified as corporations. Sole proprietorships are businesses owned by a single individual. Partnerships include most associations of two or more of: individuals, corporations, noncorporate organizations that are organized for profit, or of other private businesses. Other private businesses are made up of tax-exempt cooperatives, including credit unions, mutual insurance companies, and rural utilities providing utility services and farm marketing and purchasing services.”

(5) Are S corporations undervalued? We are researching whether closely held S corporations are being appropriately valued in the Fed’s accounts. NIPA corporate profits includes the profits of both C and S corporations. C corporations pay corporate taxes on their earnings. Their shareholders report any dividends they receive on their personal tax returns.

S corporations are legal entities that pay no federal corporate profits taxes; instead, all their earnings are treated as taxable income of shareholders, regardless of whether the income is distributed as dividends or retained by the corporation. As a result, most income is paid out as dividends.

In the early 1980s, C corporations produced almost all business income. In 2013, only 44% of the income of business owners was earned through C corporations. Owners of S corporations and partnerships now earn about half of all income from businesses. The shift occurred because of tax and legal changes that benefited pass-through business owners and made the pass-through form more attractive to file. For instance, in 1986, the top individual income tax rate fell below the corporate tax rate. This created significant incentives for a business to un-incorporate and for new businesses to organize as pass-throughs.

The S&P 500 companies tend to account for about 50% of total after-tax corporate profits (Fig. 12 and Fig. 13). The difference between total profits in the NIPA and S&P 500 aggregate earnings is attributable mostly to the profits of S corporations, accounting for roughly the other half of corporate profits (Fig. 14).

 Strategy II: The Fed’s Triennial Survey. The Fed recently released its Survey of Consumer Finances tracking changes in US family finances from 2016 to 2019. It’s been conducting these surveys every three years since 1983. They include information about family income, net worth, balance sheet components, credit use, and other financial outcomes. Here are some of the key findings related to stock ownership of families:

(1) Directly and indirectly held stocks. “Families may hold stocks in publicly traded companies directly or indirectly, and information about each of these forms of stock holding is collected separately in the Survey of Consumer Finances. Indirect holdings are those in pooled investment funds, retirement accounts, and other managed assets. Indirect holdings, particularly through tax-deferred retirement accounts, are much more common than direct holdings.

“When direct and indirect forms of stock holdings are combined, the 2019 data show a slight uptick in stock ownership since 2016. In 2019, about 53 percent of families owned stocks, compared with nearly 52 percent in 2016. …. In 2019, about 31 percent of families in the bottom half of the income distribution held stocks, whereas about 70 percent of families in the upper-middle-income group held stock, and more than 90 percent of families in the top decile held stock.”

(2) Median values of stock holdings. “In addition to these differences across income groups in stock market participation rates, there are significant differences in the value of stock market holdings, conditional on holding stock. In 2019, the conditional median value of stock holdings for the bottom half of the income distribution was about $10,000, compared with $40,000 for the upper-middle-income group and nearly $439,000 for the top income decile. Conditional mean values are substantially larger than the conditional median values and exhibit wider differences across groups.”

(3) Retirement assets. “Among families that have these assets, the average combined IRA and DC pension account balance increased to $269,600 in 2019, and the gains occurred throughout the usual income distribution. For families in the bottom half of the distribution, although participation in IRA or DC plans fell in 2019, the average balance for participating families increased slightly from 2016, reaching $57,400. The average balance for participating families in the upper-middle part of the distribution increased about $3,700 between 2016 and 2019, to $170,600. The average balance for participating families in the top 10 percent of the distribution increased the most, reaching $692,800.”

(4) Ownership of business equity. ‘Ownership of business equity was about 13 percent in 2019. The conditional median value was more than $89,000, and the conditional mean value was more than $1.2 million. The wide difference between the median and mean values reflects the small fraction of privately held businesses with very high valuations. Ownership of equity in nonresidential property was 6.7 percent in 2019, and conditional median and mean values of equity in nonresidential property were about $70,000 and $375,000, respectively.”

(5) Bottom line. Wealth inequality, like income inequality, is a controversial subject. Contributing to the controversy is that both sides in the debate tend to make assertions without providing much, if any, data to support their vociferously held views. Melissa and I are working on compiling and analyzing the available data. Consider today’s commentary as part of an ongoing study.

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Hot Houses

October 26 (Monday)

US Economy I: ‘V’ Is for Velocity. The economic recovery since April’s trough remains V-shaped through October. That’s according to three of the five currently available regional business surveys conducted by the Federal Reserve Banks of New York, Philadelphia, and Kansas City. The averages of their composite business, new orders, and employment indexes all rose to their best levels since February, just before the lockdown recession (Fig. 1).These regional surveys suggest that the national M-PMI along with its new orders and employment indexes will still be strong when October’s numbers are released on Thursday, November 1.

Q3’s real GDP will be reported on Thursday, October 29. As of October 20, the Atlanta Fed’s GDPNow tracking model showed a 35.3% (saar) V-shaped rebound, following the 31.4% plunge during Q2.

We aren’t big fans of the velocity-of-money concept. However, if we look hard enough, we can see that occasionally the growth rate of M2 (using the y/y percentage change in the three-month moving average) does lead the growth rate in nominal GDP (Fig. 2). The velocity of money, defined as nominal GDP divided by M2, was relatively stable from 1962 through 1992 (Fig. 3). But then it inexplicably trended higher during the 1990s and has been trending downward since the early 2000s. It went into a freefall during Q2, as nominal GDP plunged 8.5% y/y while M2 soared 23.5% y/y through September. It’s a slam-dunk that velocity will rebound dramatically over the second half of this year.

The Index of Leading Economic Indicators was released on Thursday. It’s for September, not yet October, but it’s up five months in a row by 10.6%, signaling that the Index of Coincident Economic Indicators (CEI) should continue to move higher during Q4 (Fig. 4). Given that real GDP’s Q3 rebound is so strong, we are revising our forecast for a full recovery in both the CEI and GDP to the end of 2021 rather than the end of 2022 (Fig. 5).

Nevertheless, the recovery isn’t V-shaped for everyone. Depending on the city and on the industry, the jobs-market glass is either half full or half empty. That’s the message from the latest edition of LinkedIn’s Workforce Confidence Index. While much has been written about deurbanization by us and others, some cities are flourishing, including Colorado Springs, Provo, Tampa, Greenville, and Providence. “Most of the leading cities tend to be in the Sunbelt, benefiting from steady population growth and corporate relocations,” reports LinkedIn’s Laura Lorenzetti. The bad news is that too many workers are still unemployed, as jobless claims totaled 787,000 last week. While some industries remain challenged by the pandemic, others are expanding and hiring, especially in housing-related businesses.

US Economy II: These Joints Are Jumping. Sure enough, our deurbanization theme continues to boost housing-related industries tremendously. New and existing home sales are soaring. So are housing-related retail sales. As a result of the pandemic, people are moving out of densely populated cities to suburban and rural areas. Rising urban crime is contributing to this migration.

Both developments seem to be convincing Millennials—a generation known for preferring to rent and work in cities—to work from their newly purchased homes in the suburbs. We believe that even once the pandemic is over, Millennials will continue to move from renting in the cities to owning in the suburbs. Rising homeownership and turnover should continue to stimulate housing-related retail sales as well as auto purchases. Let’s review the latest relevant data:

(1) Existing and pending home sales. The National Association of Realtors (NAR) reported that sales of existing single-family homes soared 64.4% from May through September to 5.9 million (saar), the highest pace since April 2006 (Fig. 6). The months’ supply fell to a record low of 2.5 months during September. Constrained supply is prompting would-be homeowners to act sooner rather than later to buy or build a new home. The motivated buyers in the existing home market caused the NAR pending home sales index to soar to a record high during August, led by activity in the South (Fig. 7 and Fig. 8).

(2) Existing and new home prices. Soaring demand for existing homes and a dwindling inventory of such homes are causing prices to jump. September’s median existing single-family home price was up 15.2% y/y, while the average price rose 12.0% (Fig. 9). Interestingly, new single-family home prices have been flat this year, making them increasingly attractive relative to existing ones (Fig. 10).

The NAR reported that the biggest increases in sales over year-ago levels occurred for the most expensive homes, the next biggest y/y sales gain for next most expensive, and so on in a strikingly linear progression: $1M+ (106.5%), $750K-$1M (85.5), $500K-$750K (66.6), $250K-$500K (36.2), $100K-$250K (4.3), and $0-$100K (-16.3). Sales in vacation-destination counties have seen a strong acceleration since July, with a 34% y/y gain in September.

(3) New home sales. The shortage of existing homes on the market has sent more would-be homebuyers to scout out new homes. The National Association of Homebuilders reports that the traffic of prospective home buyers rose to a record high during September (Fig. 11). New single-family home sales jumped above single-family housing completions for the first time ever during August (Fig. 12).

(4) Gen Z and Millennials. The NAR reported that first-time buyers were responsible for 31% of existing home sales in September, down from the 33% in both August 2020 and September 2019. However, there are more first-time buyers coming, as well as buyers who would like to trade up.

The NAR recently conducted a July/August survey to assess the impact of the coronavirus on potential home buyers. The Executive Summary reports: “Over two-thirds of Millennials would like a larger home with more rooms and would like to make it easier to work from their current home by adding an office or private workspace. While majorities of Gen Z and Gen X feel the same way, they trail Millennials by seven to thirteen points in these wishes. Over two-thirds of Millennials and Gen Xers would like a larger yard or access to more outdoor space (Gen Z also falls into this category) or would like to move to a place with fewer people and more outdoor space.”

(5) Housing-related retail sales. Last week, we observed that the sum of retail sales of building materials, garden equipment, furniture, home furnishings, electronics, and appliances soared 37.6% since April through September to a record $671 billion (saar) (Fig. 13).

US Economy III: Swooshing Gasoline. Weekly gasoline usage has been our favorite high-frequency economic indicator. It has confirmed that the economy troughed during the week of April 24 when gasoline usage bottomed at 5.3mbd (Fig. 14). Gasoline usage staged a V-shaped recovery since then through the first week of July, when it rose to 8.5mbd. It’s been relatively flat since then; though at 8.6mbd during the October 16 week, it’s only 7.8% below last year’s usage at this time of year.

Central Banks I: To Infinity & Beyond. The major central banks continue to expand their balance sheets at a frenetic pace. Apparently, they think that they can drown the coronavirus in liquidity, or at least inoculate us from the harmful economic and financial consequences of the pandemic until the medical community discovers a vaccine that will stop it from spreading.

The Fed’s balance sheet soared $2.9 trillion from the week of May 27 through the week of October 21 to a record $7.1 trillion (Fig. 15). It’s been relatively flat since then through the October 21 week. However, that’s because the Fed’s QE4ever program has been very successful in stabilizing the financial system, resulting in a big drop in the sums provided through the Fed’s various emergency liquidity facilities (Fig. 16). Meanwhile, the Fed’s portfolio of securities continues to rise in record territory, reaching $6.5 trillion during the October 21 week, up $2.7 trillion since the March 6 week.

Over that same period, the balance sheets of both the European Central Bank (ECB) and Bank of Japan (BOJ) continued to soar to new record highs (Fig. 17 and Fig. 18). In US dollars, here are the increases and levels since the March 6 week through the October 16 week: Fed ($2.9 trillion to $7.1 trillion), ECB ($2.7 trillion to $7.9 trillion), and BOJ ($1.1 trillion to $6.6 trillion). Over this short period, the three central banks combined increased their balance sheets by $6.7 trillion to a record $21.6 trillion.

As we’ve observed before: A trillion here, a trillion there adds up to real money.

Central Banks II: Bond Vigilantes Fight the Fed. The Fed has been working hard to bury the Bond Vigilantes this year. The federal funds rate was lowered by 100bps on March 15, and QE4ever was announced on March 23. Since then, through the October 21 week, the Fed has purchased $266 billion in US Treasury bonds (Fig. 19).

That seemed to work. The 10-year US Treasury bond yield has remained below 1.00% since March 20 (Fig. 20). However, it has moved up from a record low of 0.52% on August 4 to 0.85% on Friday. It’s getting closer to 1.00%, which Melissa and I think might be the level that causes the Fed to seriously consider announcing an official “yield-curve target” of 0.50% to 0.75% for the bond yield.

The yield has been moving up on the better-than-expected rebound in economic activity along with concerns that another fiscal stimulus package might actually overheat the economy. The Bond Vigilantes may not be dead and buried after all, but rather they may be the walking dead.

I was quoted in an October 23 Bloomberg article as follows: “‘There is a possibility that if the stimulus package finally gets through, the perception will be that the economy is doing reasonably well and now it’s going to be on fire,” chief investment strategist Ed Yardeni said. “If the bond yield starts moving above 1%, then I think the Fed is going to be very concerned because housing has gotten a tremendous lift here from low mortgage rates.’”

However, most of the article refuted my thesis, as follows:

(1) “Federal Reserve Bank of Chicago President Charles Evans threw cold water on a popular bond market narrative this week. The consensus over the past several months has been that should long-dated yields rise meaningfully, the central bank stands ready to bulldoze rates lower by shifting their purchases further out the curve. But with rates so low, that might not be as potent as in the past, Evans said.

“‘I don’t think there’s a lot of scope for portfolio-balance effect to really lower long-term interest rates a lot because they’re already very low,’ said Evans in a conference call with reporters. ‘So, we could try to do more on asset purchases, but I’m not quite sure how far we would get.’”

(2) “That comment likely came as a surprise to the scores of bond traders who have been all but trained not to push yields too high. Policy makers have repeatedly demurred on the topic of yield-curve control: In June, Fed Chairman Jerome Powell said they were still in the ‘early stages’ of evaluating it. Later that month, St. Louis Fed President James Bullard said he didn’t see it as a pending policy. In August, Fed Vice Chairman Richard Clarida said yield caps could be a possibility in the future.”

Let’s see what happens if and when the yield rises above 1.00%.

Movie. “On the Rocks” (+) (link) is a comedy film written and directed by Sofia Coppola about a father (played by Bill Murray) and his daughter (played by Rashida Jones), who suspects that her husband is having an affair. The two of them start tailing him. Along the way, the father explains why men are the way they are and women are the way they are, causing each other lots of grief. His daughter responds that he didn’t have to leave her mother and cause everyone in the family so much grief. The father admits his failings. Murray always plays his characters the same hilarious way, and does so again in this film. The influence of Woody Allen on Coppola’s script and directing is evident from the start.

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Speed Bumps for Tech

October 22 (Thursday)

Information Technology: Peering into the Future. The Covid-19 pandemic has driven home just how important technology is to our daily lives, including our livelihoods. It’s unfathomable to consider what might have happened to the economy if Covid had struck in 1985, when we didn’t have the technology to work from home. Businesses, schools, and individuals have spent a bundle making their technology devices and systems faster, more secure, and more useful by adding peripherals like video cameras and headsets.

The S&P 500 Information Technology sector has led the market for much of this year and enters the homestretch as the undisputed leader. Here’s the performance derby for the S&P 500 sectors ytd through Tuesday’s close: Information Technology (30.3%), Consumer Discretionary (26.4), Communication Services (9.1), Materials (6.9), S&P 500 (6.6), Health Care (4.2), Consumer Staples (3.8), Industrials (-0.4), Utilities (-1.2), Real Estate (-7.7), Financials (-19.4), and Energy (-50.4) (Fig. 1).

Technology-related shares represent half of the 20 top-performing stocks ytd in the S&P 500. Some are card-carrying members of the S&P 500 Information Technology sector, like semiconductor companies NVIDIA (up 132.0% ytd) and Advance Micro Devices (77.9); software companies ServiceNow (83.6), Cadence Design Systems (62.4), Synopsis (62.6), and Salesforce.com (57.4); as well as Apple (60.7) and PayPal Holdings (86.7). Others reside in different S&P 500 sectors including Amazon (60.1) in Consumer Discretionary and Netflix (62.4) in Communications Services.

After these companies’ fantastic run so far this year, we thought it time to take a look at some of the hurdles they may face next year. For one, regulators at home and abroad are gunning to rein in some of the largest US technology names. Also, the Covid-induced tech spending enjoyed over the past six months won’t likely be replicated. Lastly, there has been a surge of IPOs in the cloud and software space that have performed admirably so far, but some companies have scant earnings and high valuations, a potential sign that the market is getting frothy. Let’s take a deeper look:

(1) Beware of regulators. In a widely anticipated move, the US Department of Justice (DOJ) filed on Tuesday an antitrust lawsuit against Alphabet’s Google, claiming that the search provider uses anticompetitive practices to maintain its market dominance. Eleven Republican state attorneys general joined the DOJ as plaintiffs.

As an October 20 WSJ article explained, “The Justice Department alleges that Google is illegally maintaining its monopoly in search through exclusionary contracts with distributors like mobile-phone makers, wireless carriers and web browsers to make Google their default search engine,” for which Google pays billions of dollars a year. The government says that gives Google control over about 80% of the US search market, denying competitors the ability to gain a foothold. Google’s chief legal officer has countered that the suit is flawed and that consumers use Google because they choose to, not because they are coerced or lack alternatives.

This won’t likely be the only lawsuit that Google or other tech giants will face in the coming year. The DOJ continues to investigate Google’s digital advertising business, and the Federal Communications Commission (FCC) is conducting a review of the social media platforms that may result in the roll back of legal protections they enjoy.

In general, the social media companies, like Facebook and Twitter, cannot be sued for content that others publish on their platforms in the same way that newspapers and broadcasters can be sued. However, conservatives have argued that protection should be lifted because the platforms are not agnostic, and they have been censoring conservative content. The issue gained momentum after Twitter applied a fact-checking notice to President Trump’s tweets that contained claims regarding voter fraud. The outcome of the election could determine whether the FCC review is completed or acted upon.

Large tech companies face heat abroad as well. The UK competition regulator has told its government to establish a digital regulator within a year or his agency “will take action” against Facebook and Google, an October 18 FT article reported. Under consideration: launching antitrust cases against the companies that are run in parallel with similar cases in the EU.

In addition to considering lawsuits, the EU is establishing rules to ensure that tech giants give access to competitors and share data with rivals, an October 11 FT article reported. The list reportedly includes 20 large Internet companies chosen based on their revenue and number of users, which implies that US corporations like Apple, Facebook, and Google will likely be included. There are also proposals to revise the EU’s Digital Services Act, which governs the Internet, for the first time in two decades.

(2) Beware the earnings pull forward. In addition to changing how we worked and lived, Covid-19 changed what we purchased. The increased time at home boosted the number of new Netflix subscribers, and the scramble to set up a home office meant a surge in Logitech’s fiscal Q1 and Q2 earnings. However, that burst of activity is unlikely to be repeated in the current quarter.

Netflix added 15.8 million subscribers in Q1 and more than 10 million subs in Q2, making its first-half 2020 subscriber additions only 10% lower than the new subscribers signed up in all of 2019. To the company’s credit, it warned on July 16 that it has seen a “pull-forward” of demand in the first half of 2020 from the second half of the year. Analysts reduced their estimates for Q3 subscriber additions from 5.3 million to 3.6 million, but it wasn’t enough.

On Tuesday night, Netflix reported net new subscribers increased only 2.2 million in Q3, a bit less than the company’s 2.5 million forecast and far below analysts’ target. The company also forecast 6 million new subscribers in Q4, a touch below analysts’ forecast of 6.3 million. Shares tumbled 5.7% after the market closed Tuesday due to the report.

Logitech also appears to be expecting a slowdown in the second half of its fiscal year. The Swiss company makes all the products needed to work or game from home, including keyboards, mice, headsets, speakers, and cameras. Logitech’s sales rose 75% to $1.3 billion in FQ2 ending September, and non-GAAP operating earnings surged to $354 million, up 295% from $89 million a year ago. Analysts were only expecting $834.6 million of revenue, and shares rallied 15.5% to $92.64 on the news.

The company forecast full year non-GAAP operating income of $700 million to $725 million, up more than 80% y/y. Based on its forecast, Logitech expects non-GAAP operating income of $229 million to $254 million in the second half of fiscal 2021 (ending March), flat to 10.0% higher than the $231 million of non-GAAP operating income it generated in the second half of fiscal 2020.

(3) Beware of the record-setting IPO market. With two months to go in the year, there have already been 332 IPOs, more than any year since 2000, when 397 IPOs were priced, according to data on stockanalysis.com. Almost a quarter of the deals are in the tech sector, according to Renaissance Capital. And some of the largest, best-performing issues were sold by companies in the cloud and software industries.

Snowflake, a cloud data warehousing provider, raised $3.4 billion in the largest software IPO ever. Since its September 16 offering, Snowflake shares have soared 109.8% versus 1.2% for the S&P 500. Application development software company JFrog’s shares are up 85.8% since pricing on September 16. Shares of Unity Software, which makes video game development tools, have risen 67.6% since its $1.3 billion IPO on September 18 (versus 2.6% for the S&P 500). And shares of Bentley Systems, which makes infrastructure software, are up 73.8% since pricing on September 23 (versus 3.8% for the S&P 500).

(4) Beware of the data. The S&P 500 Information Technology sector is expected to have revenue growth of 3.5% this year and 8.0% in 2021 (Fig. 2 and Fig. 3). That’s expected to lead to solid earnings growth of 4.2% in 2020 and 13.6% in 2021 (Fig. 4 and Fig. 5). Analysts’ net earnings revisions have been positive in October (12.6%), September (15.1%), and August (9.4%) (Fig. 6).

The sector’s forward P/E, at 27.0, is high but not outrageous (Fig. 7). It undoubtedly has risen since the 2008 recession, when the sector’s forward P/E hit a low of 9.9 in November 2008. However, it’s only roughly twice the expected forward earnings-per-share growth rate and far below the P/Es in the 40s during the tech bubble.

More concerning are the increases in some tech-related industries’ forward P/Es. The Internet & Direct Marketing Retail industry, which boasts Amazon as a member, has a forward P/E of 67.6, up from 40.8 a year ago. The Movies & Entertainment industry, which contains Netflix, has a forward P/E of 56.4, more than double the 26.3 of a year ago. Lastly, the Application Software industry has a 49.8 forward P/E, up from 33.6 a year ago.

Consumer Discretionary: Booming Homebuilding. The Covid-inspired homebuying boom continued in September as the exodus from cities into suburbs persisted. Here’s a quick look at some of the recent data points:

(1) Homebuilders keep building. Single-family homebuilding starts jumped 8.5% to a cyclical high of 1.108 million units (saar) in September (Fig. 8). Activity may remain strong, with single-family building permits increasing by 7.8% to a cyclical high of 1.119 million units (saar) in September (Fig. 9). And amazingly, even after the recent surge in activity, home starts and permits have only returned to more normal levels of activity after many years of depressed building in the wake of the 2008 financial crisis.

(2) Mortgage applications take a breather. That said, we’ll keep an eye on mortgage applications to fund the purchase of a home, as they fell 2% last week, marking the fourth week of declines. As a result, the new purchase index is down 6.9% from its peak during the September 18 week, but remains up 26.0% y/y (Fig. 10). At 3.04%, the 30-year mortgage rate continues to hover close to the September 17 all-time low of 2.93% (Fig. 11).

(3) Homebuilding stocks hit new high. The S&P 500 Homebuilding industry stock price index has finally topped its previous peak hit in 2004, before the housing industry imploded in the Great Financial Crisis. It’s up 35.1% ytd, making it the 12^th best-performing industry among those we track in the S&P 500 (Fig. 12). Its performance is topped by other housing-related industries: Household Appliances, up 35.5% ytd, and Home Improvement Retail, up 35.7% ytd.

The S&P 500 Homebuilding industry’s revenue is expected to increase 4.1% this year and 12.9% in 2021, while its earnings are forecast to jump 24.2% in 2020 and 14.6% next year (Fig. 13 and Fig. 14).

Disruptive Technologies: Measuring the Unmeasurable. If you attended school in the 1970s, you might remember the introduction of the decimal system and, perhaps, being miffed at having to learn a new way of measuring things when inches, feet, and yards did the job nicely. Now, as scientists have gotten better at measuring things in ever smaller increments, there’s more lingo to learn.

Nanoseconds measure events that are billionths of a second, picoseconds measure trillionths of a second, femtoseconds quadrillionths of a second, and attoseconds quintillionths of a second. These are all part of the International System of Units, which include 10 prefixes for decimal amounts and an additional 10 prefixes for larger multiples of the basic units.

We bring you this lesson on measurement and prefixes because you’ll hear these terms increasingly, as scientists, armed with new know-how on measuring shorter periods of time, have developed better ways to observe and measure the movement of electrons, which could lead to better understanding of chemical and biochemical reactions.

It was recently reported that scientists have measured the shortest interval of time ever: 247 zeptoseconds, which is a trillionth of a billionth of a second. One zeptosecond equals 10^-21 seconds. Scientists at Goethe University in Frankfurt, the Fritz Haber Institute of the Max Planck Society in Berlin, and DESY, a particle accelerator in Hamburg, measured this distance by firing x-rays from the particle accelerator at a hydrogen molecule, an October 19 NBC News article explained.

When hit, the hydrogen molecule’s electrons were ejected, an event that was measured by using a COLTRIMS reaction microscope. Scientists saw for the first time that the electron shell in a molecule does not react to light at the same time. There is a delay as the photon travels through the hydrogen molecule, first hitting one electron and then the next.

Another set of researchers at the ETH Zurich in Switzerland have tracked an electron’s motion in liquid water, a September 24 article in Physics World reported. Previously, electrons’ motion had been measured only in gaseous environments. The ability to study electrons in liquid is important because many chemical reactions occur in liquids and are triggered by light, like photosynthesis in plants, eyesight in retinas, and DNA damage. “With the help of attosecond measurements, scientists should gain new insights into the most elementary steps of these processes in the coming years,” the researchers’ team leader told Physics World.

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Financial Stability Could Lead to Instability

October 21 (Wednesday)

Strategy: Electing to Mark Time. While House Speaker Nancy Pelosi (D-CA) and US Treasury Secretary Steve Mnuchin are slow-walking toward another stimulus package, the elections are fast approaching. Since rising to a record high on September 2, the S&P 500 has also been slow-walking toward the elections (Fig. 1).That’s partly as a result of the uncertainty about whether another stimulus package will be passed before Election Day and, more importantly, uncertainty about the outcome of the election. There are eight possible outcomes:

(1) Trump wins, and the Republicans win both houses of Congress. (“Red Sweep.”)

(2) Trump wins, and the Republicans keep the Senate but lose the House. (Gridlock wins.)

(3) Trump wins, and the Republicans lose the Senate and the House. (Gridlock wins.)

(4) Trump wins, and the Republicans lose the Senate but win the House. (Gridlock wins.)

(5) Biden wins, and the Democrats win both houses of Congress. (“Blue Sweep.”)

(6) Biden wins, and the Democrats keep the House but lose the Senate. (Gridlock wins.)

(7) Biden wins, and the Democrats lose the Senate and the House. (Gridlock wins.)

(8) Biden wins, and the Democrats win the Senate but lose the House. (Gridlock wins.)

Joe and I agree with the widely held view that gridlock is bullish for the stock market. In our civics classes in high school, gridlock was called “checks and balances.” The Founders created this constitutional system to reduce the risk of political extremism. They designed the system so that more often than not, politicians on either side of the aisle wouldn’t have unchecked power. In the past when one party ruled the White House and both houses of Congress, the electorate had the choice of depriving them of that power every two years, which is what it did on a regular basis, though not necessarily every two years. (Here is a link to a useful table titled “Party Control of the Presidency and Congress from 1933-2010.”)

In any event, Joe and I expect that the bull market will proceed through 2021 no matter who wins the White House and no matter whether the next president’s party wins both houses of Congress, as we explained in our October 14 Morning Briefing titled Que Sera, Sera. We still have a target of 3800 for the S&P 500. We just aren’t sure whether that happens by mid-2021 or by the end of this year. Our hunch is that the market will get there sooner rather than later under any of the first four scenarios in which Trump wins. In any of the four scenarios in which Biden wins, the market might slow walk to 3800 by the middle of next year.

No matter the election outcome, we prefer a slow walk to new highs for the market to give earnings a chance to catch up. The S&P 500’s forward P/E has been hovering around 22.0 since May 28, up from this year’s low of 12.9 on March 23 (Fig. 2). Forward revenues bottomed during the May 28 week, rising 4.7% through the October 8 week (Fig. 3). Forward earnings bottomed during the May 15 week, rising 12.9% through the October 15 week.

S&P 500 operating earnings comparisons won’t turn positive until next year on a y/y basis. The analysts’ consensus estimates currently show Q3 and Q4 declines of 19.3% and 13.4% (Fig. 4). For 2020, 2021, and 2022, we are forecasting $125.00 per share (down 23.3%), $155.00 (up 24.0%), and $180 (up 16.1%) (Fig. 5). Industry analysts are currently expecting $131.13, $165.83, and $189.73.

Fed: Not Doing Much Lending. The lender of last resort hasn’t been doing the volume of lending during the pandemic that it had promised. The Fed did respond to the GVC with QE4ever on March 23, purchasing $2.54 trillion in US Treasuries and mortgage-backed securities since then (Fig. 6). The Fed also provided several liquidity facilities, which jumped from $383 billion during the March 11 week to a recent high of $1.22 trillion during the May 13 week (Fig. 7). As the financial panic abated, the liquidity facilities loans fell to $587 billion during the September 30 week. But other lending facilities have barely been used, mostly because QE4ever calmed the financial markets quickly and dramatically.

 For example, the Fed announced on April 9 that it would fund up to $2.3 trillion in credit market instruments with its SPVs. Of that, the Fed’s Primary and Secondary Corporate Credit Facilities (PMCCF and SMCCF) are set up to purchase up to $750 billion combined in corporate debt, including exchange-traded funds (ETFs), as we detailed in our April 15 Morning Briefing. Eligible bonds include investment-grade corporate bonds as well as BBB-rated bonds that recently went over the edge. Any such “fallen angels” that dropped below that rating after March 22 may still be purchased by both facilities, according to the updated term sheets of the PMCCF and the SMCCF.

Compared to the potential size of purchases, the transactions have been limited. But corporate debt purchases have picked up since they began in early May. As of September 30, the PMCCF was operational but had not yet closed any transactions, according to the Fed’s credit facilities update dated October 7. On May 12, the Fed began purchasing corporate-bond ETFs through the SMCCF. As of May 19, the total outstanding amount of the Fed’s loans under the SMCCF was $1.3 billion. It was $12.9 billion as of September 30.

Of all bonds purchased through September 28, according to the detailed spreadsheet disclosure, 41% were rated in the high-investment grade category (AAA/AA/A), while 56% were rated BBB and 3% were rated B, with a combined weighted average maturity of 2.9 years. Consumer (including cyclical and non-cyclical) issues composed 37% of the purchases on a par-value basis. The Fed noted: “The Board continues to expect that the CCFs will not result in losses to the Federal Reserve.”

The Fed’s other major facilities include the following (total outstanding loans as of September 30): Paycheck Protection Program Liquidity Facility ($67.6 billion), Money Market Mutual Fund Liquidity Facility ($7.1 billion), Term Asset-Backed Securities Loan Facility ($3.2 billion), Main Street Lending Program ($2.2 billion), and Municipal Liquidity Facility ($1.7 billion). The Primary Dealer Credit Facility totaled $233.0 million, and the Commercial Paper Funding Facility totaled $29.9 million.

Of note, according to the related transaction spreadsheets, the Main Street Lending program included loans to about 250 entities, and the Municipal Liquidity facility included loans to two entities: the State of Illinois and the New York Metropolitan Transportation Authority.

Global Financial Stability I: Policymakers Saved Markets. If there is one thing that investors have learned since the start of the Great Virus Crisis (GVC), it is that there’s no such thing as policymakers running out of ammo. Before the GVC, many believed that central bankers held interest rates too close to zero for too long and that fiscal policymakers were tapped out. Nevertheless, following the onset of the pandemic, global central bankers and governments have unleashed unprecedented monetary and fiscal policy actions to serve as a “Bridge to Recovery.”

That is the title of Chapter 1 of the October 2020 Global Financial Stability Report (GFSR) from the International Monetary Fund (IMF). The report’s remaining chapters are expected to be released on Friday. Our short interpretation of the GFSR’s Chapter 1 is that policy actions have saved financial markets but have disconnected markets from underlying economic fundamentals, and that has elevated global financial risk.

Global markets have performed well with the US and China outperforming, led by a dominance by technology companies. Globally, weaker performance has been observed in contact-intensive sectors as well as cyclical energy and financial issues. The GFSR’s Figure 1.3 shows that swift central bank actions have calmed stock market volatility in spite of the pandemic uncertainty.

Indeed, market performance would likely have been much weaker without the unprecedented policy support. On a ytd basis, the US stock market has outperformed even though that outlook for corporate earnings had deteriorated, says the IMF. Bond spreads have widened, but less so than economic fundamentals would suggest, the report adds. Major factors that could cause renewed problems for the financial markets are the anticipation of decreased policy support and a delayed recovery. Nevertheless, the IMF attributed the containment of near-term global financial risks “for now” to the unprecedented global policy response.

But the report also warns that financial markets are fragile, as the policies that have saved us may lead to excessive risk-taking. In our view, investors seem to believe that “this too shall pass” since many underlying fundamentals already have recovered—suggesting that the markets may not be as disconnected as the IMF contends. Nevertheless, the IMF’s view is important because it has the potential to spark global regulations around excessive risk-taking and/or to cause policymakers to rethink their actions in the context of financial stability.

Here are the latest GFSR’s key points:

(1) Elevated corporate debt & sovereign deficits. As the pandemic spread and related lockdowns occurred, governments and firms around the world scrambled to raise cash by taking on more debt. In the global sovereign sector, fiscal deficits expanded as fiscal support was added. With that, six out of 29 systemically important jurisdictions showed elevated vulnerabilities in corporate, banking, and sovereign sectors, according to the IMF. Non-financial corporate (NFC) debt load may lead to greater insolvencies if the recovery stalls. Small and mid-sized enterprises in contact-sensitive industries—like hotels, restaurants, and entertainment venues—are especially vulnerable to insolvency.

(2) Capitalized banks. In an analysis of 29 countries (excluding China), banks were found to have enough capital to absorb anticipated losses and maintain sufficient capital buffers in the IMF’s baseline scenario. It’s only in the IMF’s adverse scenario that the “weak tail” of banks experience capital shortfalls that could constrain lending.

(3) Contained EME flows. Portfolio outflows for emerging market economies (EMEs) and frontier economies are expected to remain contained. The probability of portfolio outflows over the next three quarters fell from about 60% during late March to 25% during September. EMEs have benefited from global low interest rates and could start to show greater financial instability if external financing becomes increasingly strained.

(4) Vulnerable entities. The heart of the IMF’s Chapter 1 is found in Figure 1.9.2. on page 11. It presents a heatmap of financial vulnerabilities by sector and region by quintile (denoting the “worst” as red and the “best” as green, with varying shades indicating the directional degree of risk).

The US has mixed results across types of entities evaluated. Sovereigns scored in the worst category and non-bank financial institutions (including NFCs, insurers, asset managers, and others) each independently scored in the second to worst category. But banks and households were both in the green, specifically in the dark green (best) and light green (next to best), respectively.

In the euro area, similar mixed assessments of risk were given across types of entities. Sovereigns, NFCs, and banks all received the worst designation, and asset managers were assessed as next to worst. But households, insurers, and other financial institutions were assessed as next to best.

China’s results were less mixed. Significant financial vulnerabilities were detected for households, NFCs, and banks. Sovereigns and asset managers received a next-to-worst designation. Insurers and other financial institutions were assessed at neutral risk levels.

(5) China debt interlinkages. In a dedicated box (1.3), the IMF explored China’s specific vulnerabilities. It concluded that “[l]inkages between local governments, firms, and banks could pose significant financial stability risks and underscore the urgency of accelerating structural reforms in China, even as authorities seek to support the recovery from COVID-19. Key priorities should be to strengthen the intergovernmental fiscal coordination framework, introduce bank and corporate restructuring frameworks in line with international best practices, and address remaining gaps in financial supervision and regulation.”

Global Financial Stability II: Balancing Support & Risk-Taking. The IMF recommends in its latest GFSR that monetary policy remain accommodative for as long as it takes to reach a sustainable recovery. But it also recommends financial reform and prudential supervision, particularly for the non-bank financial sector, to ensure that low global returns do not cause excessive risk-taking.

The report states: “As policymakers build a bridge to recovery, policies will have to adjust, depending on the evolution of the pandemic and the pace of the economic rebound.” The IMF presents a matrix of policy approaches in the GFSR, given policy guidance for each of three phases: i) Gradual Reopening under Uncertainty; ii) Pandemic under Control; and iii) Post-pandemic Financial Reform Agenda.

Here’s a recap of the key guidance points:

(1) Monetary policy, liquidity, and credit. The IMF recommends continued monetary policy accommodation to remain at least for the first two scenarios. However, liquidity is to be maintained only during the “uncertainty” phase and to be withdrawn as the spread of the virus comes “under control.” Credit provisions to support increased bank lending through the use of capital buffers also are recommended only during the earlier phase.

In the “under control” phase, credit provisions are to be removed, but policies to address problem assets and to recapitalize and rebuild as necessary are recommended. In the “post-pandemic” phase, increased regulation is recommended for non-bank financials and globally to prevent risk-taking in a lower-for-longer environment. During each phase of the recovery, policymakers are encouraged to look out for unintended consequences of their actions and to be mindful of future vulnerabilities, especially as bank capital is drawn.

(2) Adverse scenario. Support should be scaled up in the event of a worsening spread of the virus and more restrictions to global activity, the IMF suggests. However, added support should be targeted, an approach best achieved through fiscal policy. Central banks should consider further easing, and policies should be developed to support insolvent entities.

(3) Green & digital shoehorns. Shoehorned into the IMF’s policy suggestions are recommendations for fiscal spending on green infrastructure and digital technologies. Environmental performance has weakened in regions that have suffered economically from the pandemic, and the pandemic has accelerated the digitalization of economies, says the IMF. The crisis “presents an opportunity to engineer a transition to a greener economy,” the IMF stated.

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Is the Fed Pegging The Bond Yield?

October 20 (Tuesday)

Bonds I: De Facto Yield-Curve Targeting. The 10-year US Treasury bond yield has been trading in a tight range between 0.52% and 0.88% since March 23, when the Fed implemented QE4ever (Fig. 1). The average yield since then through Friday’s close was 0.68%. The Fed lowered the federal funds rate by 100bps to zero on March 15 (Fig. 2). However, so far, Fed officials haven’t announced that they intend to peg the bond yield below 1.00%. But that seems to be what they are doing. If they weren’t doing so, the bond yield would probably exceed 1.00% based on its past relationship with various economic indicators. Consider the following:

(1) Copper/gold price ratio. The ratio of the nearby futures prices of copper to gold multiplied by 10 has been a reasonably good indicator of where the bond yield should be (Fig. 3). When the yield traded below (above) this ratio for a short while, it typically moved higher (lower). On Friday, the bond yield was 0.76%, while the yield implied by the ratio was at 1.61%. The spread between the two has ranged between -128bps and 188bps since 2004 (Fig. 4). It’s currently at -85bps.

(2) Economic surprise. The 13-week change in the bond yield has been highly correlated with the Citigroup Economic Surprise Index (CESI) (Fig. 5). This year, the CESI has soared from a record low of -144.6 on April 30 to a record high of 270.8 on July 16. The index was down to 134.2 on Friday, remaining well above all its previous cyclical peaks prior to this year. Yet the 13-week change in the bond yield was just 12bps on Friday. (By the way, the CESI has had a seasonal tendency to rise during the second half of most years since 2009—a pattern that also has been reflected in the 13-week change in the bond yield but not so far this year.)

(3) Purchasing managers index. Since 2010, there has been a fairly good correlation between the M-PMI and the bond yield (Fig. 6). It continued to hold earlier this year when both dropped sharply together during the two-month lockdown recession in March and April. The M-PMI has rebounded from 41.5 during April to 55.4 during September, while the bond yield remains under 1.00%.

(4) The TIPS yield. The Fed’s QE4ever should have raised concerns in the bond market about the possible inflationary consequences of such open-ended ultra-easy monetary policy. But assuming, as we do, that the Fed is keeping a lid on the bond yield, investors have snapped up Treasury Inflation-Protected Securities (TIPS) for protection against inflation since they can’t get that in nominal yields. The result has been that the 10-year TIPS yield plunged from -0.04% on March 23 to -0.95% on Friday (Fig. 7). The yield spread between the bond yield and the TIPS, which is a widely used proxy for expected inflation over the next 10 years, jumped from this year’s low of 0.50% on March 19 to 1.71% on Friday (Fig. 8).

By the way, the 10-year TIPS yield is very closely correlated with the real bond yield, defined as the 10-year nominal yield less the yearly percentage change in the PCED (personal consumption expenditures deflator) inflation rate (Fig. 9). The correlation between the inflation proxy and the PCED inflation rate isn’t as high (Fig. 10).

Interestingly, the inflation proxy is much more highly correlated with the nearby futures price of copper and with the inverse of the trade-weighted dollar (Fig. 11 and Fig. 12).

(5) Fed buying bonds. From February through September, the Treasury issued $259 billion in publicly held marketable bonds, with the outstanding amount rising to a record $2.67 trillion (Fig. 13). Over the same period, the Fed purchased $338 billion in Treasury bonds, holding 37% of the outstanding supply.

(6) Yield-curve targeting. As Melissa and I observed last week, at his June 10 press conference, Fed Chair Jerome Powell was asked by Nick Timiraos of the WSJ about the possibility of “yield caps.” Powell revealed that at the latest meeting of the Federal Open Market Committee (FOMC), the participants received a briefing on the historical experience with yield-curve targeting (YCT) and said that they would evaluate it in upcoming meetings.

We also provided an excerpt on this subject from the June 9-10 FOMC meeting Minutes, in which the Fed’s staff presented a two-handed assessment of YCT. On the one hand, they said that it could be achieved without the Fed having to buy lots of bonds. On the other hand, it might require the Fed “to purchase very sizable amounts of government debt.” It seems to us that by not formally announcing a target for the bond yield, the Fed has had to purchase lots of bonds to keep it under 1.00%.

The staff also warned that under YCT, “monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank.” You think? It seems to us that by lobbying so publicly and frequently for more fiscal stimulus in recent weeks, the Fed has already ceded its independence in the interest of implementing Modern Monetary Theory in response to the Great Virus Crisis.

(7) Global perspective. There is another explanation for why the US government bond yield is so low. It may have finally succumbed to the gravitational pull of government bonds yielding around zero in Japan and -0.50% in Germany since mid-2019 (Fig. 14). While the core CPI (Consumer Price Index) inflation rate in September was 1.7% in the US, it was a record low of 0.2% in the Eurozone, and Japan’s rate was -0.4% during August (Fig. 15).

Bonds II: Valuing Dividends Under ZIRP. Joe and I previously have observed that the stock market is working on answering a very relevant question these days: What is the fair-value forward P/E of the S&P 500 when the 10-year US Treasury bond yield is near zero? The answer on Friday was a forward P/E of 21.9. Multiplying this forward P/E by forward earnings of $159.16 per share during the October 15 week implies that the S&P 500 was fairly valued on Friday at its closing price of 3483.81.

Of course, that’s the wrong answer if the latest forward P/E is either too high or too low relative to the fundamentals, implying the market is actually either overvalued or undervalued. Joe and I are in the fairly valued camp for now given that interest rates remain so close to zero from the front end to the back end of the yield curve.

Focusing on actual dividends rather than forward earnings supports the view that stocks are appropriately valued, if not undervalued, given that the bond yield is so low. As we observed in our September 14 Topical Study #85: S&P 500 Earnings, Valuation & the Pandemic, “The focus on valuing earnings is a relatively new phenomenon that started with the bull market of the 1990s. Before then, most valuation models for individual stocks focused on dividends, not earnings. Investors compared the dividend yield, not the current earnings yield, to the bond yield. Corporations were valued on their ability to pay and grow dividends, which represented a tangible return to investors. Retained earnings—profits after taxes and dividends—were reinvested in the business, presumably to increase the capacity of the corporation to pay more dividends in the future.”

In our study, we extended our Blue Angels framework to show the hypothetical value of the S&P 500 (P) using the actual dividends (D) paid out by the S&P 500 companies divided by dividend yields (D/P) from 1.0% to 6.0% (Fig. 16). Currently, in October 2020, the conclusion of this Blue Angels analysis is that stocks are attractive relative to bonds because the dividend yield, at 1.75% during Q3, well exceeds the bond yield, and the long-term uptrend in S&P 500 dividends has been roughly 6% since the end of 1946 (Fig. 17).

As noted above, the real bond yield is negative. The core PCED inflation rate is currently 1.7%, while the 10-year yield is under 1.00%. The 10-year TIPS yield was -0.95% on Friday. So the bond yield is unattractive to investors not only because it is historically low but also because it is below inflation. When the bond yield exceeded the inflation rate, it was an alternative to stocks. Now, it is a losing proposition in real terms. In the past, the S&P 500 dividend yield usually kept pace with inflation, while the S&P 500 forward earnings metric has always well exceeded inflation (Fig. 18).

China: Continuing To Recover. The pandemic started in China during January and February. It then spread to the rest of the world, which is still struggling with the virus. Yet remarkably, China recovered from this health crisis, and so has its economy since March. We are hard-pressed to explain that divergence unless it’s simply that the virus flourishes more in democratic societies than authoritarian ones. That’s the most we’re willing to open this toxic petri dish today. Instead, let’s assess China’s latest economic performance:

(1) Real GDP rose 4.9% y/y during Q3 (Fig. 19). It rose 12.6% q/q (saar) following Q2’s 49.5% rebound from Q1’s -43.0 plunge.

(2) Industrial production also rebounded impressively from a y/y growth rate of -13.6% during January to 6.9% during September (Fig. 20).

(3) Real retail sales on a y/y basis dropped by a record 20.1% during March but rose 1.6% during September. Jackie and I continue to monitor developments in China. We believe that the legacy of the Chinese Communist Party’s disastrous one-child policy from 1979 through 2015 has come back to haunt China’s consumers, as they are burdened now by an increasingly geriatric population profile.

Epidemiology I: The Grim Reaper. Melissa and I previously have compared the pandemic to a world war against the virus. In most wars, there tend to be more than one front. In this one, there are health, economic, and financial fronts. We clearly have made lots of progress on the economic and financial fronts. But that won’t be sustainable if we lose the battles on the health front.

There’s still no vaccine, though at least one might be available for widespread distribution by mid-2021. There’s still no cure, though the medical community has developed treatment protocols that increase the chances of surviving the disease. Lockdowns earlier this year worked, but at a terrible cost to jobs and mental health. They were supposed to flatten the curve so that hospitals wouldn’t be overwhelmed with cases. Yet now that lockdown restrictions have been lifted, cases are going up and some hospitals are facing shortages of capacity and equipment once again. Reinstating lockdowns on a widespread basis seems too draconian after our first experience with them. So instead, governments are resorting to targeted restrictions in response to outbreaks.

For the US, we monitor the case data compiled by the COVID Tracking Project. Here are the latest developments:

(1) Tests. On a 10-day moving average basis, new positive test results rose from a recent low of 36,000 on September 15 to 52,000 on October 16, the highest since August 14 (Fig. 21). That’s mostly because the number of new tests has jumped from 705,000 to 995,000 over this same period (Fig. 22). The positivity rate remains relatively low at 5%.

(2) Hospitalizations and deaths. Following the increase in the number of positive cases, current hospitalizations are up from a recent low of 29,750 to 35,000 on October 16. The number of deaths may soon move higher following the increase in hospitalizations. However, for now, the trend has been down from the summer’s peak of 1,195 deaths per day to 737 on October 16.

A September 1 blog post by the COVID Tracking Project team reported that deaths in long-term care facilities—which house less than 1% of the US population—represented a shocking 43% of all US Covid-19 deaths relative to just 7% of all US cases identified in these facilities. The death percentage decreased only slightly to 41% in the month since, according to an October 8 COVID Tracking Project blog post.

The good news is that the positivity rate remains low, as more testing has increased the likelihood that people will be quarantined and treated more quickly before they spread the disease and succumb to its worst outcome. However, the available test positivity data may be unreliable, as detailed in the blog linked above. The data issues we’ve often discussed since the pandemic began continue. So consider any virus data with caution.

Epidemiology II: Editorial. Melissa and I agree with the “Focused Protection” approach to the pandemic endorsed by several infectious disease epidemiologists and public health scientists in the Great Barrington Declaration.

Our viewpoint: We needed to lock down the economy earlier this year, because we didn’t know much about this virus. So far, the evidence is clear that it poses the most risk to the very elderly and those with severe underlying pre-existing medical conditions. We need to protect those groups, but the rest of us need to go back to our lives and develop herd immunity through natural infection. Masks should be required to slow the spread until an effective and safe vaccine is approved for widespread distribution.

The Declaration rightly observes:

(1) “Current lockdown policies are producing devastating effects on short and long-term public health. The results (to name a few) include lower childhood vaccination rates, worsening cardiovascular disease outcomes, fewer cancer screenings and deteriorating mental health—leading to greater excess mortality in years to come, with the working class and younger members of society carrying the heaviest burden. Keeping students out of school is a grave injustice.

“Keeping these measures in place until a vaccine is available will cause irreparable damage, with the underprivileged disproportionately harmed.”

(2) “Fortunately, our understanding of the virus is growing. We know that vulnerability to death from COVID-19 is more than a thousand-fold higher in the old and infirm than the young. Indeed, for children, COVID-19 is less dangerous than many other harms, including influenza.

“As immunity builds in the population, the risk of infection to all—including the vulnerable—falls. We know that all populations will eventually reach herd immunity—i.e. the point at which the rate of new infections is stable—and that this can be assisted by (but is not dependent upon) a vaccine. Our goal should therefore be to minimize mortality and social harm until we reach herd immunity.”

(3) “The most compassionate approach that balances the risks and benefits of reaching herd immunity, is to allow those who are at minimal risk of death to live their lives normally to build up immunity to the virus through natural infection, while better protecting those who are at highest risk. We call this Focused Protection.”

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Stocks & the Economy: Still Connected So Far

October 19 (Monday)

US Economy I: Haves & Have Nots. Progressive pundits have been obsessed with the disconnect between the stock market and the economy. How can the S&P 500 be back up in record-high territory when the pandemic continues to weigh on the economy, with millions of people still unemployed? The implication is that Wall Street is cold-hearted and tone-deaf to the suffering that the pandemic has inflicted on so many people. The narrative is that the Fed’s QE4ever response to the financial calamity unleashed by the virus saved the day for the rich, while everyone else continues to suffer miserably. The recovery isn’t V-shaped, say the progressive skeptics, but rather K-shaped, with the rich getting richer and the poor getting poorer.

In many ways, that’s an accurate picture of the current situation. The rich have gotten richer as their stock portfolios have regained all that was lost from February 19 through March 23, and then some. However, lots of average Americans also have benefited as their pension plans (including 401Ks) rebounded. The Fed’s latest Survey of Consumer Finance reported the following relevant statistics about wealth in America:

(1) Net worth. “Families at the top of the income and wealth distributions experienced very little, if any, growth in median and mean net worth between 2016 and 2019 after experiencing large gains between 2013 and 2016. Families near the bottom of the income and wealth distributions generally continued to experience substantial gains in median and mean net worth between 2016 and 2019.”

No one knows how the pandemic of 2020 has upended these recent happy developments. But the Fed’s survey showed that progress in the right direction was being made before the pandemic hit. Once it is over, there’s no reason to believe that the more egalitarian trend of 2016-19 wealth distribution can’t resume.

(2) Retirement plans and stocks. “Nearly two-thirds of working-age families participated in retirement plans in 2019, down slightly from 2016. Participation continued to be uneven across the income distribution. Less than 40 percent of families in the bottom half of the income distribution were in a retirement plan, compared with more than 80 percent of upper-middle-income families and more than 90 percent of families in the top decile of income.

“Ownership rates of corporate equities increased between 2016 and 2019, driven by families in the lower half of the income distribution. Still, less than one-third of lower income families in 2019 were participating in the stock market, compared with about 70 percent of upper-middle-income families and more than 90 percent of families in the top decile of the income distribution.”

That doesn’t sound as bad as the progressive notion that only the “One Percent” own stock and have been getting richer.

(3) Homes. “The homeownership rate increased between 2016 and 2019 to 64.9 percent, a reversal of the declining trend between 2004 and 2016. For families that own a home, the median net housing value (the value of a home minus home-secured debt) rose to about $120,000 from about $106,000 in 2016.”

Home prices have been rising in record-high territory since March 2016 (Fig. 1). Americans collectively hold a record $30.8 trillion in household real estate, with a record $20.2 trillion in owners’ equity. According to the Census Bureau, 81.9 million households owned their own homes, while 42.6 million were renters as of mid-2020 (Fig. 2).

(4) Education. The Fed’s survey shows that among the biggest dividers between the Haves and Have Nots is education: “Wealth continued to increase among families with either a high school diploma or some college. However, families without a high school diploma, which saw the largest proportional gains in median and mean net worth between 2013 and 2016, saw the largest drops between 2016 and 2019.”

No surprise there, since unemployment rates have always been lowest to highest among workers with a Bachelor’s degree, some college, a high school degree, and less than a high school degree (Fig. 3). The proportion of the labor force with a college degree rose from 21.7% during 1992 to 37.4% during September 2020 (Fig. 4).

(5) K-shaped recoveries. In some ways, recoveries are always K-shaped. Workers with high levels of educational attainment tend to be re-employed faster than those who’ve obtained lower levels of education.

US Economy II: A Few V-Shaped Indicators for October, So Far. The V-shaped rebound in the stock market has in fact been consistent with the V-shaped economic recovery so far. The October 16 update of the Atlanta Fed’s GDPNow tracking model estimated that real GDP soared 35.2% (saar) during Q3 after plunging 31.4% during Q2 and 5.0% during Q1. That would certainly be a V-shaped recovery—and consistent with the unprecedented rebound from the unprecedented two-month lockdown recession during March and April.

But that doesn’t rule out the prospect of the recovery’s shape-shifting in subsequent quarters into a U, W, or a Nike swoosh. Debbie and I are forecasting 30% for Q3 and 10% for Q4. If Q3 turns out to be more like 35%, we will probably trim back our expectations for Q4. We are in the V-camp for the second half of this year and expect more of a swoosh next year, with real GDP back at its 2019 record high at the end of 2021.

In any event, we now have the first indications that October’s major economic indicators may continue to confirm that the recovery remains V-shaped so far, as it has since most of the indicators bottomed during April. Consider the following:

(1) Regional business surveys. This month’s regional business surveys from the Federal Reserve Banks of New York and Philadelphia were strong (Fig. 5). The average of their composite businesses indexes was 21.4, the highest since February (24.8). The average of their new orders indexes rose to 27.5, also the highest since February (27.9). The employment component averaged 10.0, only slightly below its reading of 10.3 in July and above its 8.2 reading during February before the virus hit the fan. This augurs well for the three other October regional business surveys conducted by the Federal Reserve Banks of Richmond, Kansas City, and Dallas. It also augurs well for October’s M-PMI, which is highly correlated with the general business indexes of the regional surveys.

(2) Pumping up. Weekly gasoline usage is yet another upbeat economic indicator, which started the month with a better-than-seasonal uptick following a seasonal slide during September (Fig. 6). Gasoline usage during the October 9 week was just 7.7% below last year at this time. The Federal Reserve Bank’s Weekly Economic indicator continued to trend higher during late April through the October 10 week (Fig. 7).

Economy III: More V-Shaped Indicators for September. On Friday, September’s retail sales report was stronger than expected, while September’s industrial production release was weaker than expected. Before we have a closer look at these indicators, let’s review September’s surprisingly strong survey of small business owners conducted by the National Federation of Independent Business (NFIB) and released last Tuesday:

(1) Small business survey. Small businesses have been particularly hard hit by the pandemic. Yet September’s survey of small business owners also showed lots of V-shaped indexes of their activities. The overall Small Business Optimism Index rebounded from a low of 90.9 during April to 104.0 during September (Fig. 8). Worth noting is that the recent bottom was still well above the 81.6 reading during March 2009, and the latest reading was just slightly below this year’s February reading.

The NFIB’s employment indicators also have recovered remarkably well (Fig. 9). The net percentage of small business owners planning to increase hiring over the next three months rebounded from 1% during April to 23% during September, the highest reading since December 2018! Over this same five-month period, the percentage with job openings jumped from 24% to 36%, while the percentage with few or no qualified applicants for job openings rose from 41% to 50%.

(2) Retail sales. Leading the ongoing rebound in retail sales have been housing-related goods and autos. Arguably, both reflect the wave of de-urbanization triggered by the pandemic and rising urban crime. The sum of retail sales of building materials & garden equipment, furniture & home furnishings, and electronics & appliances rose to a record $671 billion (saar) during September (Fig. 10). This series is up 37.6% since April and up 8.5% since February.

Retail sales of motor vehicles and parts is up 67.7% since April to a record $1,378 billion (saar) during September (Fig. 11). It is up 9.1% since February.

Also rebounding impressively since their April lows are retail sales of clothing & accessory stores (546.5%), sporting goods, hobby, book & music stores (110.3), and health & personal care stores (16.6) (Fig. 12).

(3) Industrial production. Given the record-setting strength in retail sales from April through September, it was puzzling to see the 0.6% m/m downtick in industrial production during September (Fig. 13). It remains 7.1% below its February reading. The weakness was evident in auto assemblies, which doesn’t jibe with the strength in auto retail sales (Fig. 14). The same can be said about the downtick in production of appliances, furniture, and carpeting in the face of booming housing-related sales.

We expect that the uptrend in production will resume to meet strong demand over the rest of this year. Making more sense are the industrial production indexes for communications equipment, computers & peripheral equipment, and semiconductors. Industrial production indexes for communications equipment and semiconductors rose to new record highs in September, while the index for computers & peripheral equipment reached a new cyclical high (Fig. 15).

Movie. “Godfather of Harlem” (+ + +) (link) is a television drama series based on the tumultuous life and times of crime boss Bumpy Johnson. In the early 1960s, he returned from 10 years in Alcatraz to his home in Harlem, which was run by the Italian mob. There, Bumpy took on the Genovese crime family to regain control. The resulting battle is epic, and so is the acting and directing. Notable personalities with important roles in the saga are Malcolm X, Adam Clayton Powell, Muhammad Ali, Frank Costello, and Joseph Bonanno.

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The Future of Semis, Banks & Cows

October 15 (Thursday)

Technology: Semis Sending Strong Positive Signal. Semiconductor sales continued to rise through the end of the summer as demand for digital equipment of all varieties far surpassed the depressing economic impact of Covid-19. Worldwide sales of semiconductors rose 4.9% y/y in August to $36.2 billion, based on a three-month moving average. Sales were the strongest in the Americas with a 23.6% gain, followed by China (3.0%) and Asia Pacific/All Other (2.1). But some regions saw declines, including Japan (-1.4) and Europe (-10.1) (Fig. 1).

Looking ahead, y/y comparisons for semiconductor sales in the Americas will be tough from September to November, as those months last year brought a brief spike in sales before Covid-19 hit. Once it did, sales proceeded to fall from January to April.

Sales increases on a m/m basis were positive in all regions during August, the Semiconductor Industry Association reported. Sales rose m/m in Asia Pacific/All Other (5.6%), Europe (5.5), China (2.9), the Americas (2.6), and Japan (1.5).

Let’s dig deeper into the outlook for semiconductor sales:

(1) Analysts optimistic about semis future. The semiconductor sales numbers are confirmed by data on the US industrial production of semiconductors and other electronic components, which rose in August for the third month to a new record high (Fig. 2). In addition, Wall Street analysts remain upbeat about the industry’s future revenue and earnings growth. They forecast S&P 500 Semiconductors revenue will rise 4.9% this year and 8.3% in 2021 (Fig. 3). Earnings are expected to drop slightly this year by 1.8%, but recover nicely in 2021 to 12.6% growth (Fig. 4).

For much of this year, the S&P 500 Semiconductors has been a top-performing industry. Since the start of the year through Tuesday’s close, its stock price index is up 33.6%, and y/y the index has risen 54.2%, making it the ninth best performing of the industries we track (Fig. 5). Not surprisingly, there are many tech names among the top 10 performing S&P 500 industries y/y through Tuesday’s close: Technology Hardware, Storage & Peripherals (95.3%), Internet & Direct Marketing Retail (84.0), Copper (76.1), Computer & Electronics Retail (70.0), Application Software (68.1), Gold (66.8), Systems Software (55.9), Air Freight & Logistics (55.5), Semiconductors (54.2), and Trucking (49.5) (Table 1).

(2) Acquisitions proliferate. Some of the semiconductor stocks have been helped by the numerous large acquisitions announced this year; investors’ fingers must be crossed in hopes that they own the next target. Analog Devices announced plans in July to buy Maxim Integrated for more than $20 billion in stock. The deal combines two large analog chip companies. In September, Nvidia agreed to purchase Arm Holdings from Softbank for $40 billion. And last week, it was reported that Advanced Micro Devices (AMD) is in negotiations to buy Xilinx for more than $30 billion. Both Nvidia and AMD shares have had impressive runs over the past year, soaring 206.4% and 186.7%, respectively, versus 18.4% for the S&P 500.

(3) Keep an eye on P/Es. The biggest concern about the industry is valuation. The S&P 500 Semiconductor industry’s forward P/E is 21.0, close to its highest levels of the past decade (Fig. 6). Now that many schools have purchased a computing device for each student and many people working from home have upgraded their PCs, investors might consider how much demand has been dragged forward from future years. The semiconductor industry’s forward P/E levels don’t leave much room for error.

Financials: Bank Reality Check. “The economy, stupid” are words presidential candidates have learned to live by. The phrase—coined by James Carville in 1992 when he was a strategist for then-presidential candidate Bill Clinton—is meant to keep campaigns focused on the economy because that’s what voters care about.

The sentiment still holds true today, but the phrase might be tweaked to “It’s Covid, stupid.” The longer the disease lingers, the bigger its impact on the economy and the higher the odds that companies and consumers will default on their loans. So far, banks’ Q3 loan losses and earnings largely have beat analysts’ forecasts. But most banks’ shares fell this week nonetheless, as bank leaders made clear that the Covid risk to loan portfolios looms. As if for emphasis, CEO warnings have come as the number of US Covid cases increases, two vaccine trials and a drug trial are halted, and an economic stimulus bill remains stymied in Congress.

Here’s a brief look at what bank execs are saying:

(1) Keeping an eye on loans. So far, it looks like the huge loan loss reserves that banks set aside in Q1 and Q2 were large enough to compensate for expected loan losses (Fig. 7). Increases to reserves described in Q3 earnings reports have been extremely modest so far, but executives on the Q3 earnings announcement conference calls seemed cautious when discussing the future.

JPMorgan, for example, set aside only an additional $611 million for loan losses during Q3, down from the $10.5 billion added to reserves in Q2, for a total of $34 billion reserved for loan losses. CEO Jamie Dimon said that if the economy recovers, the bank might have $10 billion in excess reserves; but if a recession ensues, it might need to set aside and additional $20 billion in reserves.

Bank of America posted Q3 net income of $4.9 billion after setting aside $1.4 billion in loan loss reserves last quarter—far less than the $5.12 billion in Q2 and the $4.76 billion in Q1. On an optimistic note, CEO Brian Moynihan said in the earnings conference call that the bank believes its “reserve builds are behind us, which means the P&L impact of those loans should be in our financials already.”

(2) Capital markets save the day. For the most part, commercial loan growth was tepid; however, banks with capital markets operations benefitted from higher trading and underwriting revenue. At Goldman Sachs, for example, trading revenue jumped 29% y/y and underwriting fees increased 60% y/y. The company’s Q3 operating profit almost doubled, thanks to a jump in revenue in its market-making and other principal transaction units. Conversely, the company’s provision for credit losses was only $287 million, a fraction of the $1.6 billion it reserved in Q2.

US bonds and equities sold since the onset of Covid-19 has soared. The 12-month sum of new corporate bonds sold jumped to $2.39 trillion in August, the highest pace since November 2007. New issuance of stocks soared also, to $267 billion in August, the highest pace on record (Fig. 8).

Investors tend to discount revenue increases from trading and underwriting because they can ebb and flow with the markets. They prize interest income, which is considered more stable. After surging earlier this year, banks’ commercial and industrial loans outstanding have fallen to $2.7 trillion as of the September 30 week, down from a peak of $3.1 trillion during the May 13 week, as companies have repaid the loans they drew from their revolvers as insurance when Covid first spiked earlier this year (Fig. 9).

At the same time, falling interest rates have crushed banks’ net interest margin, now at 2.81% in Q2 down from 3.48% as recently as Q4-2018 (Fig. 10). Those two trends mean that banks’ net interest income, which peaked in Q4-2018 has been falling since (Fig. 11). At Bank of America, Q3 adjusted net interest income was $10.2 billion, down $733 million q/q and down $2.1 billion y/y.

Disruptive Technologies: Mock Meats and Peak Cows. Vegetarians by definition eschew eating meat, getting their daily nutrients mostly from veggies and fruits. As of 2018, their numbers were small; just 5% of American adults considered themselves vegetarians, according to a Harris Poll National Survey. Farmers raising cows, pigs, and chickens had little to fear. But there’s a new method of “growing proteins” that doesn’t require livestock. Instead, precision fermentation allows micro-organisms to produce complex molecules, like proteins, through a fermentation process.

If this method of creating proteins takes off, cows could be replaced by factories filled with vats brewing the molecules needed for dinner. And instead of farmers tending to their herds, there will be software engineers using artificial intelligence and top-notch computers to design delectable molecules that replicate the proteins we’re used to eating but do a lot less damage to Earth.

While it may sound impossibly futuristic—and far from appetizing—privately held Impossible Foods already uses the process to make the proteins in its Impossible Burger, currently available at grocery stores including Kroger, Target, and Walmart and cooked in Burger King restaurants. Let’s take a look at what the future may hold for our burgers:

(1) Disrupting cows. Tony Seba, co-founder of think tank RethinkX, is known for his futuristic thinking about technology-driven disruption. In the past, we’ve referred to his report about the disruption he expects from electric cars. Last year, he published a report co-authored by RethinkX Research Fellow Catherine Tubb that looks at how the production of proteins through fermentation and other non-traditional methods could lead to the disruption of industrial farming. If they’re correct, the impact reaches well beyond the farmer, hurting companies that produce fertilizers, farm equipment, and livestock pharmaceuticals, as well as impacting farm property values and lenders to the farmers.

Highlights of the report include the following predictions: Demand for cow products will fall 70% by 2030; about 60% of land currently used for livestock and feed production will be freed up for other uses by 2035 (that represents a quarter of US land); the price of this “modern food” will be half as much as traditional animal products; and revenue in the US beef and dairy industries will be cut in half by the start of the next decade.

(2) Environmental benefits. Many of those involved with precision fermentation are hoping this new method of food production will help the environment by allowing land that’s now used for animal grazing to return to its natural state. It would reduce the amount of methane expelled by animals. And it would reduce the carbon dioxide produced during every stage of meat processing, starting with the need to mine for the ingredients in the fertilizer that helps to grow the crops that are used in animal feed.

These new food factories could be located closer to where the food is consumed than are farms. This distributed manufacturing model theoretically would reduce the energy used and environmental damage caused by transporting food from the farm to the table.

Impossible Foods’ website claims that producing its burger uses 87% less water, uses 96% less land, and emits 89% fewer greenhouse gasses into the atmosphere compared to producing a beef burger from a cow.

(3) The Impossible recipe. A key ingredient in the Impossible Burger is “heme,” a molecule that occurs naturally in human blood, contains iron, and gives meat its meaty taste. Heme is also in soybean roots. Impossible Foods makes heme artificially by extracting the DNA for heme protein from soybean roots and inserting that DNA into genetically engineered yeast. The yeast then is fermented, but instead of producing alcohol as it multiples, the DNA-altered yeast produces heme. The heme then is used in the Impossible Burgers.

Impossible Foods expanded its portfolio earlier this year by introducing pork- and sausage-like products. They are made using the same fermentation method that’s used to create the beef in Impossible Burgers, but different seasonings are used in the pork. Pork is actually the most widely consumed meat worldwide. Nearly 1.5 billion pigs are killed for food each year, a number that has tripled in the last 50 years, according to the World Economic Forum. The company is working on the production of steak next.

(4) Beyond genetic modification. Not everyone is using genetic modification to produce meat-free burgers. Beyond Burgers uses plant products in its burgers. The company’s shares, which were priced at $25 in its 2019 IPO, closed Tuesday at $187.62.

Thai company NR Instant Produce turns jackfruit into a mock-pork product, an October 13 Bloomberg article reports. And Solar Foods, a private company based in Finland, uses fermentation to produce a protein powder it calls “Solein.” The company uses a natural bacteria that consumes carbon dioxide and hydrogen to produce the protein powder. The hydrogen is produced through water electrolysis that uses hydropower as its power source. The protein powder has little taste and would be added to foods to increase their protein content. Solar Foods is targeting consumers interested in healthy, sustainable diets.

Cows, mooove over.

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Que Sera, Sera

October 14 (Wednesday)

Election I: What Will the Future Bring? My day job is to forecast the outlook for the global economy and financial markets. Yet in recent weeks, I can’t get that song out of my head—the one titled “Que Sera, Sera.” The lyrics include: “Que sera, sera / Whatever will be, will be / The future’s not ours to see / Que sera, sera.” Doris Day introduced the song in the Alfred Hitchcock film “The Man Who Knew Too Much” (1956).

I share the stock market’s attitude on the coming elections: Que sera, sera. Consider the following:

(1) This virus too shall pass. No matter who wins the White House and which party wins majorities in the Senate and the House, the pandemic should be over more or less by the second half of next year. A recession isn’t very likely next year. Whether Donald Trump wins a second term or Democratic contender Joe Biden is our next president, the future will bring more government spending. Infrastructure spending is likely to increase under either one.

Under Biden, there might be lots more spending on Green New Deal initiatives and a whole host of other programs. Trump probably wouldn’t need to raise taxes to finance his spending agenda in a second term. However, Biden’s spending ambitions are so vast that they certainly would require much more in tax revenues. As Melissa discusses below, the “Biden Plan” will include higher income and corporate taxes and probably a wealth tax.

Of course, a regime change so radical in terms of taxes as a transition from Trump to Biden could cause a recession. However, the spending programs proposed in the Biden Plan will certainly pump lots of money back into the economy. Nevertheless, yet another round of massive government intervention in the economy is bound to weigh on the long-term vitality and productivity of our economy. So the bull market in stocks should continue under Biden, though the winners and losers are likely to be quite different under another four years of Trump versus four years of Biden. Que sera, sera.

(2) The most powerful person in Washington. In any event, the most powerful person in Washington in terms of influence over the stock market is the Fed chair. Fed Chair Jerome Powell is likely to serve out his first four-year term through February 2022. He seems to be committed to keeping interest rates close to zero through the end of his term. He probably won’t be reappointed if Trump wins a second term. He probably will be if Biden wins, but he might choose to move on to other pursuits. In any event, the market can look forward to another year of ultra-easy monetary policy under Powell.

In my book Fed Watching for Fun & Profit, I call Powell the “pragmatic pivoter.” Remember how he pivoted in late 2018 and early 2019 on the outlook for interest rates? Instead of raising them, he lowered them three times last year (Fig. 1). In response to the pandemic, he pivoted on Modern Monetary Theory. He had been against it prior to the pandemic. Ever since the pandemic hit, he has been all for it. He has regularly called for more fiscal stimulus and virtually guaranteed that the Fed would keep interest rates near zero by purchasing all the additional Treasury debt. Que sera, sera.

(3) Do investors prefer Trump or Biden? When the presidential campaigning started in earnest last summer, it was widely agreed that stock investors mostly preferred another four years of Trump’s economic policies. They certainly liked his tax cuts and his deregulation of business. They worried about his trade war with China but took heart when he started to deescalate it at the start of this year. During this past summer, when Biden became the Democratic candidate for president, there were mounting concerns that Trump might lose, though in a bitterly contested election. Some commentators suggested that such concerns contributed to September’s stock-market selloff.

After the first presidential debate on September 29, the consensus was that Trump lost it and could lose the election as well. So why is the S&P 500 up 6.0% since then through Monday’s close with all 11 sectors up over this period (Fig. 2)? Here is the performance derby over this period: Utilities (8.6%), Consumer Discretionary (7.3), Financials (7.2), Information Technology (6.6), S&P 500 (6.0), Real Estate (5.7), Materials (5.3), Industrials (5.2), Health Care (5.0), Consumer Staples (5.0), Communication Services (4.2), and Energy (2.8) (Table 1).

Now the consensus perspective seems to be: At least a Trump trouncing would likely mean an uncontested election! Que sera, sera.

(4) Goldman weighs in. Besides, Goldman Sachs has declared that a Biden victory could be bullish for the markets. On September 24, David Kostin, Goldman Sachs’ chief US equity strategist, predicted “a modestly positive net impact” if Democrats sweep the November elections, pushing S&P 500 earnings higher, according to Business Insider. “A large increase in fiscal spending, funded in part by increased tax revenue, would boost economic growth and help offset the earnings headwind from higher tax rates,” according to a report by Goldman’s strategists. They opined that Congress would enact a “pared-down” version of Biden’s plans for tax reform, starting in 2022. New trade policies would support corporate profits throughout Biden’s term, according to Business Insider.

Goldman’s S&P 500 price target is 3600 by the end of this year. Ours is still 3500 by the end of this year and 3800 by the middle of next year. Que sera, sera.

Election II: Biden Has a Tax Plan. Joe Biden’s progressive $3 trillion or more tax proposal would impose higher taxes on both labor and capital, potentially weighing on the economy over the coming decade. It reverses some, but not all, of the tax cuts from the Trump administration’s 2018 Tax Cuts and Jobs Act. Here are the key elements of Biden’s proposal, mostly according to his dedicated website page:

(1) Lower-income groups directly benefit. Individuals earning less than $400,000 can expect not to incur any new direct tax increases. The Child Tax Credit would be expanded from $2,000 per qualifying child to $3,000 for children aged 6 to 17 with a $600 bonus for children under the age of 6. It would be fully refundable and advanceable. Biden would also reinstate the first-time homebuyers credit, making it permanent and advanceable. Individuals would receive a refundable tax credit for health insurance premiums exceeding 8.5% of their income.

(2) Wealthier income groups directly hit. Furthering Biden’s progressive tax agenda, the top individual tax rate would be increased to 39.6% from 37.0%. Itemized deductions would be limited. Individuals earning $1 million or more would be subject to a capital gains tax equivalent to their individual income tax rate. Retirement tax benefits would be “equalized” for contributions to plans among income groups. Biden would impose incremental Social Security payroll taxes on individuals earning more than $400,000 and repeal the step-up in basis rule. Estate tax exemptions would be reduced by 50.0%.

(3) Corporate tax directly hit too. Biden would raise the federal corporate statutory tax rate to 28.0% from Trump’s 21.0%, which had been lowered from 35.0%. To mitigate tax-avoidance strategies, Biden would charge a 15.0% minimum corporate book income tax. On all foreign-sourced income of multi-national corporations, a 21% tax rate would apply; that’s double the current rate under Trump’s offshore tax law (see here for more). A tax penalty would be charged for jobs sent overseas. Tax incentives would be issued to promote Biden’s green policies.

(4) Indirect hit for all. According to a September 29 Tax Foundation analysis, the most significant tax-revenue generators over the next decade under Biden’s proposals when conventionally scored (i.e., cost estimated excluding the macroeconomic feedback of the actions) are the increase in the corporate tax rate ($1.05 trillion), increase in the Social Security payroll tax ($820 billion), increases in taxes on capital gains and dividends, as well as the repeal of the step-up in basis rule ($469 billion).

Biden’s tax proposals are highly progressive, skewing the tax code in favor of lower-income individuals. However, Biden’s tax policies would result in lower after-tax income for all income groups on a dynamic basis, estimates the Tax Foundation. The Tax Policy Center has calculated similar distributional effects, with lower after-tax incomes estimated for all income groups when including macroeconomic feedback in the estimates.

(5) GDP estimates all lower. Notably, on a dynamic basis, the revenue collected under Biden’s tax policies over the next decade would be reduced to $2.65 trillion from $3.05 trillion, according to the Tax Foundation. Biden’s tax plan would likely modestly shrink the size of the economy over the long term, based on analyses from Penn Wharton Budget Model (PWBM), Tax Foundation (TF), and American Enterprise Institute (AEI), per a July 30 compilation of these estimates by the Committee for a Responsible Federal Budget. All three analyses found that Biden’s plan “would reduce incentives to work, save, and invest due to its increases in effective marginal tax rates.” Specifically, AEI estimated the Biden plan would reduce long-run GDP by 0.2% relative to the baseline, PWBM estimated a 0.7% reduction, and TF estimated a 1.5% reduction.

Election III: Biden Has Lots of Spending Plans. Imposing a $3 trillion tax hike during a wobbly economic recovery seems like a very bad idea. However, the overall impact of Biden’s tax proposals on the US economy depends on how the tax revenues are spent by the potential new incoming administration. We have plenty of clues as to Biden’s spending focus based on his agenda outlined for his campaign platform.

If Biden were to take the White House, the US could see a historically large $2 trillion spending package directed toward climate initiatives and economic equality, as we covered in our July 21 Morning Briefing. Waiting in the wings is also the Democrats’ second-round $2 trillion pandemic stimulus bill, currently stalled in interparty negotiations. Combined, the extraordinary amount of incremental spending should counter some, but not all, of the negative economic consequences of tax hikes, depending on whether the investments are productive.

Election IV: Blue Wave Portfolio. For any of this to come to pass, however, not only would Biden have to win the White House, but the Democratic party would need to maintain control of the House and take control of the Senate. Right now, none of this is guaranteed, but it is possible. While we are not banking on it yet, it would be prudent for investors to prepare for a swift rotation into a Blue Biden Portfolio, as outlined in our July 21 note linked above. The good news is that we do not expect a broad equity market selloff resulting from a Blue wave, primarily because there is no alternative to stocks besides cash, yielding nothing. Consider the following:

(1) Blue wave possible. On October 11, Barron’s summarized the latest polls and concluded: “With just 23 days to go before voting in the U.S. presidential election ends, most polls show former Vice President Joe Biden with a lead both nationally and in key battleground states.”

A September 26 CNN article titled “Why Biden would likely have a Democratic Senate if he wins” observed that the Democrats need a net gain of only three seats to win control of the Senate if Biden wins the presidency and four if he doesn’t (with the difference attributable to which vice president would break a tie vote). Democratic Senate candidates have at least nominal polling advantages in five seats currently held by Republicans (Arizona, Colorado, Iowa, Maine, and North Carolina) versus Republicans’ polling lead of one seat held by the Democrats (Alabama).

(2) Blue Biden Portfolio. We haven’t changed our prospective list of winners and losers under a Blue Wave scenario since our July 21 commentary (linked above). Among the winners likely would be: domestic energy-efficient technologies (e.g., wind and solar), railroads, homebuilders, building contractors, manufacturers and material suppliers, broadband network providers, utilities, autos, medical suppliers, and innovative technologies (e.g., artificial intelligence). Pot stocks, too, would benefit from the federal decriminalization of marijuana. Prospective losers: airlines and aerospace, pharmaceuticals, and health care.

(3) Blue wave & TINA. CNBC observed in a September 21 article that Biden’s capital gains tax hike could spark a big sell-off in stocks. However, we think that the sell-off would likely not result in a broad market decline, but rather a rotation into blue-friendly equities, as noted above. Primarily, we think so because there is no alternative (a.k.a. TINA) to stocks given that the Fed is likely to maintain interest rates near zero for years to come.

But the capital gains tax increase alone might not cause equity markets to falter. True, investors historically have sold assets that had appreciated ahead of such tax increases, resulting in waves of selling. But institutions make up the lion’s share of investors these days (75% according to recent research from the Tax Policy Center, as reported by CNBC), and they aren’t subject to a capital gains tax. Even back in 1986, when this was less the case, equities continued to rise overall even as investors took capital gains before a pending capital gains tax hike.

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’Tis the Earnings Season: Leaders & Laggards

October 13 (Tuesday)

Earnings I: Looking Ahead. The Q3 earnings season is starting. It always takes place during October, the month that ends with Halloween. Investors are expecting more treats than tricks during the latest reporting season. That’s because despite the 33% (saar) plunge in nominal GDP during Q2, earnings didn’t fall as steeply as feared, and now nominal GDP is expected to be up 37% during Q3. The latest reading from the Atlanta Fed’s GDPNow tracking model for Q3’s real GDP growth rate is currently 35%.

For real GDP, Debbie and I are still predicting a gain of 30% during Q3 followed by a 10% increase during Q4. If Q3 turns out better than our current estimate, we will probably lower our estimate for Q4. So our forecast for this year calls for a V-shaped recovery during the second half of the year. Next year, we expect that the V will morph into the Nike swoosh, with real GDP recovering all that was lost during the lockdown recession by the second half of 2021 (Fig. 1).

Of course, the relationship between S&P 500 earnings and real GDP growth isn’t a tight one. Earnings are determined by revenues and profit margins. So to get at what the GDP forecast implies for earnings, it is best to compare S&P 500 revenues—on an aggregate basis rather than a per-share basis—to nominal GDP growth, both on a y/y basis. Even that approach is necessarily imperfect given that something like 30%-40% of S&P 500 revenues is derived from overseas. Even if we accurately predict revenues, there’s still the profit margin to consider when attempting to map GDP to earnings. Despite this hedge clause, let’s do our best to do all of the above:

(1) Revenues & nominal GDP in 2020. The growth rates of S&P 500 aggregate revenues and nominal GDP are positively correlated, but not as highly as widely thought (Fig. 2). Their cycles coincide, but the former is more volatile than the latter. When we disaggregate nominal GDP into its goods and services components, we find that the growth rate of S&P 500 aggregate revenues is more highly correlated with the goods component, which is the more cyclical of the two (Fig. 3). Until the unprecedented lockdown recession, there was very little correlation between the growth rate of nominal GDP of services and S&P 500 aggregate revenues (Fig. 4).

This is the first recession to have hit the services economy. In fact, on a y/y basis, nominal goods GDP growth typically has turned negative during recessions, while services GDP growth never did so until this year’s lockdown recession (Fig. 5). Not surprisingly, the growth rate of the quarterly S&P 500 aggregate revenues series is very highly correlated with the growth rate of the monthly series for manufacturing and trade sales, which includes goods but no services (Fig. 6).

Here are the y/y growth rates through Q2 and for the troughs of the previous recession for S&P 500 aggregate revenues (-10.7%, -19.6%), nominal GDP (-8.5, -3.3), nominal GDP goods (-8.6, -8.2), and nominal GDP services (-9.1, -0.4).

Our q/q forecasts for real GDP translate into y/y growth rates of -3.6% during Q3 and -1.8 during Q4, or -1.6% and 0.2% for nominal GDP (adding 2.0ppts for inflation).

We believe that should be consistent with y/y growth in both aggregate and per-share revenues of -4% during Q3 and -3% during Q4 (Fig. 7). Despite all the commotion about buybacks, the spread between the growth rates of aggregate and per-share S&P 500 revenues has been relatively small since 1994 (Fig. 8). That’s because, as Joe and I previously have estimated, roughly two-thirds of buybacks have been made to offset share dilution from employee stock plans rather than to artificially juice up earnings per share. (See our May 20, 2019 Stock Buybacks: The True Story.)

(2) Revenues & nominal GDP in 2021 and 2022. Next year, Debbie and I are predicting that real GDP will rise 3.0% Q4/Q4, with nominal GDP up 5.0% over this period. For 2022, we see comparable growth rates of 2.0% and 4.0%. We are currently predicting that S&P 500 revenues per share will fall 5.3% this year, then increase 8.2% and 5.2% in 2021 and 2022, respectively (Fig. 9).

(3) Earnings and margins in 2020. We are currently projecting that S&P 500 earnings per share will fall 23.3% from last year’s $163 to $125 this year, and rise 24.0% to $155 next year and 16.1% to $180 in 2022 (Fig. 10). In our forecast, the profit margin rises from 9.3% this year to 10.7% next year and 11.8% in 2022 (Fig. 11). Of course, if a new administration in the White House next year raises the corporate tax rate, we will have to lower our projected margins.

As for the current and coming earnings seasons, we are predicting y/y growth rates for S&P 500 earnings per share of -28.8% for Q3 and -16.7% for Q4. Industry analysts are currently predicting -21.8% and -14.1% as of the October 8 week (Fig. 12). They had been too pessimistic going into the Q2 earnings season, resulting in an upside hook for the quarter in our Earnings Squiggles charts.

We might raise our Q3 and Q4 earnings estimates after we see banks’ earnings reports this week. Banks are certainly the wild card with respect to their impact on aggregate S&P 500 earnings. During tough times, they usually increase their provisions for loan losses for several quarters. So far, they’ve only done so during Q2.

The two-month lockdown recession started in March and ended in April. The economic recovery during May and June helped to lift Q2’s actual results relative to expectations. In addition, many companies and their workers adapted quickly to the lockdowns and continued to operate virtually if they could do so or on premises by following social-distancing guidelines. Furthermore, quite a few companies actually saw their sales boosted by the pandemic.

Earnings II: Looking Forward at the Sectors. As you may know, Joe and I are impatient. We can’t wait around for quarterly data to assess the current and prospective outlook for earnings. So we put a lot of weight on the weekly S&P 500 forward revenues, forward earnings, and forward profit margin—all of which are great high-frequency coincident indicators of their comparable quarterly series (Fig. 13). All three signaled bottoms during the week of May 28. All three have been recovering steadily since then. All three suggest that their quarterly comparable series bottomed during Q2 and should recover over the rest of the year. (See our S&P 500 Earnings, Valuation & the Pandemic: A Primer for Investors.)

Let’s focus on the 12.9% recovery in S&P 500 forward earnings since the May 28 week through the October 1 week, and examine which sectors and industries have led and lagged the overall advance over this period. (See our S&P 500 Sectors & Industries Forward Earnings.) I asked Joe to run our performance derby table for forward earnings over this period (Table 1). Here is what we found:

(1) Sectors. All of the 11 sectors of the S&P 500 bottomed at about the same time as the total for the S&P 500 (Fig. 14). At new highs since the start of the bull market in March 2009 are Information Technology and Health Care. Here is the sectors’ performance derby over the recovery period so far: Energy (333.7%), Consumer Discretionary (40.0), Industrials (20.8), Materials (18.7), Financials (13.3), S&P 500 (12.9), Health Care (9.7), Communication Services (8.6), Information Technology (8.0), Consumer Staples (5.2), Utilities (0.8), and Real Estate (-6.1).

(2) Information Technology & Health Care industries. Leading the way to new highs in the S&P 500 Information Technology sector are Technology Hardware, Storage & Peripherals (9.8%) and Systems Software (8.2) (Fig. 15). Semiconductor (8.5) and Semiconductor Equipment (14.2) are back to their record highs of 2018 (Fig. 16).

In the S&P 500 Health Care sector, both Biotechnology (6.2%) and Managed Health Care (6.4) remain on never-ending moonshots, while Pharmaceuticals (7.8) have recently resumed edging higher into record territory (Fig. 17).

(3) Industrials, Energy, and Materials. In the S&P 500 Industrials sector, most of the major industries are showing upturns from their recent bottoms but remain below their pre-pandemic levels, including Air Freight & Logistics (39.2%), Construction Machinery & Heavy Trucks (25.8), Electrical Components & Equipment (11.4), Industrial Machinery (20.9), and Railroads (9.0) (Fig. 18).

Still down-and-out among the Industrials, though bottoming, are Aerospace & Defense (5.8%) and Industrial Conglomerates (7.3). The same can be said of the major industries in the S&P 500 Energy sector.

 In the S&P 500 Materials sector, both Industrial Gases (8.6%) and Metal & Glass Containers (8.0) are back at cyclical highs. Also bottoming are Diversified Chemicals (6.7), Fertilizers & Agricultural Chemicals (11.2), Specialty Chemicals (9.5), and Paper Packaging (9.3).

(4) Financials. In the S&P 500 Financials sector, the following industries are mostly off their bottoms but still well below their pre-pandemic highs: Asset Management & Custody Banks (14.3%), Consumer Finance (48.5), Diversified Banks (19.5), Investment Banking & Brokerage (20.0), and Life & Health Insurance (7.4) (Fig. 19).

(5) Consumer Discretionary and Consumer Staples. Among the S&P 500 Consumer Discretionary sector’s industries, the biggest recoveries have occurred in work-from-home-housing-related ones: Automotive Retail (23.3%, new high), Computer & Electronics Retail (30.4, new high), General Merchandise Stores (25.6, new high), Homebuilding (54.8), Home Furnishings (61.4), Home Improvement Retail (18.3, new high), Household Appliances (38.9), Internet & Direct Marketing Retail (52.4, new high), and Restaurants (22.3) (Fig. 20).

Struggling to find/make bottoms are Casinos & Gaming, Hotels Resorts & Cruise Lines (negative), Movies & Entertainment (8.6%), and Specialty Stores (8.4).

In the Consumer Staples sector, at or near record highs are Household Products (6.1%), Hypermarkets & Super Centers (7.6), and Tobacco (6.4) (Fig. 21). Bottoming are Packaged Foods & Meats (5.9) and Soft Drinks (5.2). Still falling is Drug Retail (-13.5).

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Don’t Fight T-Fed

October 12 (Monday)

The Fed I: Birth of T-Fed. What a difference a pandemic makes. Prior to the Great Virus Crisis (GVC), Fed officials were either dismissive of Modern Monetary Theory (MMT) or remained silent on the subject since it crosses into the realm of fiscal policy. Fed officials have had a very long tradition of never crossing that line. They do monetary policy. Congress and the White House do fiscal policy. Period! Nothing to see here. Move on.

Since the GVC, Fed officials repeatedly and frantically have been exhorting the fiscal authorities to do much more to support the economy. They’ve made it very clear that they will continue to help finance the resulting federal deficits by purchasing most, if not all, of the Treasury debt issued to pay for more fiscal stimulus. They’ve certainly been doing so since March 23, when they implemented QE4ever, which has already mostly financed the $2.2 trillion CARES Act signed by President Donald Trump on March 27. Consider the following:

(1) Consolidating the Treasury & the Fed. Over the past 12 months through August, the federal budget deficit totaled a record $2.92 trillion (Fig. 1). Over the same period, the Fed’s holdings of Treasuries is up by a record $2.26 trillion. Now that the Treasury and the Fed have joined forces in the MMT crusade to drown the virus in liquidity, we might as well consolidate the two of them into “T-Fed.” The result is that the federal government needed to borrow just $663 billion from the public over the past 12 months through August (Fig. 2)!

(2) The Fed’s portfolio of Treasuries. The Fed held a record $4.45 trillion in US Treasuries at the end of September (Fig. 3). That amounts to 24.2% of the Treasury’s marketable debt outstanding (Fig. 4). The Fed owns 20.0% and 36.9% of US marketable Treasury notes and bonds, respectively (Fig. 5).

(3) Good ol’ Feddie. During the Great Financial Crisis, mortgage giants Fannie Mae and Freddie Mac were placed in conservatorship on September 7, 2008. The Fed rose to the occasion and was transformed by then-Fed Chair Ben Bernanke into “Feddie.” QE1 was introduced on November 25, 2008. In this first round of quantitative easing, the Fed committed to purchase $1.24 trillion in mortgage-backed securities and agency debt (Fig. 6). Since QE4ever, the Fed has purchased $618 billion in such securities, bringing their total to a record $1.98 trillion during September. The result has been record-low mortgage rates, which has contributed to the housing boom caused by de-urbanization in response to the pandemic and mounting urban crime (Fig. 7).

The Fed II: De Facto Yield-Curve Targeting. What if another big round of deficit-financed fiscal spending pushes up bond yields and mortgage rates? That would be a big setback for MMT crusaders. The 10-year Treasury bond yield has averaged 0.68% since MMT Day (March 23) through Friday’s close. It rose to 0.79% on Friday, up from the record low of 0.52% on August 4 (Fig. 8).

Have no fear; the Fed is here with YCT (yield-curve targeting), which it will use if necessary to supplement MMT by keeping a lid on bond yields. Actually, the remarkable stability of the bond yield near record lows since March 23 suggests that the Fed may be capping the bond yield below 1.00% without officially saying so.

Ever since March 23, Powell repeatedly has stated that the Fed intends to keep interest rates close to zero for a very long time. At his June 10 press conference, he famously said: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” He reiterated that policy in his July 29 press conference, saying: “We have held our policy interest rate near zero since mid-March and have stated that we will keep it there until we are confident that the economy has weathered recent events and is on track to achieve our maximum employment and price stability goals.”

Remember that the Fed lowered the federal funds rate by 100bps to zero on March 15. No target was set for the bond yield at that time or has been since then—so far. At the June 10 presser, Nick Timiraos of the WSJ asked Powell about the possibility of “yield caps.” Powell revealed that at the latest meeting of the Federal Open Market Committee (FOMC), the participants received a briefing on the historical experience with YCT and said that they would evaluate it in upcoming meetings. Here is the excerpt on YCT from the June 10 FOMC meeting Minutes:

“The second staff briefing reviewed the yield caps or targets (YCT) policies that the Federal Reserve followed during and after World War II and that the Bank of Japan and the Reserve Bank of Australia are currently employing. … [T]hese three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt. But the staff also highlighted the potential for YCT policies to require the central bank to purchase very sizable amounts of government debt under certain circumstances … and the possibility that, under YCT policies, monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank.”

So how might the Fed be keeping a lid on the 10-year bond yield? Simple: The Fed has been buying all the bonds that the Treasury has been issuing in recent months and then some. From February through September, the Treasury issued $259 billion in bonds with maturities exceeding 10 years. Over that same period, the Fed purchased $338 billion of such bonds.

 The Fed III: How To Print Money. Fed Chair Jerome Powell’s important interview on 60 Minutes with Scott Pelley was aired on May 17. Pelley asked where Powell got the trillions of dollars that the Fed spent on purchasing bonds since March 23: “Did you just print it?” Powell forthrightly responded: “We print it digitally. So as a central bank, we have the ability to create money digitally. And we do that by buying Treasury bills or bonds or other government guaranteed securities. And that actually increases the money supply. We also print actual currency, and we distribute that through the Federal Reserve banks.”

Powell also acknowledged that there was no precedent for the scale of QE4ever: “The asset purchases that we’re doing are a multiple of the programs that were done during the last crisis.” Let’s review how T-Fed’s actions since MMT Day have boosted the M2 monetary aggregate:

(1) US Treasury’s deposit account at the Fed. The Treasury has been borrowing at a record pace in the Treasury market to fund the various government support programs aimed at reducing the economic damage and pain resulting from the GVC. The federal budget deficit has totaled a record-shattering $1.9 trillion from March through September. As a result, the US Treasury General Account at the Fed has jumped from $439 billion at the end of February to $1.7 trillion during the October 7 week (Fig. 9).

(2) The Fed’s US Treasury purchases. Over that same period, the Fed facilitated the Treasury’s massive borrowing with massive purchases of US Treasuries, totaling $1.99 trillion. The Fed now owns a record $4.46 trillion in US Treasuries as of the October 7 week (Fig. 10).

(3) Commercial bank deposits and cash. The Fed also facilitated the mad dash for cash that started during February as the viral pandemic triggered a widespread pandemic of fear. The Fed’s purchases of Treasuries and agency securities from the public boosted commercial bank deposits by $2.28 trillion from the end of February through the September 30 week as the public sold securities to raise cash (Fig. 11).

The huge 20% y/y jump in this liability item on banks’ balance sheets was offset on the asset side by “cash” assets, which are basically the banks’ reserve balances at the Fed (Fig. 12). They really aren’t cash per se, since the banks can’t make loans with these deposits at the Fed. They can make more loans by lending out the increase in their deposits less reserve requirements, which were lowered to zero on March 15. When they do so, the banks also create more deposits. That’s the way a fractional-reserve banking system works. (By the way, the answer to the oft-asked question of why the banks don’t lend out all that cash on their balance sheets is that they can’t, because it is a balancing item determined totally by the Fed’s balance sheet!)

(4) Commercial bank loans. The Fed’s MMT maneuvers also facilitated the $781 billion jump in commercial bank loans from the end of February through the May 13 week (Fig. 13). Commercial and industrial loans soared $715 billion over this same period as businesses cashed in their lines of credit, fearing a cash crunch (Fig. 14). The surge in loan demand was easily funded by the increase in deposits. Indeed, the brief surge in borrowing by banks during the weeks of February 12 through March 25 has been more than reversed subsequently (Fig. 15).

(5) Companies issuing bonds and paying down lines of credit. Now many businesses that had rushed to draw their lines of credit during the mad dash for cash earlier this year are paying them down. Nonfinancial corporations raised a record $1.44 trillion over the past 12 months through August at record-low yields, thanks to the Fed’s backstopping the corporate bond market as part of QE4ever (Fig. 16). And what are the banks doing with the cash from the loan paydowns? They are buying Treasuries and agencies to the tune of $527 billion since the start of this year through the September 30 week (Fig. 17).

The Fed IV: MMT Junkies. T-Fed was born on March 23, the day that the Fed adopted QE4ever. Ever since then, Fed officials have been basically saying: “More, more, more!” They want another round of MMT. They don’t call it that, but that’s what they are asking for.

Fed Chair Jerome Powell was asked about MMT during congressional testimony on February 26, 2019. He hated it back then: “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong,” the Fed chair said. The “US debt is fairly high to the level of GDP—and much more importantly—it’s growing faster than GDP, really significantly faster. We are going to have to spend less or raise more revenue.”

Powell rejected the notion that the Fed should enable fiscal spending: “[T]o the extent that people are talking about using the Fed—our role is not to provide support for particular policies,” he said. “Decisions about spending, and controlling spending and paying for it, are really for you.” In effect, he told Congress: “Fiscal policy is your domain. Leave us out of it.”

Again: What a difference a pandemic makes! Consider the following:

(1) March. In his March 3 and March 15 unscheduled press conferences Powell said it wasn’t the Fed’s “role to give advice to the fiscal policymakers” and that fiscal policy would need to be handled on a “discretionary” basis.

(2) April. Powell’s fiscal pivot occurred during his April 29 press conference Q&A, when he said: “I have longtime been an advocate for the need for the United States to return to a sustainable path from a fiscal perspective at the federal level. We have not been on such a path for some time, which means … that the debt is growing faster than the economy. This is not the time to act on those concerns. This is the time to use the great fiscal power of the United States to … do what we can to support the economy and try to get through this with as little damage to the longer-run productive capacity of the economy as possible.”

(3) June. During his June 10 press conference, in prepared remarks, Powell said: “I would stress that [the Fed has] lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. … Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. The CARES Act and other legislation provide direct help to people and businesses and communities. This direct support can make a critical difference not just in helping families and businesses in a time of need, but also in limiting long-lasting damage to our economy.”

(4) July. During his July 29 press conference Q&A, Powell stated: “Fiscal policy … can address things that we can’t address. If there are particular groups that need help, that need direct monetary help—not a loan, but an actual grant as the PPP program showed—you can save a lot of businesses and a lot of jobs with those in a case where lending a company money might not be the right answer. The company might not want to take a loan out in order to pay workers who can’t work because there’s no business.”

(5) September. In prepared remarks at his September 16 presser, Powell said: “The path forward will also depend on the policy actions taken across all parts of the government to provide relief and to support the recovery for as long as needed.” In the Q&A, he warned that “as the months pass … if there isn’t additional support and there isn’t a job for some of those people who are from industries where it’s going to be very hard to find new work, then that will start to show up in economic activity. It will also show up in things like evictions and foreclosures and, you know, things that will scar and damage the economy.”

(6) October. At the National Association for Business Economics virtual annual meeting on October 6, Powell reiterated his call for more MMT: “By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.”

An October 7 WSJ editorial commented: “It’s important to understand how unusual this is. The Fed’s job is monetary policy and financial regulation. Yet here is a Fed chief lobbying Congress, and the public, on behalf of one side of a fiscal debate.”

(7) Other talking Fed heads. And the beat goes on … On Thursday, Dallas Fed President Robert Kaplan said in a Bloomberg Television interview: “I think the Fed can do more, and I’m sure we’ll look at all our options, but those aren’t substitutes for fiscal policy.”

The same day, Boston Fed President Eric Rosengren emphasized in an interview with Bloomberg News: “There’s a limit to how far we can push the 10-year Treasury rate or the mortgage-backed rate down.” He added: “That’s not to say we shouldn’t do it. It just says the magnitude of the impact, when rates are already so low, is probably much less than what we want, which is why I think you’re hearing Federal Reserve speakers call out for more fiscal policy.”

The Fed V: MMT’s Best Friends Forever. The Fed isn’t the only central bank that has embraced MMT. Arguably, the Bank of Japan (BOJ) led the way with its zero-interest-rate policy, which has been in place since the late 1990s. The People’s Bank of China certainly has enabled China’s commercial banks to finance lots of government spending since 2008.

In her September 4, 2019 speech as the new president of the European Central Bank (ECB), Christine Lagarde called on “the other economic policy makers” to do “what they had to do” to stimulate economic growth. And that was before the pandemic. Since the World Health Organization declared the pandemic on March 11, the ECB’s assets have soared by €2.0 trillion to a record €6.7 trillion (Fig. 18). This past July, the European Union approved a €750 billion economic recovery fund, which will be financed by issuing common debt, providing more bonds for the ECB to buy.

On Thursday, September 17, BOJ Governor Haruhiko Kuroda pledged to work closely with the country's new Prime Minister Yoshihide Suga to support the economy. So far, Suga has indicated that he is not focused on the inflation target. Instead, a top priority of his administration is protecting jobs, reported Reuters. Suga’s emphasis on jobs may influence Kuroda to deemphasize the importance of the inflation target, as Powell’s Fed has recently done. Since the last week of February through the September 25 week, the BOJ’s balance sheet has soared 18% in yen (Fig. 19).

The three major central banks are all MMT’s BBFs (Best Friends Forever). Their combined balance sheet has jumped $6.8 trillion to a record $21.2 trillion since the February 21 week through the September 25 week (Fig. 20). Here in dollars are each of their increases over this period and their most current record highs: Fed ($3.0 trillion $7.0 trillion), ECB ($2.5, $7.6), and BOJ ($1.3, $6.6).

It’s good to have friends.

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Banks, Sweden & Digital Currencies

October 08 (Thursday)

Financials: Reality Check Coming. Financials has been one of the S&P 500’s worst-performing sectors this year, battered by a flat yield curve, surging loan losses, and a regulator that’s prohibiting the payment of dividends and stock buybacks. Next week, as banks’ Q3 earnings start rolling in, we’ll get a better feel for how well banks are reserved for loan losses. Many set aside billions of dollars for losses in Q2 as Covid-19 descended. Given the poor performance of bank stocks, investors may already have priced in banks’ need to continue building reserves in Q3.

The S&P 500 Financials sector’s stock price index has barely rebounded from the market’s March selloff, while the S&P 500 Technology and Consumer Discretionary sectors have hit new highs. Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Information Technology (26.3%), Consumer Discretionary (22.3), Communication Services (6.5), S&P 500 (4.0), Materials (3.7), Health Care (3.0), Consumer Staples (1.9), Utilities (-4.1), Industrials (-4.2), Real Estate (-6.2), Financials (-20.6), and Energy (-50.6) (Fig. 1).

Let’s take a look at bank reserves and loan losses over the past few months:

(1) Bad news: Losses in many loan categories rising. While home-related loans continued their strong performance through Q2, delinquencies in other loan categories were increasing, in some cases sharply. The percentage of balances that are 90 days or more delinquent remains at an extremely low 0.8% for home mortgages and only 1.3% for home equity loans (Fig. 2).

Conversely, there has been a sharp spike in credit-card loan delinquencies to 9.8% in Q2 compared to 8.4% in Q4. The figure looks like it’s ready to climb further. The peak of delinquencies during the Great Financial Crisis (GFC) was 13.7% during the first half of 2010.

Auto loan delinquencies have been slowly grinding higher over the past five years and now stand at 5.0% of total balances. That’s just below the record high of 5.3% during Q4-2010. Student loan delinquencies have dropped sharply to 7.0% from north of 10% last year; borrowers have been allowed to pause those payments without interest accruing since March and can continue to do so through year-end.

One area of concern is commercial mortgages: Loans outstanding for commercial mortgages have climbed far more sharply since the GFC than loans outstanding for residential mortgages (Fig. 3). In addition, vacancies in certain real estate sectors are creeping up and rents are falling. The apartment vacancy rate rose to 5.0% in Q3, the highest since Q1 2012, the office vacancy rate edged higher to 17.4%, the highest since Q3 2011, and the retail vacancy rate increased to 10.4%, the highest since Q4 2013, according to data from Reis in an October 6 Calculated Risk report. So far, however, commercial real estate loan delinquencies have ticked up only to 0.9% in Q2, from a low of 0.7% during Q2-2019 (Fig. 4).

(2) Good news: Reserves are up. Banks have been setting aside funds to deal with the loan losses that are sure to mount. The allowance for loan and lease losses at all commercial banks has surged higher, to $219.7 billion during the September 23 week, a level last seen during the GFC (Fig. 5). Large banks have been more aggressive, with their allowance rising to $142.3 billion, up from $68.8 billion at the start of the year. Small banks have increased their allowance only to $75.3 billion, up from $42.9 billion on January 1.

(3) Hope in the squiggles. Earnings for banks and brokerages are going to be ugly this year; but after falling like a knife into negative territory, 2020 earnings forecasts have stopped sinking. Estimates for next year are expected to bounce for the S&P 500 Diversified Banks and Investment Banking & Brokerage industries but continue to fall for the S&P 500 Regional Banks industry. Here’s a closer look.

The S&P 500 Diversified Banks stock price index has fallen 37.0% ytd through Tuesday’s close, making it the worst-performing industry in the Financials sector (Fig. 6). Yet the industry’s forward earnings bottomed in late April and have resumed an upward trajectory (Fig. 7). The industry’s 2020 earnings are now expected to fall 56.6% in 2020, an estimate that has remained relatively steady over the past five months, and earnings are expected to jump 64.0% in 2021, an estimate that has come down from its peak of 85.3% in late April (Fig. 8).

The picture isn’t quite as rosy for the S&P 500 Regional Banks industry, though it too has enjoyed an upward hook in forward earnings (Fig. 9). Regional Banks’ 2020 earnings forecasts now stand at a 26.3% drop, which is an improvement over the 48.5% decline that was expected back on June 18. However, the 2021 earnings growth estimate has fallen from 52.0% on April 30 to the current 1.4% drop (Fig. 10). The S&P 500 Regional Banks stock price index remains down 28.3% ytd.

The S&P 500 Investment Banking and Brokerage industry’s forward operating earnings also have improved since late April (Fig. 11). Earnings growth expectations for 2020 in this industry have been trimmed in recent months to a 21.0% decline, while 2021 forecasts have seesawed from 27.9% in late April down to 6.4% in early September before rebounding to 18.3% since then (Fig. 12). The S&P 500 Investment Banking and Brokerage stock price index is down only 12.5% ytd.

Epidemiology: A Closer Look at Sweden’s Experiment. Last spring, Sweden went rogue. It kept its economy open even as most countries shut down their economies as Covid-19 turned into a pandemic. The country aimed to balance the risk of the virus with the damage of closing schools and businesses.

Swedish schools have remained open for children 16 and under. Restaurants and businesses have continued to operate. The country did ban gatherings of more than 50 people; it also closed museums and canceled sporting events. Citizens were urged to keep socially distant, work from home when possible, and wash their hands frequently. In March, visits to nursing homes were prohibited. But mask-wearing was not—and still is not—required. Here’s a look at how the country has fared in the months since choosing this course of action:

(1) Death rate spikes, then plateaus. When the number of total deaths in the country quickly spiked past 4,000 in May and 5,000 in June, derision from many quarters quickly followed. But in the subsequent weeks, the new deaths slowed and the curve flattened. As October begins, the total number of deaths remains below 6,000, according to statistics from Worldometer.

Sweden’s Covid-19 death rate, once among the worst compared to other developing nations, now looks much better than many. Sweden has experienced 582 deaths per 1 million citizens. That’s below the levels of Italy (596), the UK (624), the US (649), Spain (685), and Belgium (869). But it is still north of levels in Norway (51), Finland (62), Denmark (114), and the Netherlands (378).

After Sweden’s death rate peaked in April and May—when the number of daily new deaths bounced between 80 and 115—it fell sharply over the summer. Now daily new deaths in Sweden can be counted on one hand. That’s vastly better than the levels experienced in the US on October 5: (697), Spain (261), UK (76), France (66), Italy (28), Netherlands (21), Germany (19). But it’s on par with Denmark (4), Finland (0), and Norway (0).

(2) A new wave of cases arrives. But as Yogi Berra famously said: “It ain’t over ’til it’s over.” And the Covid-19 pandemic is not over. There’s a new surge of cases in Europe from which Sweden hasn’t escaped. New Covid cases in Sweden regularly topped 1,000 a day in June before falling to 200-300 for the remainder of the summer. The recent uptick has pushed new cases up to 600-700 a day in September and October. The most recent datapoints, for October 5, included 343 new cases, and the seven-day moving average of new cases dipped to 515, from 522 on October 3.

Here are some daily new case counts in other countries: US (31,223), UK (14,542) Spain (12,793), France (10,489), Netherlands (4,528), Germany (2,462), Switzerland (700), Denmark (322), Finland (227), and Norway (65).

With the wisdom of hindsight, Sweden has enacted a few more restrictions, and its European neighbors have not completely shut down their economies in the face of this new wave of Covid-19 cases. Sweden now recommends that “anyone experiencing cold-like symptoms such as a sore throat is encouraged to stay at home and get tested,” an October 6 WSJ article reported. In addition, “all members of a household should isolate for a week if one of them becomes infected.” As we said, so far Sweden’s death rate hasn’t spiked, and hopefully it won’t.

(3) Covid invades nursing homes. There are a number of theories about why Sweden’s death rate spiked last spring. About 42% of Sweden’s deaths occurred in Stockholm, which has a large subway system that may have made the transmission of the disease easier, speculates an August 29 article on The American Institute for Economic Research website. Also, the city’s citizens take a winter break from February 24 to March 1 and often go skiing in the Alps, where they may have caught Covid-19 from Italians, whose nation was starting to feel the brunt of the pandemic. Also, Sweden had a very mild flu season the previous year with an abnormally low death rate, perhaps sparing more vulnerable folks than usual, who then fell prey to Covid-19 this year.

Covid hit Sweden’s nursing homes hardest. About half of the country’s Covid-19 deaths were among nursing home residents, with some homes reporting that a quarter of its residents died from the disease. In Sweden, 22% of the deceased were in their 70s, 41% in their 80s, and 25% in their 90s, according to May 2020 data presented in a July 19 article that appeared on the Public Health Emergency COVID-19 Initiative website.

“I think the problem lies more with the structure of care homes,” Leif Dotevall, a communicable disease control officer in Sweden said in a June 22 FT article. The article concluded: “Many Swedish care homes are too large and disconnected from the reset of the healthcare system while workers are often badly paid, poorly qualified and on hourly contracts.” There are lingering questions about whether nursing home employees came to work sick and whether sick residents weren’t sent to hospital when they should have been.

As cases surged and hospitals in Stockholm grew crowded, “[a] March directive to Stockholm area hospitals stated patients older than 80 or with a body mass index above 40 should not be admitted to intensive care, because they were less likely to recover. Most nursing homes were not equipped to administer oxygen, so many residents instead received morphine to alleviate their suffering,” an October 6 Science Magazine article reported. The piece describes a group of scientists in Sweden that disagrees with the country’s handling of the pandemic and favors more stringent separation of the sick and mask-wearing. Sweden has responded to the high nursing home mortality rate by boosting funding for elderly care by about $500 million in its 2021 budget, a September 15 Reuters article reported.

(4) Sweden’s less bad GDP drop. Keeping Sweden’s businesses open did not save the country from an economic downturn, but it did limit the damage. The country’s Q2 GDP fell a record 7.7% y/y, less than most other developed countries’ Q2 GDPs dropped: UK (-21.5%), Spain (-21.5), France (-18.9), Italy (-18.0), Eurozone (-14.7), Germany (-11.3), Japan (-10.1), Netherlands (-9.4), US (-9.0), Denmark (-7.7), Finland (-6.4), and Norway (-4.7) (Fig. 13 and Fig. 14).

Disruptive Technologies: Currencies Going Digital. The US, Europe, and China each is studying digitizing its national currency. They are not alone. Eighty percent of 66 central banks surveyed in May by the Bank of International Settlements (BIS) said they were working on a central bank digital currency (CBDC), a September 25 PYMNTS article reported.

The race to do so has only accelerated in the wake of Covid-19, which pushed consumers to make purchases online in an effort to remain out of stores and safe at home. A Fed survey taken in May found that consumers were keeping more cash on hand, but they were also buying more items online. “[A]bout 20 percent of respondents switched to paying online or over the phone for items from restaurants and big-box stores, and nearly two-thirds reported that they had made no in-person payments during the first several weeks of the pandemic,” said Cleveland Fed President Loretta Mester in a September 23 speech.

Looks like the world’s central bankers are playing a game of catchup. Here’s a quick update on digital currency progress being made in the US, China, and EU:

(1) Testing the digital yuan. The People’s Bank of China (PBOC) appears to be the furthest ahead in developing a digital currency. It has been experimenting with a digital yuan, which has been used in 3.13 million transactions valued at more than 1.1 billion yuan ($162 million), an October 5 South China Morning Post article reported. The digital yuan has been used in 6,700 situations, including paying bills, paying for transportation, and paying for government services.

“The PBOC regards digital renminbi as an important financial infrastructure for the future,” said a PBOC official quoted in the article. China already has the largest market globally for mobile payments, with its citizens using the digital wallets provided by Alipay and WeChat Pay. A digital currency would give the country the “ability trace and track economic activity in real-time”—to say nothing of tracing and tracking what individuals are buying and selling.

(2) Digital dollar being studied. As part of its efforts to study the potential for a digital currency, the US central bank has been testing distributed ledger platforms to understand their benefits and trade-offs, said Cleveland Fed President Mester in her September speech. In addition, the Boston Fed has been working with MIT to experiment with technologies that could be used for a CBDC. And finally, the Federal Reserve Bank of New York has an innovation center with the BIS to identify and understand trends in financial technology.

“Legislation has proposed that each American have an account at the Fed in which digital dollars could be deposited, as liabilities of the Federal Reserve Banks, which could be used for emergency payments,” Mester said. “Other proposals would create a new payments instrument, digital cash, which would be just like the physical currency issued by central banks today, but in a digital form and, potentially, without the anonymity of physical currency.”

A digital currency might allow the Federal Reserve to make emergency payments to individuals’ digital wallets directly without the help of banks. Before deciding on a digital currency, the Fed needs to better understand how digital currency would affect financial stability, market structure, security, privacy, and monetary policy, Mester said.

(3) The digital euro being studied too. The European Central Bank (ECB) is considering launching a digital euro development program by mid-2021, according to an October ECB report. A digital euro would provide “citizens with access to a safe form of money in the fast-changing digital world” and provide fast and efficient cross-border payments.

The digital currency should be like cash: easy for all to use, free of charge, and a protector of privacy. The ECB doesn’t want the digital euro to become an instrument of speculation, like cryptocurrencies, and it would be introduced in addition to cash, not instead of it. The digital euro must be accessible, robust, safe efficient, and private, the report states. The ECB will study the potential effects on central bank policies and the effect on bank deposit funding.

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Strategy Matters

October 07 (Wednesday)

US Strategy I: More ‘V for Victory’ Over Virus. Yesterday, Debbie and I reviewed the latest data on payroll employment and purchasing managers surveys in the US. We are still seeing a V-shaped recovery, which started during May, in the latest data for these indicators through September.

We are also seeing V-shaped recoveries in the global PMIs through September (Fig. 1). Here are their readings back in April and most recently, in September: Global Composite (26.2, 52.1), Global M-PMI (39.6, 52.3), and Global NM-PMI (23.7, 51.6). All three have been above 50.0 since July. Keep in mind that since they are very cyclical diffusion indexes, their ability to maintain a V-shaped recovery is limited. Nevertheless, it’s easy to find plenty of other V-shaped economic indicators around the world and at home:

(1) Eurozone indicators showing strong recovery. For example, the volume of non-auto retail sales in the Eurozone soared 30.3% from April through August to a new record high (Fig. 2). This augurs well for manufacturing orders in the region, which are up 40.9% since April through July (Fig. 3). The Economic Sentiment Indicator for the European Union (EU) has rebounded from April’s low of 63.8 to 90.2 through September (Fig. 4).

(2) Firming commodity prices. The CRB raw industrials spot price index has rebounded 12.3% from this year’s low on April 21 through Monday’s reading (Fig. 5). It’s back to within 2.2% of this year’s high on January 17. Over this same period, the nearby futures price of copper is up 30.8%.

(3) Rebounding S&P 500 forward revenues. In the US, the outlook for quarterly S&P 500 revenues per share continues to improve. The y/y growth rate of this series is highly correlated with both the M-PMI and NM-PMI (Fig. 6 and Fig. 7). This outlook is confirmed by the rebound in the weekly series for S&P 500 forward revenues per share. It is up 4.0% through the September 24 week from its recent bottom during the May 28 week (Fig. 8).

 US Strategy II: Growth, Value & Dividends. Since the market’s bottom on March 23, the S&P 500 Growth and Value stock price indexes rallied in tandem through June 8, with both gaining 44.6% (Fig. 9). They’ve diverged since then, with the former continuing to move higher while the latter stalled. As of Monday’s close, Growth is up 62.4%, while Value is up 39.0% since March 23.

These statistics are based on widely followed stock price indexes provided by Standard & Poor’s for S&P 500 Growth and Value. S&P also provides total-return indexes, which reflect the reinvestment of their dividends into their respective style indexes. Similarly, MSCI provides comparable stock price indexes for the US MSCI Growth and Value indexes as well as total-return indexes, but its total-return indexes come two ways—reflecting the reinvestment of dividends on both “gross” and “net” bases. The “net” reflects the dividends distributed to investors after foreign taxes are withheld.

In the following analysis, we focus on the S&P 500 and use “SPI” for the stock price indexes and “GTRI” for the gross total-return indexes, i.e., including dividends. To repeat, S&P provides SPIs and GTRIs, but does not supply “NTRIs,” or net total-return indexes, for the S&P 500 Growth and Value indexes. MSCI provides all three for its indexes.

Here is the performance derby since March 23 through Monday’s close for the relevant S&P indexes: S&P 500 SPI (52.3%), S&P 500 Growth SPI and GTRI (62.4, 63.3), S&P 500 Value STI and GTRI (39.0, 41.2). Over short periods of time, there isn’t much difference between SPIs and their corresponding GTRIs. I asked Joe to compare the S&P 500 Growth and Value performance derbies of these SPI and GTRI measures over longer time periods. Here is what he found when he sliced and diced the available data:

(1) Long-term performance of the S&P 500 Growth and Value SPIs and their GTRIs. Based on weekly data through last Friday, the S&P 500 Growth SPI is up 752.5% since June 30, 1995, nearly 2.7 times the 283.3% gain for the S&P 500 Value SPI. A look at their respective GTRIs shows the S&P 500 Growth GTRI up 1,104.6%, only 1.8 times the 618.8% gain for the S&P 500 Value GTRI (Fig. 10).

While both Value indexes have underperformed both of Growth’s, the reinvestment of dividends has given a bigger boost to Value’s GTRI. Since the start of this period in 1995 through the end of September of this year, the ratios of the GTRIs to SPIs rose to 2.2 for Value and to 1.5 for Growth.

The long-term performance since 1995 shows that Growth has not always been in the lead. The Growth and Value GTRIs performed in line from 1995 until 1998, when the tech bubble started to fuel Growth’s outperformance until 2002. Value’s GTRI then took over the long-term lead from Growth during 2004 and outperformed until the bear market of 2009. Growth and Value’s GTRI marched together from 2009 until 2015. In the five years since then, Growth’s GTRI has tripled while Value’s has only doubled.

(2) Bull market performance since 2009. Now let’s do the same drill but since the start of the bull market on March 9, 2009 through Monday’s close. Here is the performance derby for the S&P 500’s Growth and Value SPIs and GTRIs over this period: S&P 500 Growth SPI and GTRI (548.6%, 684.9%) and S&P 500 Value SPI and GTRI (268.9, 396.2) (Fig. 11).

(3) Since the end of last year. Here’s the performance derby since the end of last year through Monday’s close: S&P 500 Growth SPI and GTR (20.9%, 22.0%) and S&P 500 Value SPI and GTRI (-11.9, -9.9) (Fig. 12).

(4) Bottom line. The bottom line is that any way Joe slices and dices the data, Growth has beaten Value so far this year and since 1995, but Value has had its times to shine. It might do so again in response to the development and widespread distribution of a vaccine that would allow us to get back to some semblance of pre-pandemic normal.

European Union: Forging a Fiscal Union. European Central Bank (ECB) President Christine Lagarde repeatedly has called upon European governments to help support the global economy, asserting that central banks cannot do it alone. During a March 12 press conference Lagarde said: “I really would like all of us to join forces, and I very much hope that the fiscal authorities will appreciate that we will only deal with the shock if we come together.”

Since then, Lagarde’s wishes have been granted. Not only has national aid sizably grown, but an unprecedented effort is underway within the EU to sustain the region through the Great Virus Crisis. The bold initiative is boldly called the “Next Generation EU” (NGEU) fund, as Jackie discussed in our August 20 Morning Briefing.

As Melissa and I see it, “NGEU” could just as well stand for “Modern Monetary Theory” (MMT) if their initials matched. MMT posits that monetary sovereign governments can deficit spend as much as they please without concern for how to repay debts, as they can simply print more money to do so. The NGEU is a centralized EU funding facility, over half of which will be in grants and never need to be repaid. The service cost on the borrowed portion is bound to be extremely low, as the ECB is bound to maintain negative interest rates for a very long time—measured in years or possibly even the decades until the NGEU lending matures!

MMTers argue that the only potential roadblock to indefinite central bank-financed government spending would be overheating inflation. But neither the European monetary nor fiscal authorities show any signs of concern about that right now. At the ECB’s September 10 monetary policy meeting, the Governing Council decided to maintain its extraordinarily accommodative policy despite signs of recovery. Speaking in an interview ahead of WSJ’s CEO Council yesterday, Lagarde said that the ECB is prepared to add more stimulus to support the “shaky” European recovery. “We are not the only game in town anymore,” she added, indicating her appreciation for the recent government actions to provide stimulus.

Further, an analysis in the ECB’s September 24 Economic Bulletin promoted the NGEU. It emphasized that the “monetary and fiscal policies, although implemented independently in the euro area, are currently acting in a mutually reinforcing way.” Back in July, Lagarde strongly advocated for the NGEU in a July 23 ECB blog post, saying that she hoped to “forge a new Europe out of this crisis.”

Indeed, the precedent-setting NGEU represents no less than a new fiscal union of European nations, borne of the coronavirus crisis. Here’s more on it from the ECB’s perspective:

(1) Welcoming NGEU. The bulletin stated that the fiscal cost of the national pandemic policy measures has been “very substantial for all euro area countries, although both the burden and the capacity to respond vary across countries. It is therefore highly welcome that Europe has responded with coordinated fiscal action” with the NGEU fund. The NGEU issuance will increase outstanding EU debt by around 15-fold, the largest ever euro-denominated issuance at the supranational level, according to the ECB’s analysis. Loans will be repaid by the beneficiary member states. Grant repayments will be covered by gross national income-based contributions and new EU “own resources” (i.e., revenues from duties, levies, and taxes).

For the NGEU, the European Commission (EC) is authorized to raise up to €750 billion in the capital markets on behalf of the EU. The funds can be used to provide loans of up to €360 billion and grants of up to €390 billion. These will be disbursed up to the end of 2026 and repaid by the end of 2058. The NGEU comes in addition to the regular Multiannual Financial Framework of around €1 trillion over the next seven years and the three European “safety nets” worth €540 billion agreed to in April 2020. (Here is a helpful infographic that further details the NGEU.)

(2) Setting a (green) precedent. The NGEU undoubtedly sets a precedent for larger and longer-term coordinated fiscal funding and deficits. In the analysis, the ECB took the position that the “NGEU constitutes a new and innovative element of the European fiscal framework. It will result in the issuance of sizeable supranational debt over the coming years, and its establishment has [signaled] a political readiness to design a common fiscal tool when the need arises. This innovation, while a one-off, could also imply lessons for Economic and Monetary Union, which still lacks a permanent fiscal capacity at supranational level for macroeconomic [stabilization] in deep crises.”

The EC was authorized by the European Council to raise capital for the NGEU fund on July 21, but it still needs to be ratified by each of the member states, according to a September 16 European Parliament press release. Final decisions then will need to be made about how the funds will be spent.

An interesting component of the NGEU is its commitment to fund climate-friendly technologies. Lagarde noted in her blog post that 30% of spending in both the NGEU fund and the EU budget “will have to be linked to the climate transition and all spending should be consistent with the Paris climate goals. This means that more than €500 billion will be spent on greening the European economy over the coming years—the biggest green stimulus of all time. Countries will only be able to receive money if they submit recovery and resilience plans that contribute to the green and digital transitions.”

Perhaps the fund should be renamed the “New Green EU”?

(3) Expanding national aid. The funding is greatly needed to support the poorer member nations that have sustained significant deficits to carry on during the crisis. Lagarde observed back in March that fiscal aid from national governments (excluding the EC) had amounted to about a quarter of 1% of euro area GDP. Since then, the level of national fiscal support has substantially increased. The bulletin stated that as a result of the economic downturn and the substantial fiscal support, “the general government budget deficit in the euro area is projected to increase significantly to 8.8% of GDP in 2020, compared with 0.6% in 2019.”

It added: “Euro area countries also have provided envelopes of loan guarantees amounting to almost 20% of GDP to reduce risks in the corporate sector.” It further noted that the euro area aggregate public debt-to-GDP ratio is projected to surge to 100.7% of GDP in 2020, 16.6ppts above the 2019 level, largely owing to pandemic-related policy measures. And even more fiscal aid for Europe is coming.

(4) Benefiting struggling nations. The financial support to be provided under NGEU is expected to total 5% of euro area GDP by the end of 2023, estimates the ECB. NGEU is anticipated to provide for a debt-based fiscal expansion of around 1% of GDP on average from 2021 to 2024, assuming that the support is used to finance additional productive spending at the national level, noted the ECB’s recent analysis.

The funds will be distributed unevenly, with sizable support “for those euro area countries that face the biggest economic and fiscal challenges after the pandemic.” Relative to GDP, Greece will be the largest beneficiary, but Spain and Italy will also receive sizeable fiscal support. The largest net “losers” will be the “frugal four” countries—i.e., Austria, Denmark, the Netherlands, and Sweden—in addition to Germany.

(5) Perpetually debating austerity. The ECB’s bulletin says that the NGEU has the potential to “significantly support the regions and sectors hardest hit by the pandemic, strengthen the Single Market and build a lasting and prosperous recovery.” In other words, the fiscally stronger nations have committed to supporting the weaker ones in the interest of a stronger union. The September 23 FT reported that Fabio Panetta, an ECB executive board member, said in a September 22 speech that for heavily indebted countries “the sizeable funding provided at the European level presents a unique opportunity to address concerns of competitiveness and long-term sustainability.” He added: “Growth will be the only solution to the accumulation of public and private debt.” That certainly sounds like a vote for MMT!

That view is not shared by all. Jens Weidmann, president of Germany’s central bank, recently warned about the risk of “creating the impression that debt at the EU level somehow doesn’t count or that it is a way of evading tiresome fiscal rules,” according to the FT. He added that the recovery fund should “remain a clearly defined crisis measure and should not open the door to permanent EU debt.” Good luck with that.

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Not So Bad

October 06 (Tuesday)

US Economy I: Private Payrolls Recovering. Friday’s employment report released by the Bureau of Labor Statistics was widely deemed to be disappointing because most economists were expecting September’s payroll gain to exceed 800,000. The reported increase of 661,000 was viewed as confirmation that the recovery in the labor market is flagging. The stronger gain that had been expected was based on the 749,000 jump in September private payrolls reported by ADP last Wednesday.

In fact, Friday’s official employment report did show an impressive 877,000 gain in private payrolls (Fig. 1). The problem is that employment in the government sector dropped 216,000 during September, led by a 280,500 decline in state and local education (Fig. 2). The late start to the new school year as a result of the pandemic depressed this category. Meanwhile, the private sector’s employment recovery remained mostly V-shaped since April through September:

(1) Private payrolls. In the private sector, payrolls plunged 21.2 million during the unprecedented two-month lockdown recession during March and April. They are up 11.4 million since then through September. Here are the comparable decreases and increases for the major components of payroll employment: goods-producing (-2.5 million, 1.4 million), manufacturing (-1.4 million, 716,000), construction (-1.1 million, 689,000), natural resources (-61,000, -40,000), service-providing (-18.7 million, 10.0 million), service-providing excluding government (-17.7 million, 10.0 million), and government (-969,000, 27,000).

(2) Payroll employment diffusion index. September’s payroll employment gains remained widespread, as evidenced by the one-month diffusion index for private payroll employment. It showed 70.3% of industries reporting higher payrolls (Fig. 3). It remains well above its record-low reading of 4.3% during April.

(3) Aggregate hours worked. The average workweek fell to 34.1 hours during March (Fig. 4). It rose to 34.7 hours during September. In combination with the increase in payrolls over this period, aggregate weekly hours in private industries jumped 12.1% from April through September after falling 16.8% during March and April (Fig. 5). It looks like a V-shaped recovery, though it’s still 6.7% below its record high of 4.5 billion hours during February.

(4) Earned Income Proxy. Every month when the employment report is released, Debbie and I calculate our Earned Income Proxy (EIP) for wages and salaries in private industry (Fig. 6). It is simply aggregate hours worked multiplied by average hourly earnings. Our EIP is highly correlated with the private sector’s wages and salaries series in the monthly personal income release. It rose 1.1% m/m during September, auguring for a similar solid increase in wages and salaries. Both series remain in V-shaped recovery formations.

That suggests that retail sales might have continued to rise to another record high last month. The sum of total wages and salaries plus government social benefits in personal income rose from $12.8 trillion during February to a record high of $15.2 trillion during April as the big boost from the latter offset the drop in the former (Fig. 7). The sum was down to $13.4 during August but still above February’s reading.

We expect that the continued rebound in aggregate hours worked will more than offset the drop in government social benefits paid going forward, assuming that another round of fiscal stimulus isn’t going to happen. Then again, it could happen, which would certainly keep the V-shaped recovery going.

US Economy II: Upbeat Purchasing Managers in Manufacturing. Debbie and I will be paying close attention to October’s regional business surveys conducted by the five Federal Reserve district banks. They did a great job of showing that the V-shaped economic recovery in the US, which started during May, continued during September on a regional basis (Fig. 8). The average of the regional composite indexes is highly correlated with the national manufacturing purchase managers’ index (M-PMI), which has rebounded from its cyclical low during April through September (Fig. 9).

Yes, we know that September’s M-PMI ticked down to 55.4 from 56.0 during August (Fig. 10). But, but … it is a diffusion index, which are always cyclical, and it remains near previous cyclical highs. So do its key components, namely production (61.0) and new orders (60.2). Its employment sub-index rebounded from its cyclical low of 27.5 during April to 49.6 during September, the best reading since July 2019.

Here are a few of the happy comments that were highlighted in the latest M-PMI survey:

(1) Transportation equipment. “Business is booming, and the supply chain has been caught off guard. We are working closely with our suppliers to ensure supply and try to control costs. The resin industry, along with plastics, is driving cost increases and scarce availability.”

(2) Computer & electronic products. “Still struggling with long lead times for components coming from China [contract manufacturers].”

(3) Machinery. “Our customer order intake is increasing significantly for deliveries in the first half of 2021. Outlook is generally positive.”

(4) Electrical equipment, appliances & components. “Demand remains high, strong finish to 2020 projected, with an even stronger 2021 fiscal year. Prices have increased in certain categories, but no major price increases of our own have been implemented yet. We are seeing an uptick in reshoring opportunities in the third quarter across various industries and products.”

(5) Wood products. “Raw material shortages, especially of hardwood logs, are starting to impact overall supply. Domestic market demand is fragmented but remains sound. Export demand, especially to China, is robust.”

(6) Plastics & rubber products. “Business has continued to be strong, with September following August. October is also shaping up to be a good sales month as well.”

US Economy III: Mostly Upbeat Purchasing Managers in Non-Manufacturing. Oh and by the way, the services sector—which has been the most challenged by the pandemic’s voluntary and enforced social-distancing restrictions—is doing remarkably well according to the latest non-manufacturing purchase managers’ index (NM-PMI) (Fig. 11). It bounced back from April’s low of 41.8 to 57.8 during September with solid readings for production (63.0) and new orders (61.5). Even the employment component (51.8) of the NM-PMI managed to cross above 50.0, having rebounded from its record low of 30.0 during April.

Then again, keep in mind that some of the improvement in the NM-PMI is attributable to housing-related activity. While the construction industry is included in the goods-producing sector of payroll employment, it is included among non-manufacturing industries in the survey of national purchasing managers. Furthermore, the mining industry, which is also in the NM-PMI survey, is holding up reasonably well. Another twist is that retail and wholesale trade sales are included as goods consumption in GDP but as services in the NM-PMI survey.

In any event, here are some of the comments reported in the latest NM-PMI survey that are certainly consistent with our recent assessment of the strength and breadth of the post-lockdown recovery:

(1) Construction. “Work orders are improving rapidly. Lack of available labor is having a significant impact on our ability to fulfill orders.”

(2) Mining. “Activity level is holding steady, with optimistic outlook.”

(3) Health Care. “Elective procedures remain at near-historic levels, even with periodic and small [coronavirus] spikes within the region.”

(4) Retail trade. “Business has come back solidly since mid-July, with a strong August and September. However, suppliers are plagued with lead-time challenges …”

(5) Wholesale trade. “Very good sales trend in home-improvement product sales, but challenges on market conditions exist like limited ocean capacity from Asia to U.S., delays in port and rails as a result of COVID-19 pandemic impact.”

(6) Movie theaters. “Our industry is facing a bleak outlook, as the Hollywood studios have pulled back almost all of their content from October and November and moved it into next year. Coupled with the state health mandates restricting our attendance, we expect to operate at a loss in 2020 and 2021.”

US Economy IV: Purchasing Managers Seeing More Inflation. For now, Debbie and I view the recent upturns in survey-based price indexes as good news that confirms the economic recovery rather than a worrisome development on the inflation front. Nevertheless, we will be monitoring this front, which could heat up if we continue to make progress on the health, economic, and financial fronts of the world war against the Covid virus.

Let’s have a closer look at the latest price indexes derived from the five regional Fed surveys and the national surveys that produce the M-PMI and NM-PMI:

(1) National price indexes. The national M-PMI and NM-PMI surveys are used to compile prices-paid indexes. Prices-received indexes are not available. The available national prices-paid indexes reflect fairly moderate upturns since April. The manufacturing prices-paid index is up from a recent low of 35.3 during April to 62.8 during September (Fig. 12). The comparable non-manufacturing index is up from 50.0 during March to 59.0 last month. Both upturns are consistent with previous ones since at least 2005. Headline and core CPI (consumer price index) and PCED (personal consumption expenditures deflator) inflation rates have remained mostly below 2.0% since then.

(2) Regional price indexes. The average of the prices-paid indexes of the five regional Fed surveys is highly correlated with the national M-PMI’s prices-paid index. The regional average index has had a similar rebound as the national measure (Fig. 13).

Finally, the regional average of the five prices-received indexes has also rebounded, but less so than its comparable prices-paid index (Fig. 14).

(3) Bottom line. The message from these price indicators is straight-forward: Nothing to see here; move along—for now.

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E Pluribus Unum Shopper

October 05 (Monday)

Best Wishes. President Donald Trump and First Lady Melania Trump were diagnosed with Covid on Friday. We wish them a speedy recovery. This is a head-spinning new development in a head-spinning year. Nevertheless, we are assuming that the President will remain in charge through the end of his first term. We aren’t certain how this development might influence the rapidly approaching presidential election. For now, we believe that the economy will continue to recover through the end of this year and into next year no matter who wins.

US Consumer I: Born to Shop. “E pluribus unum” certainly doesn’t apply to our highly partisan political discourse these days. The phrase is Latin for “Out of many, one.” It is a traditional motto of the US, appearing on the Great Seal. Its inclusion on the seal was approved by an Act of Congress in 1782. Another motto is “Novus ordo seclorum,” which is Latin for "New order of the ages.” That doesn’t seem to apply these days either given our political and social disorder.

Then again, we all seem to be united when it comes to shopping. While the country remains bitterly divided politically, we are united in our drive to thrive. That certainly helps to explain the remarkable economic recovery in recent months from the two-month lockdown recession during March and April.

 American consumers almost never disappoint us. Debbie and I often have said that when Americans are happy, they spend money and when they are depressed, they spend even more money—because shopping releases dopamine in our brains, which makes us feel good. Obviously, the Great Virus Crisis (GVC) is writing a new chapter in the history of consumer behavior. We aren’t virologists, but one widespread side effect of the virus is evident: Most consumers have been suffering from cabin fever, which can be depressing, and weren’t able to seek relief through shopping during the lockdown recession.

In our May 21 Morning Briefing, we predicted that “US consumers will open their wallets and spend once some semblance of normalcy returns.” So far, so good. As the lockdown restrictions were gradually lifted during May, consumers rushed to spend lots of the cash they had saved up during the lockdown.

Housing-related spending has been especially strong, as consumers have decided it’s time to remodel their cabins if they are going to spend more time working, learning, and entertaining at home. They’ve also rushed to buy more new and existing cabins in suburban and rural areas in a broad-based wave of de-urbanization triggered by the pandemic. In addition, the pandemic may have convinced many Millennials (who are currently 24 to 39 years old) that now is the time to buy a house rather than to rent an apartment. The Fed is contributing to the resulting housing-related boom by keeping mortgage rates at record-low levels.

All these developments were confirmed last Thursday, when the Bureau of Economic Analysis (BEA) released the August personal income report. Friday’s employment report for September released by the Bureau of Labor Statistics (BLS) suggests that consumers continued to gain purchasing power from their participation in the labor market—i.e., working—which should more than offset the decline in purchasing power provided by the government with pandemic-support benefits.

If Washington provides another round of such support anytime soon, that will unleash even more dopamine, adding to the economic “V is for Victory” victory over the pandemic’s economic impact. Consider the following:

(1) Consumer-led V-shaped recovery. The October 2 update of the Atlanta Fed’s GDPNow model showed that Q3’s real GDP is tracking at a record jump of 34.6% (at a seasonally adjusted annual rate, or saar) following the record 31.4% drop during Q2. That’s certainly a V-shaped recovery so far.

Leading the way up during Q3 is a 36.8% projected rebound in real consumer spending, following the 33.2% drop during Q2. Consumers contributed 24.0 percentage points to the freefall in real GDP during Q2, when lockdown restrictions held them back (Fig. 1). They are likely to contribute more to the Q3 upswing. By the way, spending on consumer services was hit hardest by the lockdown during Q2, as evidenced by the -22.0ppt contribution of this component to the drop in real GDP!

In current dollars, personal consumption expenditures has rebounded 18.6% from April through August (Fig. 2). It is only 3.4% below its record high during January. Interestingly, consumer spending on goods is up 24.0% over this period to a new record high. Spending on services is up 16.1% since April but still 7.4% below its record high during February. During August, consumer spending totaled $14.4 trillion (saar) with services at $9.5 trillion and goods at $4.8 trillion.

(2) A pile of savings to spend. How can it be that consumer spending has rebounded so strongly when millions of workers remain unemployed? During the lockdown recession, personal saving soared from $1.4 trillion (saar) during February to an all-time record of $6.4 trillion in April (Fig. 3). It was back down to $2.4 trillion during August.

Consumer spending clearly was boosted by the jump in the government social benefits component of personal income from $3.2 trillion (saar) during February to a record $6.6 trillion during April (Fig. 4).

However, government social benefits was down to $4.1 trillion during August. That’s still well above the $3.2 trillion during February. The same pattern is evident in personal saving. So there is still enough “potential” fiscal stimulus left over to provide “kinetic” energy to consumer spending over the next few months, in our opinion.

(3) Earned income rebounding. But don’t we need another round of fiscal stimulus to keep the consumer recovery going until a vaccine is available? Not if wages and salaries continue to rebound along with employment. The former is up 7.6% since April through August, while the latter is up 6.5% from April through September (Fig. 5).

Our Earned Income Proxy (EIP) Is highly correlated with wages and salaries in the private sector (as reported in the BEA personal income release). The EIP is up 10% from April through September (Fig. 6). The EIP is based on the monthly BLS payroll data. It is simply aggregate hours worked by all workers—which is up 12.1% from April through September—multiplied by average hourly earnings. Aggregate hours worked reflects payroll employment—which is up 8.8% from April through September—multiplied by the average length of the workweek. This augurs well for the ongoing V-shaped recovery in both consumers’ purchasing power and their spending.

(4) Housing-related spending leading the way. The latest personal income release confirms our view that a housing-related spending boom is underway as a result of de-urbanization and record-low mortgage rates. Spending on furniture & furnishings and household appliances soared 38.9% from April through August to new record highs since June of this year (Fig. 7).

Construction spending on new homes and home improvements are included in the residential investment component of GDP rather than in personal consumption. The recent jumps in new and existing home sales suggest that both categories of residential construction should be rising to new cyclical highs soon and could be on their way to record highs in coming months (Fig. 8). Together, they totaled $589.4 billion (saar) during August, 13.1% below the record high during February 2006.

Altogether, housing-related consumer and construction spending totaled a record-high $906.4 billion (saar) during August, surpassing the previous record high during February 2006 by 1.3% (Fig. 9).

(5) Spending on autos also strong. Undoubtedly, the pandemic also has boosted the demand for autos along with the demand for houses by people moving out of cities to the suburbs and rural areas. Sure enough, current-dollar spending on new motor vehicles jumped 50.6% from April through August to the highest pace since July 2005 (Fig. 10). Spending on used cars is up 94.5% since April.

(6) Services are on the mend too. As noted above, the services economy also has been recovering, but has a ways to go to regain all that was lost during the lockdown recession. That’s because several important services-providing industries remain challenged by various voluntary and enforced social distancing restrictions.

Initially, the pandemic caused spending on health care services to plunge 34.7% from February through April (Fig. 11). Hospitals suspended elective procedures in anticipation of a huge influx of Covid patients. Since April through August, this category is up 43.5%, which is only 6.4% from its record high during February.

Also taking a big hit from the lockdowns was spending on food services, including restaurants. This category plunged 47.5% from February through April but rebounded 69.4% through August (Fig. 12). It is still 11.2% below its record high during January. It is likely to struggle to climb higher in coming months as winter weather forces restaurants to halt outdoor dining and do the best they can with significant capacity limits on indoor dining.

Among the services-providing industries, the most challenged have been the following (showing the percentage changes from February through April and from April through August, as well as the percentage below the February pace): Air Transportation (-93%, 888%, -36%), Hotels & Motels (-83, 176, -54), Gambling (-80, 320, -18), Amusement Parks, Campgrounds, & Related Recreation (-90, 240, -67), and Admissions to Specified Spectator Amusements (-97, 423, -82) (Fig. 13 and Fig. 14).

(7) Yardeni household contributing to economic recovery effort. I’ve often compared the pandemic to a world war against the Covid virus. The war isn’t over, but some progress has been made on the health, financial, and economic fronts. I did my part for the war effort on the health front by promoting wearing masks back in March. Now, it’s up to the doctors to reduce the lethal consequences for those who still get infected using the various treatment protocols that seem to work best. Reportedly, progress is being made in developing vaccines.

On the financial front, the Fed’s QE4ever and ZIRP4ever have provided badly needed good news. Pessimists doubt that can last if the economic news doesn’t get better. However, our view is that the economic news has been getting better since April and continues to do so through September.

Meanwhile, the Yardeni clan is doing our part for the war effort on the economic front. We aren’t letting cabin fever get us down. We are repainting the living room and den and getting new furniture for both rooms. The salesman who sold us a couple of sofas said that his business has been amazing since mid-June. Customers are telling him that instead of spending money on European vacations, they are buying new furniture.

The paint-store manager told us that he’s had the best three months since he has been in business. He has a help-wanted sign for part-time and full-time positions on his front door. The painter told us he wasn’t sure when he could fit us into his packed schedule. Take a look at the stock price chart of Sherwin-Williams Co. It’s up 74% since March 23 through Friday’s close. That beats the 65% gain for the FAAMGs (Facebook, Amazon, Apple, Microsoft, and Google) over the same period!

We also managed to purchase a new car, even though several auto salesmen told us that they didn’t have too many cars in stock because demand was so strong. The garage attendant in my mother-in-law’s apartment building on the Upper East Side of Manhattan told us that he could accommodate us for only 30 minutes because his facility was packed with cars that tenants had just purchased. We aren’t buying a boat or camper, but friends who are doing so told us that the pickings are slim.

US Consumer II: More on Government Social Benefits. The personal income release includes a line for government social benefits and four of its components (Fig. 15). Here is where they were in February, April, and August in billions of dollars (saar): total ($3,026, $6,411, $3,979), Social Security ($1,067, $1,075, $1,082), Medicare & Medicaid ($1,425, $1,464, $1,549), unemployment insurance ($28, $493, $634), and other ($506, $3,379, $714). That last item was boosted by the one-time pandemic support checks sent to lots of taxpayers.

Our analysis suggests that there is still enough fiscal stimulus in government social benefits and accumulated in personal saving to boost consumer spending, possibly through year-end. In addition, monetary policy remains very stimulative, especially for housing-related industries. Washington is discussing providing another round of fiscal stimulus before the end of this year, which certainly would keep the V-shaped recovery V-shaped through early next year.

US Consumer III: Paying Taxes. Last Thursday, we marveled at the resilience of the US Treasury’s receipts of income and payroll taxes based on the 12-month sums of the data through August. Now we can compare both data series to the comparable ones in the monthly personal income release from the BEA, which are shown seasonally adjusted at an annual rate through August (Fig. 16 and Fig. 17). The BEA data series exceeds the comparable Treasury series because the former includes taxes paid to state and local governments.

More specifically, personal income includes an item for “personal current taxes.” These payments are made by persons to government agencies and consist primarily of taxes on income, including realized capital gains, and on personal property. They do not include personal contributions for government social insurance. The series is highly correlated with the Treasury’s income tax receipts series. Both have rebounded since April through August. That reflects the upturn in wages and salaries discussed above. It might also reflect taxes on the pandemic support payments, including unemployment insurance.

Personal income also includes an item for “contributions to social insurance programs,” a.k.a. payroll taxes. This series includes employer contributions for government social insurance (which is also included as an offsetting supplement to wages and salaries) and payments by employees, the self-employed, and other individuals who participate in the following government programs: old-age, survivors, and disability insurance (Social Security); hospital insurance, supplementary medical insurance; unemployment insurance; railroad retirement; veterans life insurance, and temporary disability insurance.

This personal income series is highly correlated with the Treasury’s series for payroll taxes too. The former has rebounded 6.1% from April through August, while the latter has been making new highs since the start of this year because it is a 12-month moving average and the recession was so short that it doesn’t show up in this series. That’s truly amazing!

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Lots of Issues To Debate

October 01 (Thursday)

US Politics: Debate Debacle. The presidential debate on Tuesday evening was historic—historically horrible. The only good that came of it is that it saved us from wasting our time watching the next two presidential debates.

Former Vice President Joe Biden mostly kept his cool, unrattled by President Donald Trump’s barrage of attacks and interruptions. Biden often looked straight into the television camera, directly addressing the viewers. Trump tended to growl in Biden’s direction most of the time.

Biden had a few memorable choice lines—including his advice early on for the President to shut his mouth, which seemed disrespectful at first but before long proved to be a very good suggestion. Biden’s declaration that “I am the Democratic Party right now” was also memorable. However, he equivocated on some questions, such as whether he would pack the Supreme Court and his stance on maintaining law and order.

Trump came out swinging from the start of the debate. His punches often had been previously telegraphed, so they mostly missed their mark. He took a direct blow from the moderator after refusing to denounce white supremacists. Trump pushed hard on Biden’s recent swerving to the left.

The widespread view seems to be that Biden won the debate, but he did so basically by staying ambiguous about several key issues. Does yesterday’s stock rally suggest that Biden would be bullish for stocks? That’s not the conventional view given that Biden was definitive about one issue: He said he will raise the corporate tax rate from 21% to 28%.

More likely is that the stock market was lifted yesterday by Treasury Secretary Steven Mnuchin’s saying that there is a chance of a “reasonable compromise” in Washington on another fiscal stimulus bill. In addition, there’s no debating that yesterday’s economic news was very good. ADP reported a 749,000 increase in private payrolls for September, and pending sales of existing homes jumped 8.8% in August.

US Economy: V-Shaped Recovery Winning the Debate. Here’s more on the latest data confirming that the hotly debated slope of the recovery is still V-shaped:

(1) ADP payroll. According to ADP, private payrolls fell 19.7 million from February through April, and have increased 9.3 million since then through September (Fig. 1). Here are the comparable numbers for service-producing companies (-17.3, 7.8) and goods-producing ones (-2.4, 1.5).

Interestingly, the biggest job losses during the lockdown recession were among large companies, down -9.3 million from February through April, followed by a 3.9 million gain through August (Fig. 2). By comparison, here are the comparable stats for medium-sized companies (-5.0, 2.1) and small-sized ones (-5.4, 3.3).

(2) Pending home sales. The housing boom that we’ve been writing about was confirmed yesterday by the jump in the Pending Home Sales Index to a record 132.8 during August, up from a record low of 69.0 during April (Fig. 3). It is an excellent leading indicator of actual existing home sales, since it is based on contracts actually signed. The boom is evident in all four regional sub-indexes (Fig. 4). There’s no debating that this is great news for housing-related retail sales.

 Real Estate: Covid Creates Winners & Losers. “All happy families are alike; each unhappy family is unhappy in its own way” is the famous first sentence of Leo Tolstoy’s classic novel Anna Karenina. Like unhappy families, no two recessions are ever quite the same.

In the Great Financial Crisis, homeowners with outsized mortgages and home equity loans meant residential real estate took it on the chin during the downturn, while commercial real estate escaped relatively unscathed. In the ensuing years, the amount of commercial real estate debt increased. Now during the Great Virus Crisis, with retailers and hoteliers facing sharp drop-offs in business, commercial real estate is having a much tougher time than residential real estate, a market that’s booming.

The Real Estate sector is among the worst performing of the 11 S&P 500 sectors. Here’s the performance derby for the S&P 500 sectors’ stock price indexes ytd through Tuesday’s close: Information Technology (26.4%), Consumer Discretionary (21.6), Communication Services (7.5), S&P 500 (3.2), Materials (2.7), Health Care (1.9), Consumer Staples (0.7), Industrials (-5.1), Utilities (-8.9), Real Estate (-9.4), Financials (-22.7), and Energy (-50.0) (Fig. 5).

Most, but not all, real estate industries are performing poorly this year. In positive territory are Industrial REITs (real estate investment trusts), up 11.0% ytd through Tuesday’s close, and Specialized REITs, up 12.2%.The rest of the Real Estate industries’ stock price indexes have fallen sharply: Real Estate Services (-23.7%), Health Care REITs (-28.5), Office REITs (-30.1), Hotel & Resort REITs (-42.2), and Retail REITs (-43.1) (Fig. 6).

Here’s Jackie’s look at what’s driving this underperformance and some ramifications for related industries:

(1) Earnings forecasts keep tumbling. While the S&P 500’s forward earnings (i.e., the time-weighted average of analysts’ consensus earnings estimates for this year and next year) have improved since the end of May, Joe points out that analysts have continued to slash earnings forecasts in the S&P 500 Real Estate sector, bringing down its forward earnings calculation. Over the past 13 weeks, forward earnings for the broader index climbed 9.2% while forward earnings for its Real Estate sector tumbled 4.3%.

The dour outlook is spread across many real estate industries, with only the S&P 500 Specialized REITs industry bucking the trend; its forward earnings has risen 9.4% over the past 13 weeks. Here’s how the other S&P 500 Real Estate industries have fared in terms of forward earnings over the past 13 weeks: Hotel & Resort REITs (to a deeper loss), Industrial REITs (-23.7%), Health Care REITs (-18.6), Office REITs (-15.6), Real Estate Services (-10.8), Residential REITs (-9.2), and Retail REITs (-4.5).

In all, earnings for the S&P 500 Real Estate sector are forecast to fall by 31.6% this year and 3.6% in 2021 (Fig. 7). That gives the sector the weakest 2021 earnings growth of all the S&P 500 sectors except Energy.

(2) Hotel REITs clobbered. The downward revisions to Hotel & Resort REITs’ earnings were the most dramatic, perhaps because Covid-19 and its ramifications were so unexpected. Prior to Covid, the hotel industry was booming, and new hotel construction was at record levels.

“There were 214,704 hotel rooms under construction in the U.S. at the end of March, according to STR. It is the highest end-of-month construction total ever recorded by the hotel data firm. The previous record high was one month earlier in February, when STR reported 211,859 rooms under construction,” according to an April 21 article in Skift. Because of the long lead times, trends in construction often lag what’s occurring in the broader economy.

While many hotel metrics have improved from the dark days of March, they remain severely depressed on a y/y basis. For the week of September 13, US hotel occupancy was 48.6%; that’s down 31.9% from the same week last year, but it’s a vast improvement over the 22.0% registered in March, according to a Hotel News Now September 24 press release. Improvement in occupancy has plateaued in August, and for it to get another leg up may require a vaccine or a sharp drop in Covid cases.

(3) Retailers closing shop. As we noted in the September 10 Morning Briefing, what’s different about the current retail shakeout is that an increasing number of retailers are closing shop forever. They’re liquidating instead of restructuring under bankruptcy protection—and that means there’s a lot of unoccupied retail real estate on Main Street and in the mall.

From January through mid-August, retailers announced they’d closed more than 10,000 stores in the US, topping last year’s record 9,500 store closures, according to a September 29 WSJ article. Of the ytd total, 6,000 closures were due to retailers’ bankruptcy filings, and the total figure could rise north of 25,000 before 2020 is over.

Retailers plan to close more than 130 million square feet of US store space, the article states. More than half of the closures are from Bed Bath & Beyond, Macy’s, JCPenney—which is in bankruptcy and being sold to mall operators Simon Property Group and Brookfield Property Partners—and Stein Mart and Pier 1 Imports, which are liquidating after filing for bankruptcy protection.

Joe reports that the industry’s fortunes have shrunk so much that the S&P 500 Department Store’s price index will be no longer. Trading was suspended on September 18 for the first time since 1946. None of the few survivors are big enough any longer to qualify as LargeCaps (Fig. 8 and Fig. 9).

We wouldn’t be surprised to see more retail closures after the holiday selling season, the time of year when bankruptcies are more typically seen. Indeed, Retail REIT industry analysts may be anticipating more closures early next year as well, as their consensus earnings forecast implies a decline of 8.6% in 2021 after this year’s projected 13.6% decline.

(4) Why are Specialized REITs outperforming? The S&P 500 Specialized REITs includes a hodgepodge of companies that own everything from cell towers to timber. The industry’s stock price leaders ytd through Tuesday’s close are SBA Communications (up 32.1%), Equinix (30.4), Digital Realty Trust (22.7), and Crown Castle (17.2).

SBA and Crown Castle own cell towers and other items that allow for cellular communications and are sure to be in demand as 5G rolls out. Meanwhile, Equinix and Digital Realty Trust own data centers, which are in increasing demand as many of us work from home and tap into our office documents housed in the cloud. The S&P 500 Specialized REIT industry is expected to produce solid earnings growth of 19.9% in 2021, an improvement from this year’s 1.0% growth forecast (Fig. 10).

Geopolitics: The Xi/Trump Faceoff Continues. US and Chinese leaders continue the tit-for-tat that is exacerbating the cold war brewing between the two nations. The chill has even started to infect the business sector, according to WPP’s founder Sir Martin Sorrell. “It’s making it extremely difficult to run a global business when you have the two biggest economies in the world fighting one another,” he told CNBC in a September 29 article. Let’s take a quick look at the latest volleys between the two nations:

(1) Chinese media banging the drum. Chinese state media has been harping on the forced sale of TikTok to US companies, but last week the Global Times threw gasoline on the fire. Hu Xijin is editor-in-chief of the Global Times, a newspaper controlled by the Chinese state. On September 28, he tweeted: “Based on information I learned, Trump govt could take the risk to attack China’s islands in the South China Sea with MQ-9 Reaper drones to aid his reelection campaign. If that happens, the PLA will definitely fight back fiercely and let those who start the war pay a heavy price.”

(2) Not very diplomatic. Chinese and US diplomats are no longer allowed to talk. US Secretary of State Mike Pompeo announced that Chinese diplomats in the US must receive permission to meet with US local government officials or visit university campuses. China responded this week by telling Hong Kong officials to abstain from meeting American diplomats and talking with them on the phone, a South China Morning Post (SCMP) September 28 article reported. It stated: “City officials have to report to their department heads if they receive invitations for meetings from the US consulate general in Hong Kong under the updated policy. All requests will be handled on a case by case basis.”

(3) War on religion. China’s government continues its push to rid the Xinjiang region of the Uighur Muslims and their culture. The Chinese government has razed or damaged two thirds of the region’s mosques, roughly 16,000, according to a report by the Australian Strategic Policy Institute cited in a September 25 WSJ article. Shrines, cemeteries, and pilgrimage routes were also demolished, damaged, or altered, the article states.

Another report out of the same Australian organization identified more than 380 suspected detention facilities in Xinjiang that were newly built or had been expanded “significantly” since 2017. China’s Foreign Ministry denied the report’s claims and told the WSJ that it “fully protects the human and religious rights of all ethnic minorities.”

The government’s Sinicization efforts may be expanding to other regions including Sanya, a small island south of China where the Muslim Utsuls have been banned from wearing traditional dress in schools and in government offices. Mosques must now have a Communist Party member sitting on their management committees for monitoring purposes and “Arabic script must also be removed from shopfronts, along with Chinese characters such as ‘halal’ and ‘Islamic,’” a September 28 SCMP article reported.

The US has imposed sanctions on companies and individuals accused of human rights violations in the region and blacklisted several Xinjiang-based suppliers to major Western brands.

(4) Brain drain goes into reverse. As might be expected, a number of Chinese professors working in the US opted to return to China after facing US government inquiries into their undisclosed ties to Chinese institutions. Less clear is why Professor Zhu Songchun, an award-winning expert in artificial intelligence and computer vision at the University of California at Los Angeles, left the US to join Peking University to lead its Institute for Artificial Intelligence.

Zhu obtained a PhD at Harvard University in 1996 and joined UCLA after brief periods at Stanford and Ohio State. His departure follows that of Harry Shum, Microsoft’s former head of AI and research who now chairs the academic committee of the Institute of Artificial Intelligence. The two men are long-time acquaintances.

It could be problematic if leading Chinese researchers start finding their Chinese career opportunities more attractive than those available in the US. “China is the largest global source of top-tier AI talent. However, 88 per cent of those who completed graduate studies in the US have chosen to stay and work there, helping America lead the way in the field,” according to study by MarcoPolo, a US think tank quoted in a SCMP September 29 article.

Disruptive Technologies: Boring Away. Speculation is swirling about whether Elon Musk’s Boring Company is working on plans to build a tunnel from Las Vegas to Los Angeles. Industry website Teslarati noted in a September 21 article that the Boring Company’s website posts three open positions in Adelanto, California, which is strategically located between Sin City and the City of Angels. The company is searching for a human resources associate, mechanic, and Boring machine operator.

The Boring Company’s Adelanto location had already raised speculation due to pictures taken in August of large machinery and tents. Industry watchers were already on high alert after noticing that a map of the Boring Company’s Las Vegas Loop includes a dotted line representing “conceptual future expansion” with an arrow labeled “To Los Angeles.”

As we’ve discussed before, the Boring Company is in the midst of constructing a tunnel that spans the Las Vegas Convention center. “The Loop,” as it’s known, is expected to be completed in January, and then it’s expected to be expanded to connect the casinos on the Strip and the Las Vegas Airport.

Up next: a Boring tunnel linking Rancho Cucamonga, California with the Ontario International Airport, a June 14 article in Lynxotic reported. The 2.8-mile Boring tunnel is expected to cost $60 million-$75 million—compared to the $1 billion-$1.5 billion estimated cost of an alternative, above-ground light rail system. The Boring tunnel should take four years to build compared to the 10 years estimated for the light rail system.

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Inventory Swings

September 30 (Wednesday)

US Economy: Restocking. My wife and I enjoy watching Shark Tank. The television program features wannabe entrepreneurs who pitch five wealthy entrepreneurs on their ideas for new products and services they’ve conceived. The wannabes hope to convince at least one of the rich and famous capitalists to invest in their businesses. Occasionally, the show follows up to see whether the upstarts that succeeded in attracting some venture capital in previous episodes went on to succeed in their ventures. Unfortunately, the show tends to follow up only with the winners, never the losers. However, it’s clear that a main reason new business owners struggle is that they have gotten stuck with too much inventory.

The pandemic certainly caused an inventory problem throughout our economy. However, companies responded very quickly when their sales plunged by slashing their orders and production. As a result, instead of piling up, inventories were depleted. That exacerbated the drop in real GDP during the first half of this year. Contributing to the V-shaped economic recovery during the second half of this year should be a significant rebound in inventories following the dramatic inventory decline during the first half of the year. Consider the following:

(1) Voluntary and involuntary inventory cuts. Initially during the pandemic, many companies experienced involuntary inventory buildups when their sales plummeted. They had no choice but to reduce their production and/or new orders to below their rapidly falling sales, in order to slash their unintended stockpiling.

On the other hand, some companies experienced significant unanticipated inventory drawdowns because the pandemic caused their sales to boom unexpectedly. That further depleted inventories for many of them. Now they are all scrambling to rebuild their inventories after they were cut either voluntarily (due to production and orders cuts that exceeded the drop in sales) or involuntarily (due to soaring sales).

(2) Bungee jump in retail sales. During the two-month lockdown recession in March and April, there was lots of pent-up demand because stores were closed; this caused personal saving to soar from $1.27 trillion (saar) during January to an all-time record high of $6.40 trillion during April (Fig. 1). Saving was boosted by government social benefits that well exceeded the drop in wages and salaries and that weren’t all spent right away (Fig. 2).

During the lockdown recession, retail sales plunged 21.7% from February through April (Fig. 3). Then as the lockdown restrictions were gradually lifted, retail sales soared 30.2% through August to a new record high as consumers satisfied their pent-up demand. They all suffered from cabin fever during the lockdowns, which many of them rushed to cure by going shopping. Of course, some of the fever was reduced through online shopping, which jumped from 35.7% of GAFO retail sales during January to an all-time high of 50.7% during April (Fig. 4). It was back down to 41.8% during July. (NB: “GAFO” stands for general merchandise, apparel and accessories, furniture, and other items—i.e., the type of merchandise typically found in department stores.)

(3) Business sales on upswing. The rebound in retail sales to a new all-time high has led the recovery in total business sales of goods, which during July was only 1.8% below its record high during January (Fig. 5 and Fig. 6). Manufacturing shipments was only 5.5% below its record high during October 2018, while wholesale sales was only 5.1% below its record high in January.

By the way, the rebound in business sales augurs well for S&P 500 aggregate and per-share revenues, which are highly correlated with business sales even though the series does not include services (Fig. 7 and Fig. 8). Revenues probably bottomed during Q2 and should recover over the rest of this year into next year.

(4) Inventories set for voluntary rebuilding. Total business inventories plunged 5.9% from its record high during July 2019 through July 2020, i.e., over the past 12 months (Fig. 9). That compares to the 13-month 14.5% drop during the Great Financial Crisis.

Odds are that the inventory decline is already over given that data available for August suggest that inventories bottomed that month for wholesale and retail inventories (Fig. 10). (Manufacturing inventory data were still weak in July.)

(5) Inventories in real GDP. In the real GDP accounts, inventories is an odd item. In Table 3 of the GDP release, which is compiled by the Bureau of Economic Analysis, it shows up as the change in private inventories, a.k.a. “inventory investment.” All the other components show up as levels. So when calculating the percentage changes in GDP, inventories show up as changes in the change in inventories, while the other components are included as changes in their levels.

During Q2-2020, inventory investment in the real GDP accounts was a record -$286.4 billion (saar) compared to -$80.9 billion during Q1-2020 and -$1.1 billion during Q4-2019 (Fig. 11). So the change in the change was a big negative, especially during Q2. Interestingly, manufacturing inventories rose $44.7 billion during Q2, while wholesale inventories fell $30.8 billion. Retail inventories fell $260.2 billion, led by a $213.3 billion drop in auto inventories.

The monthly data show that the three-month change in nominal business inventories has turned less negative through July, when it was -$266.3 billion (saar), which is up from a record low of -$396.1 billion through June (Fig. 12). This series is highly correlated with the comparable inflation-adjusted series, which in turn is highly correlated with inventory investment in real GDP.

(6) Inventories drive trucks, railroads, and ships. Not surprisingly, inflation-adjusted business inventories is highly correlated with both the ATA Truck Tonnage Index and intermodal railcar loadings (excluding trailers) (Fig. 13 and Fig. 14). The apparent bottoming of inventories during the summer should set the stage for an upturn in the transportation indicators. The same goes for inbound container traffic at the West Coast ports, which is highly correlated with merchandise trade imports (Fig. 15).

 US Labor Market: Not All They Claim To Be. In our June 29 and July 1 Morning Briefings, Melissa and I observed that the weekly unemployment insurance (UI) report compiled by the Department of Labor (DOL) might be flawed as a result of the chaos caused by pandemic support programs.

Our concern focused on the Pandemic Unemployment Assistance (PUA) program, which was introduced on March 27 as a part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. It is intended to support the self-employed, gig workers, and others who would not typically qualify for benefits but who lost their income as a result of the pandemic. More recent evidence suggests that there indeed have been accounting issues in the weekly data. Consider the following:

(1) Counting claims isn’t so simple. A September 11 New York Times article observed: “The Labor Department reports about 15 million claims for [PUA] benefits nationwide. A comparison of state and federal records by The New York Times suggests that total may overstate the number of recipients by five million or more.”

(2) California dreamin’. That jarring conclusion was at least partially confirmed by the September 24 UI report, which compared the week ending September 5 to the week ending August 29. The report separates PUA claims from regular state UI claims for both initial and continuing claims.

An adjustment in California’s data drove the national number of PUA claimants down from 14.5 million to 11.5 million. The 6.4 million in the state’s PUA continuing claims at the end of August was nearly halved to 3.4 million during the first week in September. A September 15 California Policy Lab analysis raised several questions about the recent reliability of the state’s UI data.

(3) Riddled with discrepancies & fraud. The DOL simply compiles data reported to it by the separate state UI systems, which may not be consistent. Further complicating matters, the September 11 New York Times article pointed out that “California is at the center of increasing concerns about extensive fraud” in the PUA, which may be taking place all over the country.

(4) Data divergence. August’s employment report, compiled by the Bureau of Labor Statistics, showed that 13.6 million workers were unemployed during the month. Yet the DOL UI report for August 29 showed 13.3 million claimants through regular state UI programs and 14.5 million PUA claimants. Including a few other similar programs, the total was 29.8 million.

The ratio of just the number of people on state UI programs to the number of unemployed workers was relatively stable around 30% from 1987 through 2019 (Fig. 16). It shot up to a record 104% during August. The ratio of the number of people on state UI programs to the number of short-term unemployed (for less than 27 weeks) was relatively stable around 45% from 1987 through 2019. It shot up to 118% during August.

The bottom line: There is something very odd about the UI data, which is why we aren’t giving it much weight in our assessment of the economic recovery.

As a September 23 Bloomberg article discussed, the Fed’s zero-rate policy and the search for yield have created a borrower’s market in the credit space, even for high-yield junk. It noted that “all-in yields for U.S. junk bonds have dropped to 5.81%, near pre-pandemic levels, according to Bloomberg Barclays index data.” It mentioned Ball Corp.’s record-setting lowest coupon ever for a junk bond with a maturity of five years or longer during August at 2.875%. That’s as US high-yield bond sales totaled $329.8 billion through last Wednesday, eclipsing the prior annual sales record set in 2012.

An August 21 Capital Group Insights report by Fixed Income Portfolio Manager Shannon Ward noted that corporate defaults are indeed up (as we discussed in our August 12 Morning Briefing). The default rate has tripled from last year to around 6.0%. Nevertheless, it remains low in the single digits. Ward observed that the market for low-rated companies is ripe with opportunities for selective investors.

She also noted (as we did in our earlier note) that companies with problems that pre-dated the pandemic—such as brick-and-mortar retailers and energy companies—may be ones to avoid. Not surprisingly, these industries account for a large share of the rise in ytd defaults and bankruptcies. Lots of investment-grade companies dropped in their ratings as the lockdowns occurred, but many already have recovered. It helped that the Fed has been and remains at the ready to support these “fallen angels.” Ward notes that the BB-rated market is about 55% of the high-yield market as of July 31, 2020.

Investors with elephant guns may find more to hunt for in the debt markets than in the equity markets.

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Still on V-Shaped Recovery Track

September 29 (Tuesday)

US Economy: Not Stalling So Far. The onset of the pandemic at the beginning of the year led to an unprecedented two-month lockdown recession during March and April. That short but severe downturn has been followed by a V-shaped recovery from May through August.

Now some of the economic indicators for September are showing that the V-shaped recovery continued during the month, though a few suggest it may be starting to stall. There’s lots of chatter that it might actually do so if Washington fails to provide another fiscal stimulus package. Debbie and I aren’t convinced that’s necessarily so. As we’ve previously discussed, we believe that there is enough fiscal stimulus left from the March 27 CARES Act to keep the recovery going.

More importantly, while Fed officials have been clamoring for more fiscal stimulus, they continue to provide plenty of monetary stimulus. Near-zero interest rates across the maturity spectrum of the yield curve are keeping mortgage rates at record lows at the same time that de-urbanization is boosting demand for homes in suburban and rural areas. We believe that the resulting housing boom should more than offset the weak recoveries—and possible stalling—of many pandemic-challenged industries. Consider the following:

(1) GDP model showing impressive snapback. The Citigroup Economic Surprise Index (CESI) continues to surprise to the upside (Fig. 1). That might seem like an odd observation since it was down to 170.4 on Friday, September 25 from a record high of 270.8 on July 16. True, but anything north of roughly 100.0 means that the CESI remains in record-high territory this year compared to all previous years since the start of the data during 2003!

The surprising strength in the economic indicators that are reflected in the CESI is also reflected in the Atlanta Fed’s GDPNow tracking model. The latest reading on Friday showed that real GDP is up 32.0% (saar) during Q3, unchanged from the model’s September 17 reading. Remarkably, capital spending in real GDP is now tracking at a 38.1% annual rate, up from 32.6% on September 17. Keep in mind that real GDP fell 31.7% during Q2, led by a 34.1% drop in consumer spending and a 26.0% drop in capital spending (Fig. 2).

The FRBNY Weekly Economic Index (WEI) is up from a record low of -11. 5 during the April 25 week to -4.5 during the September 19 week (Fig. 3). It is available since 2008 and scaled to align with the y/y growth rate in the four-quarter moving average of real GDP. It includes high-frequency series covering consumer behavior, the labor market, and production. So, for example, the increase in the WEI for the week of September 19 was due to increases in fuel sales, rail traffic, and tax withholding, which more than offset an increase in initial unemployment insurance claims and a decrease in electricity output. Debbie estimates that the rebound in the WEI is consistent with real GDP rising 27% (saar) during Q3.

We’ve been bullish on the economic recovery, but not bullish enough. We’ve had to raise our Q3 estimate from 15% to 20% to 25% in recent months. Here we go again: We are increasing it to 30% (Fig. 4). We are doubling our real GDP growth estimate for Q4 from 5% to 10% because we expect significant restocking of depleted inventories. The recovery is likely to continue at a much slower pace next year. But we now expect real GDP to be back at the Q4-2019 record high during the second half of 2021 rather than the second half of 2022, as long as it doesn’t stall along the way.

 (2) Regional business surveys buoyant. Confirming the ongoing V shape of the recovery are the five business surveys available through September, conducted by the Federal Reserve Banks of Kansas City, New York, Philadelphia, Dallas, and Richmond (Fig. 5). The September averages of their indexes for overall business activity (15.5), new orders (19.5), and employment (12.6) remained solidly above zero after falling into record negative territory earlier this year during the lockdown recession.

(3) Durable goods orders rebound. The regional surveys augur well for September’s durable goods orders and shipments, which bottomed during April and have rebounded smartly through August (Fig. 6). Nondefense capital goods orders excluding aircraft is up 10.5% over the past four months through August, exceeding the January pace by 1.3%.

(4) New home sales on fire. Confirming our housing-led boom scenario are August new homes sales, which have jumped 77.4% over the past four months through August to 1.01 million units (saar), the best pace since September 2006 (Fig. 7). They probably would have been higher but for the shortage of inventories of new homes as the months’ supply fell to 3.3 during August, the lowest on record (Fig. 8).

The National Association of Home Builders compiles a Housing Market Index, which jumped from a recent low of 30 during July to a record-high 83 during September (Fig. 9). Leading the way was a remarkable rebound in the traffic-of-prospective-home-buyers sub-index from 13 during April to a record high of 73 during September!

(5) Federal tax receipts are remarkably strong. You might be surprised to hear that the 12-month sum of federal government receipts from individual income taxes rebounded by $229 billion during the past two months through August (Fig. 10). Well, that’s easily explained: Unemployment benefits are included in taxable income. So the big boost to weekly benefits provided by the federal government from April through July also boosted individual income tax revenues.

More puzzling is why the 12-month sum of payroll taxes has been rising to new record highs every single month this year notwithstanding the lockdown recession. We can’t explain it. Could it be that most of the job losers had been paid off the books? We don’t get it. Also surprising is that the 12-month sum of corporate income tax receipts has rebounded during the past two months through August. We sort of get that: The enormous package of fiscal and monetary stimulus trickled down to profits, perhaps creating more winners from the pandemic than losers as measured by business profits. Maybe.

(6) Stalling indicators. Of course, the pandemic is far from over. There probably won’t be widespread distribution of a vaccine until the second half of next year. Before then, it will be winter in the Northern Hemisphere, raising the prospect of another wave of Covid-19 combined with the seasonal flu. Restaurants that have survived by offering outdoor dining may not survive the winter. So everyone is watching such high-frequency indicators as restaurant reservations and various mobility metrics. Some of them have been stalling in recent weeks.

Among our favorite high-frequency indicators is credit-card spending (Fig. 11). After a V-shaped recovery from mid-April through late June, the uptrend has slowed through mid-September. However, the data—which are not seasonally adjusted—are still trending higher. Weekly gasoline usage has recovered smartly since it bottomed on April 24 (Fig. 12). It has stalled during September, but that’s consistent with the typical back-to-school slowdown after the summer driving season.

Corporate Finance: Impact of the Pandemic. The lockdown recession and the subsequent recovery have been unique experiences for all of us, including consumers, workers, companies, business managers, and investors. There have been winners and losers in almost every aspect of our economy.

The corporate business sector certainly has had its share of winners and losers. That’s been reflected in the stock market. Among the notable ytd winners are lots of technology companies, housing-related industries, and transportation companies (with the exception of airlines). Among the big losers are regional and diversified banks, energy-related companies, REITS, and hotels, resorts, and cruise lines. (See our S&P 500 Sectors & Industries Year-To-Date Change.)

I asked Melissa to review and update the big-picture impact of the pandemic on corporate finance. Here is her report:

(1) Mad dash for cashing in credit lines. The initial reaction of nonfinancial corporations (NFCs) to the pandemic was to raise lots of cash by cashing in their lines of credit at the banks. Commercial and industrial loans jumped $730 billion from the beginning of the year to a record high of $3.1 trillion during the May 6 week before dipping back down a bit to $2.7 trillion during the September 16 week (Fig. 13). The Fed’s quarterly data show that the increase in loan demand occurred mostly during Q1 at depository institutions (Fig. 14). The mad dash for cash abated after the Fed implemented QE4ever on March 23 and pledged to backstop the corporate bond market.

(2) Mad dash for issuing stocks and bonds. Corporate bond issuance soared after the Fed’s actions opened up the bond market after it seized up when the pandemic panic hit during February and early March. Over the past 12 months through August, corporate bond issuance totaled $2.4 trillion, led by a $1.4 trillion increase in NFC bond issuance (Fig. 15).

The rally in stock prices following the Fed’s moves led to a surge in corporate stock issuance too. The new supply of such corporate securities totaled a record $267 billion over the 12 months through August.

(3) M&A boom is MIA. Along with the increased activity in the equity and credit markets, we expected that the pandemic would trigger a flurry of M&A activity as so many deeply discounted buying opportunities popped up. But so far that hasn’t happened.

A June Harvard Business Review survey confirmed that forecast deal volume for the remainder of the year was substantially reduced during the first half of this year. Late-stage deals were done as the pandemic lockdowns began, but many early-stage deals were put on hold. Some opportunistic activity occurred, but it was not reported by most survey respondents.

Part of the problem is that the Fed’s March 23 announcement was followed by an extraordinary meltup in valuation multiples. So the pandemic-triggered buying opportunities didn’t last long enough to stimulate an M&A boom. Even Warren Buffett couldn’t fire his “elephant gun” fast enough.

(4) Buybacks are busted for now. It’s not unusual for firms to cut back on share buybacks during recessions. Standard & Poor’s data on S&P 500 buybacks shows a substantial decline in the pace of buybacks to $88.7 billion during Q2, the lowest since Q1-2012 (Fig. 16).

As Joe and I discuss in our Topical Study #84, companies often use share buybacks to offset the dilution attributable to employee stock plans, which get cut along with bonuses in general during recessions. The S&P 500 sectors with the industries hardest hit by the pandemic saw the largest quarterly declines in buybacks during Q2. For example, buybacks in Health Care and Information Technology have held up relatively well while Consumer Discretionary, Consumer Staples, Energy, and Real Estate share repurchases have dropped more significantly to record lows. Communications Services was the only sector to see an increase in quarterly buyback activity during Q2, which is not surprising since most of its industries are flourishing.

(5) Dying and thriving zombies. Will NFCs experience a major debt hangover from all the debt accumulated on their balance sheets since the pandemic hit? Maybe some, but likely not most. Given that interest rates are at record lows and that lots of companies have locked in these low rates by refinancing existing debt at extended maturities, all that debt may be serviceable, especially as the US economy recovers from the current crisis.

As a September 23 Bloomberg article discussed, the Fed’s zero-rate policy and the search for yield have created a borrower’s market in the credit space, even for high-yield junk. It noted that “all-in yields for U.S. junk bonds have dropped to 5.81%, near pre-pandemic levels, according to Bloomberg Barclays index data.” It mentioned Ball Corp.’s record-setting lowest coupon ever for a junk bond with a maturity of five years or longer during August at 2.875%. That’s as US high-yield bond sales totaled $329.8 billion through last Wednesday, eclipsing the prior annual sales record set in 2012.

An August 21 Capital Group Insights report by Fixed Income Portfolio Manager Shannon Ward noted that corporate defaults are indeed up (as we discussed in our August 12 Morning Briefing). The default rate has tripled from last year to around 6.0%. Nevertheless, it remains low in the single digits. Ward observed that the market for low-rated companies is ripe with opportunities for selective investors.

She also noted (as we did in our earlier note) that companies with problems that pre-dated the pandemic—such as brick-and-mortar retailers and energy companies—may be ones to avoid. Not surprisingly, these industries account for a large share of the rise in ytd defaults and bankruptcies. Lots of investment-grade companies dropped in their ratings as the lockdowns occurred, but many already have recovered. It helped that the Fed has been and remains at the ready to support these “fallen angels.” Ward notes that the BB-rated market is about 55% of the high-yield market as of July 31, 2020.

Investors with elephant guns may find more to hunt for in the debt markets than in the equity markets.

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The Great Debates

September 28 (Monday)

Strategy I: The Election Result Will Be Debatable. My hunch is that most Americans have stopped watching the news because it is so annoyingly partisan. However, another hunch of mine is that the upcoming three televised presidential debates could be right up there with Superbowl ratings. Everyone will be watching. Consider the following:

(1) Keeping the gaffe score. Many of us will be watching to see who takes the bait and gets most rattled. Will President Donald Trump make former Vice President Joe Biden flounder for words? The 77-year-old Democratic presidential candidate has been prone to gaffes in recent years. Googling “Biden gaffes” yields 2,900,000 links, including 257,000 videos. Biden’s national press secretary recently refused to answer whether the Democratic candidate uses a teleprompter in televised interviews to keep him on message and from fumbling his responses.

The 74-year-old President seems compelled to respond to every attack by his critics. Biden undoubtedly will do his best to provoke Trump. Googling “Trump gaffes” yields 6,230,000 links, including 379,000 videos. Arguably, there are many more news organizations that accentuate Trump’s flaws more so than his achievements than there are news outlets inclined the other way around. In addition, Trump says something provocative almost every day, while Biden has been much less vocal and visible.

(2) Cognitive test. There will be three televised debates between Trump and Biden, on September 29, October 15, and October 22. It will be very interesting to see how the stock market responds to them. My hunch is that if Trump succeeds in baiting Biden, the stock market will rally, since the President is a known known while Biden is a known unknown. We know that a Biden administration would be a radical regime change; we just don’t know how radical the change will be.

If the election results are too close and are contested, the stock market could have a wicked selloff. Last week, Trump said that he expected that the Supreme Court might have to decide who won. That statement might have contributed to the stock market selloff last Wednesday.

Then again, perhaps the election results will not be debatable if either candidate shows more pronounced signs of melting down in the heat of the debate. By now, you’ve probably heard President Trump say that he “aced” a cognitive test that required him to repeat “Person-Man-Woman-Camera-TV.” He went on and on about this one challenge on the test—recalling five objects—and how he had aced it despite its difficulty. “They get very hard, the last five questions.”

Seriously, this issue is no joke. Previously, I’ve written that the pandemic has put us all in the Twilight Zone. Adding to the weirdness of our time is that the presidential race is between two candidates who are undeniably in their twilight years. Perhaps all candidates should be required to take cognitive tests, especially those over the age of 70. For a primer on such tests, see “Biden, Trump, and Cognitive Decline: An Expert’s Primer on the Cognitive Tests That Have Become a 2020 Campaign Issue.”

By the way, I am a young septuagenarian. Each morning before I start writing the Morning Briefing, I make sure I’m in tip-top cognitive shape by repeating the following mantra 10 times: “Person-Man-Woman-Camera-TV.” So far, so good.

(3) The first televised debates. History.com observes: “In 1960, John F. Kennedy and Richard Nixon squared off in the first televised presidential debates in American history. The Kennedy-Nixon debates not only had a major impact on the election’s outcome, but ushered in a new era in which crafting a public image and taking advantage of media exposure became essential ingredients of a successful political campaign. They also heralded the central role television has continued to play in the democratic process.”

Back then, there was a cold war between the US and Russia going on abroad, and the struggle for civil rights and desegregation had deeply divided the nation at home. Today, the US and China are heading into a cold war, and racial tensions are high at home.

There were four debates. Kennedy won them all, hands down. Most radio listeners called the first debate a draw, but Kennedy won according to most television viewers. Nixon looked pale and sickly because he was sick with the flu. Kennedy’s bronze complexion made him look healthy, but it might have been a symptom of Addison’s disease, the endocrine disorder from which he suffered for much of his life. Nixon was visibly sweating under the hot studio lights and clearly looked uncomfortable, as his eyes shifted somewhat erratically.

It was a close election, with Kennedy winning the popular vote 49.7% to Nixon’s 49.5%. Polls showed that more than 50% of voters had been influenced by the debates.

(4) Bottom line. The latest debates may be just as important in determining the election result as was the first round of debates between Kennedy and Nixon. May the best septuagenarian win! Just as important will be whether the two houses of Congress remain divided or wind up both led by the same party. The stock market is likely to do better if the election delivers two more years of gridlock no matter who wins the White House.

Strategy II: The Twilight Months. September and October have a history of being down months for the stock market except when they are up months. I asked Joe and Mali to check whether the two months are especially challenging during presidential election years. Here are their findings using monthly data for the S&P 500 since January 1928, which includes 23 presidential election years:

(1) The two months before presidential elections. From the last day of August through the last day of October during the 23 presidential election years since 1928, the S&P 500 was down 0.5% on average, with declines during 10 of those years averaging 6.2% and gains during 13 of those years averaging 4.0% (Fig. 1). The biggest drops occurred during 2008 (-24.5%), 1932 (-17.0%), and 1960 (-6.3%). The biggest gains occurred during 1996 (8.2%), 1936 (7.6%), and 1988 (6.7%).

(2) The six months around presidential elections. Now let’s examine the six-month percentage changes from the end of August through the end of February during presidential election years. Those periods coincide with the eight-week-or-so run-up to the election after the summer months through the first six weeks or so of the new presidential term. Over those six-month spans, the S&P 500 was up an average of 1.3%, with declines during eight of those years averaging 15.1% and gains during 15 of those years averaging 10.0%. The biggest drops occurred during 2008-09 (-42.7%), 1932-33 (-32.5%), and 2000-01 (-18.3%). The biggest gains occurred during 1928-29 (22.6%), 1996-97 (21.3%), and 1936-37 (13.1%).

(3) The big picture. Looking at the performance of the S&P 500 under each president since FDR in 1932 shows that the six Democratic administrations over 48 years (FDR/Truman, Kennedy/Johnson, Clinton, and Obama) delivered average annual gains of 10.5%, while the seven Republican administrations over 39 years (Eisenhower, Nixon/Ford, Reagan/Bush I, Bush II, and Trump so far) have delivered gains averaging 6.9% (Fig. 2). In fact, presidents probably have had very little to do with the performance of the stock market, which continues to be driven by companies’ earnings.

Strategy III. An Update on Panic Attack #67. This year’s bear market from February 16 through March 23 in many ways seemed more like the previous 65 Panic Attacks since the start of the latest bull market on March 9, 2009 than a bear market followed by a new bull market. So we count the latest selloff since the record high of 3580.84 on September 2 as Panic Attack #67 in our chronology. (See our Table of S&P 500 Panic Attacks Since 2009.)

So far, the S&P 500 dropped 9.6% from its record high on September 2 to 3236.92 through Wednesday, September 23, making it unchanged for the year (Fig. 3). That level might have provided technical support for the index, which rose 1.9% during Thursday and Friday to 3298.46. Let’s consider a few other technical and fundamental matters relevant to the stock market:

(1) No bear market in 200-dmas. The 200-day moving average (200-dma) of the S&P 500 fell just 2.0% from peak to trough as a result of the recent “bear market.” That compares to the 41.9% drop during the previous bear market (Fig. 4).

There are barely any signs of a recent bear market in the 200-dmas of the 11 sectors of the S&P 500 (Fig. 5). The only sector clearly in a bear market is S&P 500 Energy, as its 200-dma is down 30.8% ytd through Friday’s close. At or near record highs are seven sectors: Communication Services, Consumer Discretionary, Consumer Staples, Health Care, Industrials, Information Technology, and Materials. On this basis, Financials, Real Estate, and Utilities might have stalled recently but remain on their uptrends since 2009.

(2) Momentum correction. Joe and I aren’t Chartered Market Technicians (CMTs). Nevertheless, we did spot a potential near-term problem for the market in our August 31 Morning Briefing titled “Anatomy of a Meltup,” when we asked: “Are 200-dmas signaling impending corrections in high-flyers?” We should have been more definitive; but then again, we aren’t CMTs.

As it turned out, the spread between the S&P 500 and its 200-dma peaked at 15.9% on September 2, the most since December 2009. It was down to 6.2% on Friday (Fig. 6). On March 23, it was -26.6%. Here is the performance derby for this spread for the 11 S&P 500 sectors showing the values on March 23, September 2, and on Friday’s close: Communication Services (-20.4%, 20.2%, 6.2%), Consumer Discretionary (-25.1, 28.4, 16.1), Consumer Staples (-20.0, 10.1, 3.9), Energy (-57.2, -19.5, -26.1), Financials (-37.7, -0.5, -6.1), Health Care (-21.0, 9.3, 2.8), Industrials (-37.2, 10.3, 6.4), Information Technology (-17.4, 31.3, 15.3), Materials (-33.2, 17.5, 10.3), Real Estate (-33.2, 2.9, -2.8), and Utilities (-28.9, -1.1, -2.7).

(3) An overvaluation correction. Unlike the previous 66 panic attacks, the main cause of the latest selloff is hard to pinpoint. Nothing particularly bearish occurred at the beginning of September other than the beginning of September, which has a bearish reputation. The market’s main, and widely recognized, problem was that the meltup in stock prices since March 23 seemed to make them overvalued based on most valuation models, with the notable exception of those that give a lot of weight to near-zero interest rates. (See our latest Topical Study, S&P 500: Earnings, Valuation, and the Pandemic.)

The forward P/Es for the S&P 500/400/600 peaked in early September at 23.2, 20.3, and 21.9 (Fig. 7). Here is where they were on Friday: 21.0, 18.3, and 19.0.

(4) FAAMGs give back some. The big stock market story from March 23 through September 2 was the FAAMG-led meltup in the S&P 500 and even more so in the Nasdaq, which was 18.8% below its 200-dma on March 23, 28.7% above it on September 2, and 14.1% above it on Friday (Fig. 8). The FAAMGs (Facebook, Amazon, Apple, Microsoft, and Google) are the current Magnificent Five, i.e., the S&P 500 stocks with the biggest market cap.

Their collective market cap peaked at a record $7.8 trillion on September 2 and fell to $6.8 trillion on Friday (Fig. 9). They accounted for a record 26.4% of the S&P 500 market cap on September 2 and still accounted for 24.7% on Friday (Fig. 10).

The FAAMG’s collective forward P/E peaked at 44.3 during the week of August 28 (Fig. 11). It was down to 39.1 during the September 25 week. The S&P 500 forward P/E was 21.8 and 18.4 with and without the FAAMGs during the week of September 18 (Fig. 12).

Here is the performance derby of the major stock market indexes since March 23 through September 2, from March 23 through Friday, and from September 2 through Friday: FAAMG (89.8%, 64.2%, -13.5%), Nasdaq (75.7, 59.1, -9.5), S&P 500 (59.6, 47.4, -7.9), S&P 500 ex-FAAMG (51.0, 42.6, -5.6), S&P 500 Growth (73.1, 57.3, -9.1), and S&P 500 Value (42.7, 34.3, -5.9) (Fig. 13). Here is the same ytd: FAAMG (36.9%), Nasdaq (21.6), S&P 500 (2.1), S&P 500 ex-FAAMG (-5.7), S&P 500 Growth (17.1), and S&P 500 Value (-14.8) (Fig. 14).

(5) Fundamental matters. Joe and I have viewed the selloff since September 2 as a “healthy correction.” We would have been more concerned if the market meltup continued. We felt that the market needs to consolidate its gains since March 23 to give earnings some time to catch up. Besides, there are still important issues that need to be resolved such as the course of the pandemic, its ongoing impact on the economy, and the outcome of the upcoming election. We are relatively optimistic on all three, but we acknowledge that they remain known unknowns with the potential to turn into bearish or bullish known knowns.

Meanwhile, we are glad to see that S&P 500 forward revenues continues to recover in a V-shaped fashion (Fig. 15). It plunged 8.0% from the February 20 week through the May 28 week. It has recovered 4.3% over the past 16 weeks since then through the September 17 week. The same goes for forward earnings, which dropped 21.2% after February 20, bottoming during the May 14 week. It is up 11.3% over the past 18 weeks through the September 17 week.

Movie. “Social Dilemma” (+ +) (link) is a disturbing documentary featuring several concerned American citizens who happen to have worked for the top social media companies in the country as top executives and employees. They all share a concern that the unregulated social media companies have inadvertently created a monster, which threatens democracy and social stability. They are doing so by their relentless need to increase their revenues by collecting and selling more and more data about each and every one of us. To get our attention, they are constantly doing their best to push our emotional buttons, especially fear and hate. As a result, they are exacerbating political partisanship by feeding us with news feeds and social media recommendations that are selected by their artificial intelligence algorithms to incite us. Some of the insiders suggest that the social media giants need to be regulated the same as the phone companies are regulated. A few simply observe that our smartphones create the dilemma of making us simultaneously smarter and dumber.

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Cold Warriors

September 24 (Thursday)

Geopolitics: Xi and Trump Face Off. Brashness is something normally attributed to boxers. But right now, US President Donald Trump and China’s President Xi Jinping both have enough of it to keep the whole world on edge as they duke it out in the global boxing ring.

Xi is behaving like a dictator at home and an instigator abroad. Actually, he has been doing so ever since he became the supreme leader in 2013 and went on to appoint himself president for life in 2018. A while ago, we concluded that Xi is a Maoist.

He has pushed for the loyalty of the country’s business leaders, targeted the development of industries that will make China independent of the US, and cracked down on Hong Kong dissenters. Meanwhile, skirmishes with India’s army on its border and military aggression in the South China Sea are keeping China’s neighbors on edge. And the US government has identified numerous Chinese spies at US companies and universities, who have been stealing US technologies and proprietary information to send home.

President Trump has also been provocative, dubbing Covid-19 “the China Virus.” He also has sent high-level diplomats to Taiwan and sold military equipment to the island nation, which Beijing considers to be part of “One China.” And most recently, he has threatened to prohibit China’s businesses TikTok and WeChat from operating in the US.

This high-level political tit-for-tat undoubtedly will make it tougher for companies of both countries to operate in each other’s markets. While this evolving cold war hasn’t rattled investors yet, the potential for it to do so is growing. Here’s a look at some of the bellicose leaders’ recent moves:

(1) Business must toe the line. China’s government appears to be demanding more allegiance from the country’s private businesses. The Central Committee of the Communist Party of China (CPC) issued guidelines to “strengthen the relationship” between the CPC and private enterprises. Businesspeople must “maintain high consistency” with the party regarding the political aspects of position, direction, and principles, so that they can make more contributions to the economic recovery, the guidelines stated.

In addition, President Xi through a written statement “stressed efforts to unite people from the private sector around the Communist Party of China (CPC) to better promote the healthy development of the private sector. … [Xi] asked Party branches at all levels to unite business people from the private sector and strengthen connections with the CPC,” China’s state television CGTN reported on September 16.

A September 16 Sinocism article concluded that these new CPC directives will result in “even more patriotism and political correctness from the private sector.” Companies and executives that oblige will benefit financially at home but could face questions about their intentions by foreigners if they attempt to expand overseas.

The guidelines also introduce questions about how the CPC will treat foreign-owned companies operating in China. An early indication came over the weekend when China’s Ministry of Commerce released its “unreliable entity” list. Companies will make the list if they are considered a danger to national sovereignty, security, or the development interests of China. Those on the list could be restricted or prohibited from trade or investment in China. Cisco, Dell/EMC, HP, Lockheed Martin, and Rockwell Collins could potentially be added to China’s list, according to a consulting firm quoted in a September 21 CNBC article.

(2) US has an enemies list too. China’s unreliable entity list is analogous to the US Commerce Department’s Entity List, which restricts certain foreign companies from operating in the US. Huawei, for example, made the list when the US determined that the country was a risk to US national security.

Currently, President Trump is attempting to ban the use of WeChat and TikTok in the US while those companies are still under the control of Chinese companies. Last weekend, a US judge in California blocked the Trump administration’s ban on WeChat downloads. The judge ruled in favor of WeChat users who argued the ban impinged on their First Amendment rights.

The Trump administration’s move to ban downloads of TikTok was preempted by a proposed deal in which Oracle and Walmart would take equity stakes in TikTok; the company’s data would be hosted on Oracle’s US servers but its core algorithms kept under Chinese control. The deal is still being negotiated, with TikTok parent ByteDance wanting 80% ownership after the deal and Oracle wanting 80% of the new company to be distributed to US investors, with ByteDance owning none. The Chinese government has yet to formally weigh in, but a September 23 editorial in state-run China Daily strongly criticized the sale: “What the United States has done to TikTok is almost the same as a gangster forcing an unreasonable and unfair business deal on a legitimate company.”

(3) China’s critics punished. The latest sign that no opposition will be tolerated was sent by a Beijing court, which sentenced Ren Zhiqiang, an influential businessman who’d been critical of Xi, to 18 years in prison. The 69-year-old was convicted Tuesday of corruption, receiving bribes, embezzlement, and abuse of power, and he was fined about $619,000, a September 22 WSJ article reported. The court said Ren confessed to all charges and couldn’t be reached for comment.

What does it take to be sentenced to 18 years in prison? In this case, an essay accusing Xi of mismanaging the Covid-19 pandemic and warning that his leadership style was approaching Mao Zedong’s system that crushed people’s rights and interests. Ren didn’t name Xi when he wrote: “There stood not an emperor displaying his ‘new clothes,’ but a clown who stripped off his clothes and still insisted on being an emperor,” the essay read, according to the WSJ article. “Despite holding up pieces and pieces of loincloth in trying to hide the reality of your nakedness, you don’t hide in the slightest your resolute ambition to become an emperor.”

The court ruling followed a CPC national security law imposed earlier this year that criminalizes Hong Kong’s secession, subversion of state power, terrorism, and collusion with foreign entities, with punishment as steep as life in prison. The law signaled Hong Kong’s lack of autonomy, and it effectively ended the volatile protests that had been occurring in Hong Kong against Chinese leadership.

(4) Chinese caught aggressively spying. Baimadajie Angwang, a naturalized US citizen, was the latest person charged with spying in the US for China. He allegedly reported to the Chinese government about activities of Chinese citizens, particularly Tibetans, in the New York area. Angwang—a New York City police officer and former US marine with Department of Defense security clearance—was allegedly feeding information to officials in China’s New York consulate. Angwang’s brother is reportedly serving as a reservist in China’s People’s Liberation Army. This is just one of many US allegations about Chinese-sponsored spies in the US that we’ve written about. (See our Morning Briefings on July 30, 2020, February 21, 2019, and February 7, 2019.)

(5) Fighting words. This week’s UN general assembly meeting was the latest arena in which President Trump could poke the tiger by continuing to rebrand Covid-19 “the China Virus” while placing blame for the related deaths at the country’s feet. “We must hold accountable the nation which unleashed this plague on to the world: China,” said Trump according to a September 22 FT article.

The Trump administration also irritated China with its visible support of Taiwan. US Under Secretary of State for Economic Growth, Energy, and the Environment Keith Krach flew to Taiwan last week to attend a memorial service for former Taiwan leader Lee Teng-hui. Lee was Taiwan’s first leader to suggest separating Taiwan from mainland China, which “makes him No.1 or No.2 most hated person on Beijing’s list for Taiwan,” observed Yinan He, an associate professor in the Department of International Relations at Lehigh University in a September 18 CNN article.

Krach’s trip followed US Secretary of Health and Human Services Alex Azar’s visit to the island, ostensibly in the name of pandemic cooperation. The US has also agreed to provide Taiwan with additional weapons sales and has sent more military planes and warships to the region. Most recently, the Trump administration has proposed the sale of long-range missiles that would allow Taiwanese jets to hit Chinese targets, a September 17 NYT article reported.

Xi has proven he can dish it out as well. This week at the UN annual meeting, he said he opposed unilateralism, bullying, and any country acting like “boss of the world,” according to a September 22 article in Xinhuanet. He added that the UN should uphold the rule of law and “not be lorded over by those who wave a strong fist at others.” There’s little doubt to whom he’s referring.

China also has done more than talk this year: It has been skirmishing with India’s army along the border the two nations share. It has acted aggressively in the South China Sea, holding military operations and claiming disputed territory. And it has provocatively been displaying its military might in the Taiwan Strait and flying military planes into Taiwan’s airspace.

China: High-Octane MMTea. China is famous for its herbal medicines and therapeutic teas (if only they could cure Covid-19!), but lesser known is that the nation also leads the world in the use of Modern Monetary Theory (MMT) to revive economic growth.

To explain, the Chinese government responded to the Great Financial Crisis (GFC) with massive fiscal spending and lending by the state-owned banks. They’ve continued drinking this tea ever since. They’ve been able to do so because inflation has remained subdued. Fit these puzzle pieces together, and the picture is a Chinese version of MMT. Let’s have a closer look:

(1) Infrastructure spending on the fast track. According to an August 24 Asia Times article, during August, China National Railway Corporation unveiled plans to build about 36,000 kilometers of high-speed rail arteries and feeder lines to connect China’s largest megacities—all of those with a population of half a million or more—and outlying regions. About 80% of China’s 700-plus county- and prefecture-level cities are above that population threshold, according to a 2019 census. The plan would more than double the length of China’s high-speed railway network, already the world’s longest, to more than 70,000 kilometers within 15 years.

China embarked on its building spree after inaugurating its first high-speed railway between Beijing and Tianjin just before the 2008 Olympics. Today, almost two-thirds of the world’s high-speed railways—i.e., railways with top speeds of at least 200 kilometers per hour—operating commercially are in China.

The Western Theater Command of the People’s Liberation Army noted on its WeChat account last month that an express rail link between Chengdu and Lhasa means troops and assets can be moved more efficiently into Tibet and along China’s long border with India and other countries.

(2) Lots of credit. How will China National Railway Corp. pay for this latest spending spree? It already has more than $1 trillion in debt; it will have to borrow much more. That shouldn’t be a problem since China’s banks continue to pour money into the economy. China’s bank loans equaled US bank loans during July 2010 at $6.6 trillion (Fig. 1). Since then, the former has soared $17.6 trillion to a record $24.2 trillion last month, while the latter rose only $3.9 trillion to $10.5 trillion. Over just the past 12 months through August, they were up by a record $2.8 trillion (Fig. 2). The shadow banking system provided an additional $2.0 trillion, also a 12-month record (Fig. 3).

Disruptive Technologies: Good and Bad EVs. In the September 3 Morning Briefing, we warned that that the excitement surrounding Tesla and electric vehicles (EVs) was leading to a surge of new startups doing reverse mergers with the capital market’s favorite new vehicle, special-purpose acquisition companies (SPACs). “As these two megatrends combine, we’re afraid the future will see a traffic jam at best and a four-lane pileup at worst once investors differentiate between companies with proven versus unproven technology and determine which barely profitable companies will or won’t be more profitable in the future,” we wrote.

The first casualty came sooner than expected. Nikola’s founder and Executive Chairman Trevor Milton resigned this week after a report by short-seller Hindenburg Research accused him of making false statements about the company’s technology. Among the many allegations, Hindenburg noted that the truck in a company video actually was rolling down a hill thanks to gravity and not moving under its own power, as was likely presumed by observers. The company has said the report contains misleading information. The Securities and Exchange Commission and Department of Justice are looking into the allegations, a September 21 CNBC article reported.

Nikola shares have fallen 30.5% from the close on September 2 through Tuesday’s close versus a 6.0% decline for the S&P 500, but the performance of other SPACs buying companies in the EV space has been mixed. DiamondPeak Holdings, which is slated to do a reverse merger with Lordstown Motors, has risen 63.3% since the start of September, while Net Element, which plans to do a reverse merger with Mullen Technologies, has fallen 17.3%.

Meanwhile, Tesla continues to set the pace, announcing on Tuesday planned innovations in battery technology that it believes will sharply lower their cost and enable it to sell a $25,000 vehicle in about three years. Tesla’s battery will cost 56% less than current batteries, dropping the cost of EVs down to the cost of a gas-powered vehicle.

Tesla has done so by changing the battery’s structure, chemistry, and means of manufacturing. The battery will still contain lithium, of which Musk says there is plenty in Nevada. But the battery won’t contain cobalt, which is difficult to source.

At Tuesday’s presentation, Tesla also introduced its Plaid Model S, which can drive more than 520 miles on a charge. But it doesn’t come cheap: $139,990. A day later, Chinese carmaker Geely announced a battery system it would sell to others that would give cars a range of 700km (435.0 miles). And California announced that it will ban sale of cars with combustion engines in the state starting in 2035. The little guys will have to drive awfully fast to catch up to the market’s leaders.

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The Economic Consequences Of De-Urbanization

September 23 (Wednesday)

US Economy I: Home Rush. “This Joint Is Jumping” is a happy tune from the 1949 musical comedy film by the same name. It could be the theme song for the housing market of 2020, and perhaps beyond. It is our view that the US housing boom stimulated by the pandemic may very well more than offset the pandemic-related bust in many other industries. The viral pandemic has resulted in a pandemic of de-urbanization. It has caused lots of city dwellers to move to suburban and rural homes. Large homes that were sitting on the market for months prior to the pandemic are getting snapped up, sometimes sight unseen or with only a virtual tour of the property. Houses with room for one or two offices for working and studying from home are in demand. So are ones with nice backyards and swimming pools for the kids.

As you know, Debbie and I always try to back up our theories with hard data. The question is whether the data can confirm that the strength in housing-related economic activity is sufficient to more than offset the weakness in industries that may remain depressed or fail to recover fully from the lockdown recession. Let’s have a look:

(1) Existing home sales on fire. Yesterday, we learned that existing home sales rose to 6.0 million units (saar) during August, the highest pace since May 2006 (Fig. 1). The pace of single-family existing home sales rose to 5.37 million units (saar), the highest since April 2006. The number of single-family homes available for sale was only 1.27 million units, near recent record lows (Fig. 2). The months’ supply of single-family homes sank to a new record low of 2.8 during August.

Sales are likely to remain strong since the Pending Home Sales Index compiled by the National Association of Realtors (NAR) jumped from a record low of 69 during April to 122 during July, the highest since October 2005 (Fig. 3). Existing home sales are counted when they are closed rather than when they go to contract.

(2) Soaring home prices. Booming demand combined with a shortage of supply are causing the prices of single-family existing homes to soar. The median price rose 11.7% y/y during August to a record $315,000, while the average rose 9.1% to a record $345,700 (Fig. 4 and Fig. 5).

(3) Snapping up big existing homes. The NAR reported that properties typically remained on the market for 22 days in August, down from 31 days in August 2019. Sixty-nine percent of homes sold in August 2020 were on the market for less than a month. First-time buyers were responsible for 33% of sales in August, up from 31% in August 2019. For three straight months, home sales have climbed in every region compared to the previous month. Median home prices in each of the four major regions rose at double-digit rates from levels one year ago.

 The NAR reported huge increases in sales of bigger, more expensive homes. Here are the y/y percentage changes during August by price range in sales: $0-100k (-20.5%), $100-250k (-8.9), $250-500k (14.2), $500-750k (28.2), $750k-1m (34.5), and $1m+ (44.0). The steadily northward progression of the y/y changes in sales as the sale price ranges go up is incredible.

(4) Millennials turning into homebuyers. There’s more and more anecdotal evidence that all those Millennials who’ve been renting apartments in urban areas are responding to the pandemic by buying houses in the burbs. Undoubtedly, many of them are the first-time buyers in the NAR data. Millennials were born between 1981 and 1996. That would make them 24-39 years old this year. Homeownership rates for the under-35 age group rose to 40.6% during Q2, the highest since Q3-2008, while the rate for the 35- to 44-year-old cohort rose to 64.3%, the highest since Q1-2011 (Fig. 6).

 US Economy II: Under (Residential) Construction. On Monday, Debbie and I reviewed the latest new home sales and construction data. Needless to say, that segment of the housing market is also booming. Consider the following:

(1) Starts may just be starting to jump. Multi-family housing starts completely recovered from the Great Financial Crisis (GFC) by 2013 as demand for rental apartments boomed. Single-family housing starts also have recovered since the GFC but remain around their lows during the five homebuilding cycles prior to the GFC (Fig. 7). Single-family housing completions too are back only to previous troughs prior to the GFC (Fig. 8).

(2) Snapping up new homes. During July, new single-family home sales rose to nearly match single-family completions for the first time on record, which goes back to 1968! The inventories of new homes for sale relative to new homes sold fell to previous record lows during July and is likely to make new lows in coming months (Fig. 9).

(3) Residential construction has room to grow. The Census Bureau’s monthly data on construction put in place show that spending on residential construction and home improvements combined totaled $546.6 billion during July (Fig. 10 and Fig. 11). That sum has exceeded the sum of nonresidential and public construction spending for the past few years. It could easily match its record high of $678.6 billion during February 2006 in coming months, in our opinion.

Arguably, the outlook for nonresidential construction spending is grim if de-urbanization depresses the demand for offices, hotels, and retail spaces in cities even after the pandemic is over. Public construction spending, on the other hand, may get a boost after the presidential election no matter who wins. Residential construction and home improvements together are likely to continue to climb in record-high territory, more than offsetting the likely weakness in commercial construction.

US Economy III: A Recovery with Booms & Busts. The lockdown recession was unprecedented. It lasted only two months, March and April. It was followed by a V-shaped recovery from May through August. Real GDP fell 5.0% during Q1 because March depressed the results and fell 31.7% during Q2 because April clobbered the results. On September 17, the Atlanta Fed GDPNow model was tracking Q3 at a remarkable 32.0% rate. That’s an unprecedent rebound from the unprecedented recession. Debbie and I are still projecting 25% for Q3, then 5% for Q4. We believe that there remains enough fiscal stimulus from the CARES Act and plenty of monetary stimulus to keep the economy growing through year-end.

However, there is mounting concern that the fiscal stimulus from the CARES Act, which was enacted on March 27, is petering out and that a second round is unlikely until after the November 3 election. Our optimism about the sustainability of the recovery even without a second round of fiscal support is partly based on our upbeat outlook for the housing market, which is certainly getting a boost from record-low mortgage rates thanks to the Fed’s ZIRP4ever. Let’s have a closer look at how the housing-related sector of our economy compares to the services industries that are struggling most to recover from the lockdown recession:

(1) Housing-related industries add up to lots of economic activity. Again, the sum of residential construction and home improvements was $546.6 billion (saar) during July. Retail sales of building materials and garden equipment soared to new highs in recent months, totaling $447.1 billion (saar) during August. But we aren’t going to use this series for comparison purposes because much of it is included in the residential investment component of GDP, so doing so might double-count the construction data.

Instead, let’s add personal consumption expenditures in current dollars on furniture and furnishings and on household appliances (Fig. 12). That rose to a record $315.8 billion (saar) during July. Now let’s add residential construction, home improvement construction, spending on furniture and furnishings, and spending on household appliances (Fig. 13). That totaled $862.4 billion during July.

(2) Pandemic-challenged services continue to struggle. Among the industries that are most likely to face a challenging recovery are the ones covered by the following categories of personal consumption expenditures (followed by their July saar levels): air transportation ($62.7 billion), hotels & motels (53.9 billion), amusement parks, camp grounds & related recreation (32.9 billion), admission to special spectator amusements (3.3 billion), and gambling (109.3 billion). Altogether, they peaked at a record $549.9 billion during December, and plunged 87.0% through April (Fig. 14). Collectively, they’ve rebounded 267.6% through July. Personal consumption expenditures on food services peaked at a record $863.8 billion during January and plunged 47.6% during the subsequent three months. It is up 62.0% since then through July to $733.4 billion.

US Financial Accounts: Home Run. The Fed’s Financial Accounts of the United States has been updated with Q2 data. It shows that following the Great Financial Crisis (GFC), the value of real estate held by households bottomed at $17.9 trillion during Q1-2012, a 26% drop from the then-record high during Q4-2006 (Fig. 15). There has been a remarkable 72% rebound since the most recent trough to a record $30.8 trillion.

The level of total home mortgages outstanding barely increased over this period. As a result, owners’ equity rose $12.0 trillion to a record $20.2 trillion during Q2 since bottoming during Q1-2012. Collectively, homeowners now own 65.6% of their homes, up from a post-GFC low of 45.8% during Q1-2012 (Fig. 16).

This equity is a potential shock absorber for millions of Americans who are house-rich but cash-poor as a result of the pandemic. A September 18 article in The Wall Street Journal on this subject observed: “Even if there isn’t a surge in repossessed homes to buy cheaply off the courthouse steps—which led to the emergence of Wall Street’s landlords during the foreclosure crisis a decade ago—there is likely to be a lot of forced sales and new renters.”

Furthermore, the article notes: “People behind on their payments aren’t being kicked out of their houses yet because of federal and local restrictions on foreclosure enacted during the pandemic. Many with federally guaranteed mortgages have entered forbearance, which allows them to skip payments for up to a year without penalty and make them up later.” According to the Mortgage Bankers Association, about 3.5 million home loans were in forbearance in early September. Many more borrowers are behind on their payments but not in forbearance programs with their lenders.

Rental companies formed after the GFC to scoop up cheap houses are now raising billions in rent-backed bonds. They are house-hunting to scoop up homes from distressed sellers. In some cases, they are letting the sellers stay as renters. In other words, the market has fashioned a win-win situation for the buyers and sellers.

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Fed Fully Embraces MMT

September 22 (Tuesday)

Strategy: Update on Panic Attack #67. The S&P 500 peaked at a record high on September 2. It is down 8.4% since then through Monday’s close. September does have a history of being the worst month of the year for the stock market. Since 1928, the month’s average loss has been 1.0% (Fig. 1). Only two other months have been down on average over this period, but by only 0.1% each. The bad news is that the S&P 500 lost 4.6% on average during the 49 months it was down of the 91 Septembers since 1928. The good news is that Septembers have a tendency to create buying opportunities for the remainder of the year with average gains for October (0.4%), November (0.8), and December (1.3). Oh, and January’s have had an average gain of 1.2%. However, during the 38 down months for October, the S&P 500 was down 4.7%.

Past performance is no guarantee of future returns, as we often say in our business. Joe and I have viewed the selloff since September 2 as a “healthy correction.” We would have been more concerned if the market meltup continued. We felt that the market needs to consolidate its gains since March 23 to give earnings some time to catch up. Besides, there are still important issues that need to be resolved such as the course of the pandemic, its ongoing impact on the economy, and the outcome of the upcoming election.

The uncertainty around all three known unknowns is currently weighing on the market. The virus is still out there, and spreading more rapidly again in Europe, where government officials are considering targeted lockdowns. The V-shaped economic recovery from May through August in the US is showing signs of slowing. Yesterday’s stock market selloff might have been triggered by fears that the imminent partisan fight over a new justice for the Supreme Court reduces the chances of getting agreement in Congress on another stimulus bill. These issues won’t go away in October, and the November 3 election is fast approaching.

Joe and I are sticking with our S&P 500 targets of 3500 by yearend and 3800 next year.

 Fed I: Teaming Up With the Treasury. What a difference a pandemic makes. Fed Chair Jerome Powell was asked about Modern Monetary Theory (MMT) during congressional testimony on February 26, 2019. He hated it back then. “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong,” the Fed chair said in response to a question about MMT. The “US debt is fairly high to the level of GDP—and much more importantly—it’s growing faster than GDP, really significantly faster. We are going to have to spend less or raise more revenue.”

Powell rejected the notion that the Fed should enable fiscal spending: “And to the extent that people are talking about using the Fed—our role is not to provide support for particular policies,” he said. “Decisions about spending, and controlling spending and paying for it, are really for you.” In effect, he told Congress, “Fiscal policy is your domain. Leave us out of it.”

MMT’s proponents contend that since the American government borrows in its own currency, it can always print more dollars to cover its obligations. As a result, the US can run sustained budget deficits and rack up an ever-increasing debt burden. Along the way, the Fed can help by keeping interest rates low. The only reason to stop this free flow of money would be a significant rise in inflation.

Again: What a difference a pandemic makes! Consider the following:

(1) On March 23, the Fed adopted QE4ever committing to an open-ended program of bond purchases. On March 27, President Donald Trump signed the CARES Act. The result has been a huge increase in the federal budget deficit financed by a huge increase in the Fed’s holdings of US Treasury securities. Over the past 12 months through August, the budget deficit totaled a record $2.92 trillion, while the Fed’s portfolio of Treasuries has swelled $2.30 trillion y/y through the September 16 week (Fig. 2 and Fig. 3).

(2) Despite the swelling budget deficit, the 10-year US Treasury bond yield has remained under 1.00% since March 23, averaging just 0.67% since then through Friday (Fig. 4). It’s been held down by the federal funds rate which was lowered by 100bps to zero on March 15, when plain-vanilla QE4 was also introduced. QE4ever pushed the bond yield below 1.00% since March 23.

(3) The Fed also purchased $603 billion in mortgage-backed securities (MBS) since March 23 through the September 16 week. In addition, US commercial banks have been big buyers of Treasuries and MBS. Together, the Fed and the banks have purchased $2.5 trillion in Treasuries and MBS since March 23 through the September 9 week (Fig. 5). No wonder bond yields and mortgage rates remain near record lows.

Fed II: Waiting for More Fiscal Stimulus. In other words, Covid’s knock-on effects have not only grounded airplanes, but also interest rates. Last Wednesday, the Fed confirmed that the Federal Open Market Committee (FOMC) expects to keep the federal funds rate close to zero through at least the end of 2023 as Melissa and I predicted in our September 2 Morning Briefing titled, “The Fed Is in Control.” We recalled that Fed Chair Jerome Powell famously said in his June press conference that the Fed isn’t “even thinking about thinking about raising rates.” We concluded: “[T]hat thought may remain out of mind for many years to come!”

During his September 16 FOMC press conference, Powell stated: “[T]he outlook for the economy is extraordinarily uncertain and will depend in large part on our success in keeping the virus in check … A full economic recovery is unlikely until people are confident that it is safe to reengage in a broad range of activities.”

While monetary policy officials are thinking that the US economy will require lower interest rates for longer to sustain the recovery, they are also calling for more fiscal stimulus. Apparently, their economic projections assume that more of such support is on the way, according to Powell. Now let’s focus on the FOMC’s latest projections:

(1) Dots lined up in a row. The Fed’s latest quarterly “dot plot” anonymously shows the projections of the federal funds rate of each of the 17 FOMC participants for each year from the current one through 2023. Not one of these forecasters expect an increase in the federal funds rate during 2020, or 2021, according to the September 16 Summary of Economic Projections. Only one participant forecasts a rate increase for 2022. Only four expected so for 2023 with the highest forecasted rate at just 1.25%. Both their median and central tendency forecasts are stuck at 0.1% from 2020 to 2023. That’s notwithstanding that their “longer run” forecast for the federal funds rate is 2.5%. (See our FOMC Summary of Economic Projections). (The latest dot plot reminds us of ducks lined up in a row.)

(2) Inflation projections undershoot. Notwithstanding the Fed’s latest round of ultra-easy monetary policies—including ZIRP, QE4Ever, and NALB, i.e. No Asset Left Behind—the FOMC’s median forecast for PCE inflation does not rise up to the committee’s 2.0% target until 2023. In other words, inflation isn’t expected to be an obstacle to MMT.

The slow projected ascent to 2.0% is especially significant because the Fed’s recently adopted “flexible average inflation targeting” hope (FAITH) is intended to “makeup” for past inflation misses, allowing inflation to “moderately” overshoot the Fed’s long-standing 2.0% target for inflation. But that target has only been reached during 15 months out of 102 months since the Fed set the goal on January 25, 2012 (Fig. 6). Indeed, the PCE inflation rate has been trending along a 1.3% growing trend line since then (Fig. 7). And the FOMC currently doesn’t expect to be overshooting it at least through 2023. That certainly doesn’t boost our faith in the Fed’s ability to overshoot 2.0%. (Hat tip to Vineer Bhansali for “FAITH.”)

CNBC’s Steve Liesman asked Powell during the press conference if the inflation projections are to be interpreted as a lack of confidence by the FOMC that “not only can it not hit” its 2.0% goal “but that now it can’t hit its goal of being above 2.0%. Powell stammered in his initial response. Then, he blurted out that “this very strong, very powerful guidance shows both our confidence and our determination. It shows our confidence that we can reach this goal, and our determination to do so.” He certainly didn’t boost our faith in FAITH.

When Liesman asked Powell to clarify his response, Powell answered: “The economy will be below maximum employment, below full demand. And that will tend to wear, to put downward pressure on inflation. So we think that once we get up closer to maximum employment, we think that inflation will come back generally. … It’s a slow process, but there is a process there.”

We guess that means that the Fed hasn’t completely given up on the inverse relationship between the unemployment and inflation rates as posited by the Phillips curve model. The FOMC projections show, unemployment is expected to drop from 7.6% during 2020 down to 4.0% by 2023.

(3) Bolder employment mandate. The Fed is now more committed than ever to “maximum employment.” It was prioritized ahead of inflation in the Fed’s September 16 FOMC Statement. That was widely expected following the release of the Fed’s August 27 “Longer-Run Goals and Policy Strategy,” which we previously discussed in our September 2 Morning Briefing linked above. Powell reiterated during his press conference that maximum employment would not be defined by a rule, but a “whole range of things,” including labor force participation and wage growth. Nevertheless, Powell said that there is “a lot to like about” 3.5% unemployment. He followed that up by saying: “But the good news is we think we can have quite low unemployment without raising troubling inflation.”

(4) Desperately seeking fiscal assistance. In other words, the FOMC expects that it will take a long time to generate higher inflation, even with the powerful monetary stimulus and added fiscal stimulus combined. Powell said that FOMC participants generally were assuming further fiscal action in their projections. For all the stimulus, the FOMC’s projections arrive at a “longer run” growth rate in real GDP of just 1.9%. Yet, here are their latest projections for this year and over the coming three years along with their comparable projections at their June meeting: 2020 (-3.7% vs -6.5%), 2021 (4.0, 5.0), 2022 (3.0, 3.5), and 2023 (2.5).

In his opening remarks, Powell noted: “The path forward will also depend on the policy actions taken across all parts of the government to provide relief and to support the recovery for as long as needed.” During the Q&A, Powell elaborated: “As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid. Many borrowers are benefiting from these programs, as is the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer. In these cases, direct fiscal support may be needed.”

Later, he observed that “as the months pass … if there isn’t additional support and there isn’t a job for some of those people who are from industries where it’s going to be very hard to find new work, then that will start to show up in economic activity. It will also show up in things like evictions and foreclosures and, you know, things that will scar and damage the economy.”

(5) Market inflation expectations easing. Bond investors remain doubtful about a swifter pace of inflation too. A widely used proxy for the 10-year expected inflation rate is the nominal 10-year US Treasury bond yield minus the 10-year TIPS yield. It has remained below 2.0% since yearend 2018 (Fig. 8). Following the release of the Fed’s latest strategic policy update and Powell’s speech on August 27, the proxy rose to 1.73% and then hit a recent peak of 1.80% on August 31, but it fell back to 1.65% on September 11 and has remained around that rate to date (Fig. 9).

(6) A couple of dissenters. Dissenting votes are not all that common on the FOMC. But two Fed officials, FRB Governor Robert Kaplan and FRB Minneapolis President Neel Kashkari voted against the Fed’s latest action. Nevertheless, their viewpoints were rather nuanced. Regarding the dissenting views, Powell said during his press conference that they were “sort of on two sides of the discussion” around the Fed’s new framework.

Kaplan preferred to “retain greater policy rate flexibility” beyond when “the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals as articulated in its new policy strategy statement.” Yesterday, he explained that he is concerned about too low rates for too long creating financial imbalances and instabilities. Kashkari preferred that the FOMC wait to consider raising rates until core inflation, which typically runs at a slower pace than the headline, has reached 2.0% on a “sustained basis.”

Powell said that he welcomed the discussion and that “this is all about credibility. And we understand perfectly that we have to earn credibility.” We certainly agree with that!

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The Good with the Bad

September 21 (Monday)

US Economy I: Heaven on Earth. We didn’t know how good we had it in 2019. Then the pandemic hit in 2020, and we all concluded that it will take many years before life will be as good as it was in 2019. Perhaps we’re too pessimistic. After all, 2019 was better than we realized at the time; perhaps we’ll return to the good life sooner than we realize now. Let’s examine that notion, starting with how good it was in 2019, then considering how we might rebound to the good old days sooner than widely anticipated:

(1) Household income rose to record high in 2019. My attitude toward any data series that doesn’t support my story is that either it is flawed or it will be revised to support my story. That’s been my strongly held attitude toward median real household income, the annual series compiled by the Census Bureau and used to measure poverty in America. It’s been a big favorite with economic pessimists and political progressives in recent years because it confirmed their view that, for most Americans, the standard of living has stagnated for years.

My view has been that lots of other, more reliable indicators of income confirm that the standard of living has been improving for most Americans for many years. Now even the Census series confirms my story. So it’s back on the right track after misleadingly showing stagnation from 2000 through 2016 (Fig. 1). The median household series, which is adjusted for inflation using the CPI, is up 9.2% from 2016 through 2019 and hit new highs during each of the last three years (2017-19) after remaining flat from 2000 to 2016.

Also up over the past three years to new record highs are the Census series for median family (up 11.0%), mean household (10.7%), and mean family (12.5%) incomes. Almost everyone was doing better than ever before last year.

(2) Personal income data refute stagnation myth. While the Census data make more sense to me now, they still have lots of issues. Most importantly, the Census data are based on surveys asking a sample of respondents for the amount of their money income before taxes. So Medicare, Medicaid, food stamps, and other noncash government benefits—which are included in the personal income series compiled by the Bureau of Economic Analysis (BEA)—are excluded from the Census series. In addition, the BEA data are based on “hard” data like monthly payroll employment statistics and tax returns. BEA also compiles an after-tax personal income series reflecting government tax benefits such as the Earned Income Tax Credit.

The BEA series for personal income, disposable personal income, and personal consumption expenditures—on a per-household basis and adjusted for inflation using the personal consumption expenditures deflator (PCED) rather than the CPI—all strongly refute the stagnation claims of pessimists and progressives (Fig. 2). They’ve all been on solid uptrends for many years, including from 2000 through 2016, rising 25.1%, 27.9%, and 25.9%, respectively, over this period. They often rose to new record highs during this period. There was no stagnation whatsoever according to these data series. Instead, there was lots of growth!

The standard critique of using the BEA data series on a per-household basis is that they are means, not medians. So those at the very top of the income scale, the so-called “1- Percent,” in theory could be skewing both the aggregate and per-household data. That’s possible for personal income but unlikely for average personal consumption per household. The rich can only eat so much more than the rest of us, and there aren’t enough of them to substantially skew aggregate and per-household consumption considering that they literally represent only 1% of taxpayers, but almost 40% of the federal government’s revenue from income taxes, as discussed below.

(3) Real hourly wages belie stagnation myth too. Another data series that refutes the stagnation claim of pessimists and progressives is average hourly earnings (AHE), reported in the monthly employment report and reflected in the BEA income data. Adjusting it for inflation using the PCED shows that it soared during the second half of the 1960s through the early 1970s (Fig. 3). It then stagnated during the rest of the 1970s through mid-1995 as a result of what was then called “deindustrialization.” Since December 1994, it has been rising along a 1.2%-per-year growth path. That’s a significant growth rate in the purchasing power of consumers, as real AHE compounded to an increase of 37.2% from December 1994 through July of this year. That coincides with the High-Tech Revolution, which I’ve been writing about since 1993!

By the way, the hourly wage series I am using here is for production and nonsupervisory workers, which obviously doesn’t include the rich. Furthermore, these workers have accounted for between 80.4% and 83.5% of total payroll employment since 1964 (Fig. 4). So the real AHE series includes lots of working stiffs and isn’t distorted by the 1-Percent, let alone the top 20%-or-so of earners.

(4) The CPI is very misleading. It is well known that the CPI is upwardly biased, especially compared to the PCED (Fig. 5). Since January 1964 through July of this year, the CPI is up 838.5%, while the PCED is up 646.3%. As a result, while the PCED-adjusted AHE has been rising in record high territory since January 1999, the CPI-adjusted version didn’t recover to its previous record high during January 1973 until April 2020, which makes absolutely no sense (Fig. 6)! (An extremely flawed August 2018 study by the Pew Research Center concluded that Americans’ purchasing power based on the CPI-adjusted AHE has barely budged in 40 years!)

The Fed long has based its monetary policy decision-making on the PCED rather than the CPI. In my recently released book, Fed Watching for Fun & Profit, I observed: “A footnote in the FOMC’s February 2000 Monetary Policy Report to Congress explained why the committee had decided to switch to the inflation rate based on the personal consumption expenditures deflator (PCED).” Here is the full first footnote:

“In past Monetary Policy Reports to the Congress, the FOMC has framed its inflation forecasts in terms of the consumer price index. The chain-type price index for PCE draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures. Finally, historical data used in the PCE price index can be revised to account for newly available information and for improvements in measurement techniques, including those that affect source data from the CPI; the result is a more consistent series over time.”

(5) Adjusting for household and family sizes makes a difference. The fun of making fun of the funny-looking Census income data series continues when I adjust them for the average size of households and families in the US (Fig. 7 and Fig. 8). Both series have been on downward trends since the 1940s, especially the average size of households. Households have always been smaller than families, and earned less, since the former include single-person households, which have increased significantly in recent years because young adults have been postponing marriage and older folks have been living longer, resulting in more divorced and widowed persons.

Furthermore, data available since 1982 through 2019 show that the percentage of nonfamily households has increased from 25.1% to 35.7% over that period (Fig. 9 and Fig. 10). So there are more of these households that tend to earn less than family households. No wonder that the Census data adjusted for household size and for inflation using the PCED shows less stagnation and steeper uptrends since the start of the data (Fig. 11 and Fig. 12).

(6) The rich aren’t like you and me. What about the 1-Percent, who earn too much money, have too much wealth, and don’t pay their fair share of taxes? The total number of all the tycoons on Wall Street, in Silicon Valley, and in the C-suites of corporate America—including everyone with adjusted gross income (AGI) exceeding $500,000 a year—was 1.5 million taxpayers in 2017, exactly 1% of all taxpayers who filed returns that year, according to the latest available data from the Internal Revenue Service (IRS) (Fig. 13).

Collectively, during 2017 the 1-Percent paid $625 billion in income taxes, or 26.7% of their AGI. That amount represented 38.9% of all federal income tax paid by all taxpayers who paid any taxes at all (Fig. 14, Fig. 15, and Fig. 16). The rest of us working stiffs, the “99-Percent,” shelled out $980 billion, or 61.1% of the total tax bill. What should be the fair share for the 1-Percent? Instead of almost 40% of the federal government’s tax revenue, should they be kicking in 50%? Why not 75%? They would be less rich, but everyone else would be richer—unless the 1-Percent decide to work less hard or leave the country if they lose their incentive to keep creating new businesses, jobs, and wealth.

(7) Can you Trump this? Love him or hate him, the standard of living did increase significantly during Trump’s first term (until the pandemic hit), as it has done under many previous presidents, especially those who have championed pro-growth and pro-business policies, including tax cuts and deregulation.

(8) Editorial. Progressives continue to claim that government policies need to be more progressively focused on raising taxes and redistributing income. Until recently, they’ve relied on the Census income series to prove their point, though these measures clearly leave out the positive impact that past progressive policies have already had through Medicare, Medicaid, food stamps, tax credits, and other noncash government social benefits.

Progressives long have promised that their policies will create Heaven on Earth. Arguably, they have succeeded in doing so for many Americans with their New Deal, Great Society, and Obamacare programs. These programs have reduced income inequality by redistributing income, which has been growing faster than progressives concede thanks to America’s entrepreneurial spirit and capitalist system. Progressives, who never seem satisfied with the progress they have made, run the risk of killing the goose that lays the golden eggs to pay for their programs. Incomes can always be made equal by making everyone equally poor.

As confirmed by the latest available IRS data, there is no denying that the rich got richer during 2017 and earned more taxable income than ever before. They undoubtedly continued to do so during 2018 and 2019. But now even the Census data show that real median household income rose to a record high last year. Most Americans were more prosperous last year than ever before, though some more so than others. Why does anyone have a problem with that?

The bottom line is that just before the pandemic, American households enjoyed record standards of living. Income stagnation was a myth. Income inequality isn’t a myth but an inherent characteristic of free-market capitalism, an economic system that awards the biggest prizes to those capitalists who benefit the most consumers with their goods and services. Perversely, inequality tends to be greatest during periods of widespread prosperity. Rather than bemoaning that development, we should celebrate that so many households are prospering, even if a few are doing so more than the rest of us.

US Economy II: Housing-Led Rebound. So how do we bring back the good times once the pandemic is over? We may not have to wait that long. The pandemic has triggered a housing boom that could offset many of the ongoing woes in industries still plagued by the pandemic, such as restaurants and professional sports. De-urbanization is certainly weighing on urban economies, but suburban ones are booming because more and more city apartment dwellers are moving to homes in the burbs. Consider the following:

(1) Multi-family housing starts completely recovered from the Great Financial Crisis (GFC) by 2013 as demand for rental apartments boomed.

(2) Single-family housing starts also have recovered since the GFC but remain around their lows during the five homebuilding cycles prior to the GFC (Fig. 17). Single-family housing completions too are back only to previous troughs prior to the GFC (Fig. 18). During July, new single-family home sales rose to nearly match single-family completions for the first time on record, which goes back to 1968!

(3) The inventories of new homes for sale relative to new homes sold fell to previous record lows during July and is likely to make new lows in coming months (Fig. 19).

Movie. “Defending Jacob” (+ +) (link) is a mini-series drama on Apple TV+ about a 14-year-old boy who is accused of stabbing to death a fellow schoolmate who had been bullying him. It’s actually a bit of a psychological thriller. Chris Evans plays a respected assistant district attorney whose son Jacob, is accused of the murder. In the third episode, we discover that Jacob’s grandfather is serving a life sentence in prison for murder. This raises the possibility of using the “murder gene” defense. One study published in the Journal of Molecular Psychiatry in 2014 analyzed the genes of 895 Finnish criminals, and found that the majority of violent criminals carried the genes known as “MAOA” and “CDH13.”

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Transports Cruising Along

September 17 (Thursday)

Transports: Restocking the Shelves. Most transportation industries are on a roll thanks to the Covid-inspired surge in e-commerce and the more recent need for retailers to restock their shelves. The S&P 500 Transportation stock price index hit a new record high on Wednesday and is up 11.1% ytd through Tuesday’s close, almost twice the S&P 500’s 5.3% ytd return. But even that strong result vastly understates the recovery that most transport industries have enjoyed, as the S&P 500 Transportation index is being dragged down by the 42.1% ytd decline in the S&P 500 Airlines stock price index.

Other transportation industries have more than compensated for the nosedive in airlines. The S&P 500 Air Freight & Logistics stock price index has led the way, rising 40.7% ytd. Not far behind is the S&P 500 Trucking stock price index, up 37.0% ytd, and the S&P 500 Railroads stock price index, up 12.8% ytd. All three indexes are at or near record-high levels (Fig. 1).

Americans once again are proving that shopping is their favorite sport—and, thanks to e-commerce, closed malls won’t stop them. Let’s take a look at some of the broader economic data, then home in on Tuesday’s fiscal Q1 earnings report from FedEx, which beat consensus estimates by a longshot:

(1) Trading again. The transportation industry benefits when countries are playing nicely and international trade flourishes. The US/China trade spat followed by the Covid-induced shutdown of the global economy sank trade flows, and they’ve only started to recover in recent months. Real merchandise exports jumped 25.1% in July from their May bottom, while real merchandise imports jumped 16.1% over the same period (Fig. 2 and Fig. 3).

(2) Hitting the rails and the roads. The recent surge in trade and the revival of the US economy have boosted both rail and truck traffic. Total railcar loadings excluding coal and oil are up 14.8% from the June 13 week through the week of September 12, using the 12-week moving average (Fig. 4). And the ATA Truck Tonnage Index has bounced 7.4% from its May low, though it did dip slightly in July (Fig. 5).

Activity in the West Coast ports is so strong that news reports have characterized it with hyperbolic language like “bursting at the seams.” A September 10 WSJ article stated: “The Global Port Tracker report released Wednesday by the National Retail Federation and Hackett Associates said the preliminary estimate for August showed 2.06 million loaded containers, measured in 20-foot-equivalent units, hit U.S. shores last month, which would be the most in any month since the report was first published in 2002.”

The tight markets are forcing customers to pay up if they want their merchandise delivered inland. Trucking payrolls were up by 10,000 in August, the best monthly gain since August 2018, and wages were up 3.4% y/y in July (Fig. 6 and Fig. 7). Companies seem confident enough about the future to add capacity. Medium- and heavy-weight truck sales were up 30% in August from May’s low (Fig. 8).

(3) FedEx provides the latest datapoint. FedEx’s earnings for its quarter ending August 31 confirmed the heightened demand for domestic and international shipping. A crush of online deliveries as shoppers avoided physical stores during the Covid outbreak more than made up for any drop in business deliveries. FedEx’s revenue jumped 13.5% y/y, and adjusted operating income climbed 56.2%, in the quarter.

Spending that normally would have been on services has shifted toward spending on goods, said Brie Carere, FedEx’s chief marketing and communications officer on its September 16 conference call. And those goods were being purchased online and shipped, expanding the domestic market more quickly than FedEx had forecast. The company now expects a milestone to be reached three years faster than expected before Covid: 100 million packages shipped per day in the US by 2023.

Demand was strong enough that the company was able to pass on pricing increases, including peak surcharges. Operating margins expanded 2.4ppts to 8.5%. This earnings report proves wrong those who doubted the company’s ability to rebound after dropping Amazon as a customer in 2019.

Looking forward, the company is planning ahead for the holiday shipping season, which FedEx President Raj Subramaniam expects will “be a peak like none other.” The company is hiring 70,000 additional employees, opening up new facilities, and continues to offer Sunday delivery in an effort to handle peak deliveries. In addition, FedEx is preparing to distribute vaccines, a challenge given that they need to be transported at extremely low temperatures.

(4) Analyst forecasts. FedEx is a member of the S&P 500 Air Freight & Logistics industry, which is expected to see revenue grow by 6.1% this year and 4.8% in 2021 (Fig. 9). Its earnings, which are forecast to fall slightly this year, by -0.5%, are expected to grow by 14.8% in 2021 (Fig. 10). The industry’s forward P/E, at 20.7, is elevated relative to historical levels, but it should fall as earnings improve (Fig. 11).

The S&P 500 Railroads industry saw its earnings fall this year, but analysts are expecting a recovery in 2021. This year, the industry’s revenue is forecast to fall 11.9%, and earnings are thought to drop 11.0%. But next year, revenue is forecast to grow by 8.3% and earnings by 19.5% (Fig. 12 and Fig. 13). Much of this good news appears to be priced into the industry’s stock price index already, however, as its forward P/E is 21.1, a high for the past 25 years (Fig. 14).

The S&P 500 Trucking industry also trades at an elevated forward P/E valuation of 29.3, the highest in the past decade (Fig. 15). Analysts are expecting the S&P 500 Trucking industry’s financial results to rebound in 2021. Declines are expected for revenue growth (-1.2%) and earnings growth (-4.0%) this year, followed by leaps of 8.9% and 23.0% next year (Fig. 16 and Fig. 17).

Net earnings revisions for each of these three S&P 500 industries (Air Freight & Logistics, Railroads, and Trucking) turned positive in August for the first time in more than a year (Fig. 18, Fig. 19, and Fig. 20). But as we said earlier, much or all of the earnings optimism appears to be priced into these industry indexes’ forward P/Es, all at or near all-time highs.

Disruptive Technologies: Going Green To Explore the Seas. The shipping industry, which contributes up to 3% of the world’s greenhouse gases, is trying to go green. The International Maritime Organization (IMO) aims to cut greenhouse gas emissions by at least 50% from 2008 levels by 2050. Scientists and companies are experimenting with hydrogen, ammonia, and biofuels to propel ships. With assets that live for as long as ships do, the ability to change fuels quickly is important if IMO is to meet its goals.

Marine vessels will consume about 4% of global oil in 2020, or about 4.4 million barrels per day (mbd), according to a 2019 International Energy Agency report. The type of oil being consumed by ships is changing dramatically thanks to new IMO rules banning high-sulfur fuel oil this year. Shippers will either switch to low-sulfur oil alternatives or install scrubbers that take the sulfur out of emissions. If shippers stopped using oil to propel their ships, it would have an environmental impact but a small one compared to the impact that cars’ switching to electric batteries from gasoline would have. Cars consume about a quarter of oil used worldwide.

Here are some of the industry players’ efforts to wean ships away from crude oil:

(1) Ammonia: Zero emissions, but volatile. Norwegian shipping company Eidesvik and state-backed oil and gas company Equinor built the Viking Energy, a ship that runs on ammonia fuel cells, a March 29 FT article reported. When ammonia is burnt properly, it creates water and nitrogen. It has a high-energy density, almost twice as much as liquid hydrogen and nine times as much as lithium ion batteries.

There are undeniable downsides, however. Ammonia is toxic, so spills would hurt the environment, and improper burning can produce nitrous oxide. Also, producing ammonia takes a lot of fossil fuel, defeating the purpose of going green.

(2) Hydrogen fuel cells gaining adoption. Ferries are among the largest early adopters of hydrogen fuel cells. In Europe, the move toward this propulsion method is gaining steam so that ships can meet the Norwegian government’s regulatory requirements for a zero-emissions vessel area within the country’s fjords starting in 2026.

“There are 50 ferries [using hydrogen fuel cells] on order or under construction and [the number could] well be 100 in the next few years,” said an ABB executive quoted in a November 5, 2019 Riviera article. Within five years, these ships will make up “a significant” segment of the coastal fleet.

Separately, Norwegian Electrical Systems is developing a 3.2MW hydrogen fuel cell for a large vessel being designed for shipowner Havila, a February 3 article in Recharge reported. It would be the largest fuel cell ever put on a major ship, and batteries would store additional energy, making the system emissions-free.

“The liquid hydrogen will be supplied from a bunkering vessel or truck, and then stored on board of the cruise ship in a liquid hydrogen tank. To be used in the fuel cell, the liquid hydrogen will be converted into gas again,” the article stated. Linde and PowerCell are also involved with the project.

The International Council on Clean Transportation conducted a study in March 2020 that examined whether shipping containers could use hydrogen fuel cells to travel between China to the US. It concluded that 43% of the voyages could be made without changing the ship’s space allotted for fuel or the ship’s route. Another 56% of the voyages could be made using hydrogen fuel cells if an additional 5% of cargo space were allotted to holding additional hydrogen fuel and adding one refueling stop.

Barriers to using hydrogen fuel cells include the lack of fueling infrastructure (though all new fuel sources face that barrier), the higher costs involved compared to existing fossil fuels, and the fact that it takes energy to make hydrogen.

(3) Giving biomass a chance. ExxonMobil announced earlier this week a successful trial of its first marine biofuel oil with shipping company Stena Bulk. The fuel, which has very low sulfur content, can reduce CO2 emissions by up to 40% compared to conventional marine fuel, Exxon states.

The fuel was used in the ship’s existing engines, without any modifications or additional equipment, during normal commercial operations. Initially available in Rotterdam later this year, the fuel ultimately will be available across ExxonMobil’s port network.

Biofuels are typically created using waste produced by industries such as agriculture or farming, or by dedicated biofuel crops. Their broad adoption has been stymied by their higher costs to produce than traditional fuels. The fuel would need to be widely available to become a viable alternative.

“Concerns revolve around developing countries where using land for bio crops rather than edible food can aggravate existing food insecurity. Felling forests or turning grasslands into agricultural land can also undo the positive effects of biofuels by increasing greenhouse gas emissions,” an October 1, 2018 article in Ship Technology explained. ExxonMobil’s press release didn’t give the biofuel’s cost or describe how it was produced.

(4) Ships capturing carbon. Instead of finding a carbon-free fuel, Japanese operator Kawasaki Kisen Kaisha (K-Line) is exploring how it can capture the carbon its ships emit. It’s partnering with Mitsubishi Shipbuilding and ClassNK to develop a small-scale plant to capture CO2 on K-Line’s thermal coal carrier, Corona Utility. If the carbon can effectively and safely be captured and stored on the ships, the captured CO2 would be used in “enhanced oil recovery processes or as raw material in synthetic fuel through methanation,” a September 15 Riviera article reported.

(5) Time for a crazy idea. Much of shipping involves sending raw goods from Country A, where they come from, to Country B, where they are made into products, to Country C, where they’re consumed. So producing more of the world’s goods closer to their consumption point in Country C could significantly shorten the last leg of the journey, saving a lot of energy and reducing emissions.

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Inflation & the Pandemic

September 16 (Wednesday)

Strategy: Housekeeping. Before we launch into an analysis of inflation, we need to do some housekeeping. We are raising our estimate for real GDP and S&P 500 revenues and earnings. However, we are keeping our S&P 500 targets of 3500 for the end of this year and 3800 for the end of next year. We also need to correct a typo in yesterday’s advance copy of the Morning Briefing:

(1) GDP. Debbie and I are raising our estimate for Q3-2020 real GDP growth from 20% to 25% (saar) (Fig. 1). That follows a 31.7% drop during Q2. (See our YRI Economic Forecasts.) As we have previously observed, the major economic indicators on a monthly basis show that the unprecedented lockdown recession lasted just two months, and it was followed by a V-shaped recovery from May through the available data for August. On September 10, the Atlanta Fed’s GDPNow model estimated that real GDP rose 30.8% during Q3.

The surprising strength in the various US economic indicators is very apparent in the Citigroup Economic Surprise Index, which this year soared from a record low of -144.6 on April 30 to a record high of 270.8 on July 16 (Fig. 2). The index was down to 178.1 on Tuesday, still well above the zero line.

(2) S&P 500 revenues and earnings. Joe and I are raising our estimates a bit for S&P 500 operating earnings per share by $5.00 for this year and each of the next two years (Fig. 3). Here are our estimates compared to the analysts’ consensus estimates as of the September 10 week: 2020 ($125.00, $130.05), 2021 (155.00, 166.34), and 2022 (180.00, 189.25). (See our YRI S&P 500 Earnings Forecast.)

We are raising our revenues estimates moderately too, reflecting better-than-expected online sales for lots of businesses that provided this option to their customers (Fig. 4). Here are our revenues growth rates compared to the September 3 estimates of industry analysts: 2020 (-5.3%, -4.3%), 2021 (8.2, 8.1), and 2022 (5.2, 6.7). Here are the comparable profit-margin forecasts: 2020 (9.3%, 9.6%), 2021 (10.7, 11.3), and 2022 (11.8, 12.3) (Fig. 5).

As Joe reported yesterday, S&P 500 forward earnings continues to recover. By way of comparison, forward earnings plunged 36.8% following the Lehman debacle on September 15, 2008 and bottomed 34 weeks later. This time, it is down 21.0% since the World Health Organization (WHO) officially declared the pandemic on March 11, and it bottomed ten weeks later during the May 15 week (Fig. 6). It is up 10.5% since then through the September 10 week.

(3) Mag-5 and ETFs. In yesterday’s Morning Briefing, we reported: “According to the Investment Company Institute, ‘broad-based’ domestic equity ETFs had assets of $2.2 trillion during July. Even if they all together had 25% of their assets in the FAAMGs, they would only account for $550 billion, or 8% of the current $6.8 trillion market cap of the FAAMGs. This suggests that the remaining $6.2 trillion must be held in portfolios mostly managed by individual and institutional investors. This belies the widely held notion that the Mag-5 have flourished mostly as a result of passive investments by ETFs.” Our advance release incorrectly showed $1.7 trillion as the amount held in managed portfolios; the correct figure of $6.2 trillion adds even more validity to our conclusion.

However, one of our accounts was surprised by our conclusion because he was under the impression that 50% of assets are now passively managed. That was the gist of a March 19, 2019 CNBC article titled “Passive investing automatically tracking indexes now controls nearly half the US stock market.” According to the story: “Market share for passively managed funds has risen to 45 percent, up a full point from June 2018, according to data this week from Bank of America Merrill Lynch. That continues a trend over the past decade in which investors have moved to indexing, particularly through exchange-traded funds. At the beginning of the bull run, active had a nearly 3 to 1 advantage over passive in U.S. equity funds, according to Morningstar. That gap began to narrow significantly in 2012 and has come down sharply since.”

Now let’s examine data compiled by Investment Company Institute (ICI). During July, ICI reported that broad-based domestic equity exchange-traded funds (ETFs) had $2,210.7 billion in assets (Fig. 7). Domestic equity ETFs that focused on sectors and industries had another $427.5 billion, while global/international equity ETFs had $810.2 billion. ICI reported that domestic equity mutual funds had $8,324.1 billion in assets during July, while world equity mutual funds had $2,775.9 billion during the month (Fig. 8).

So total equity ETFs accounted for 23.7% of total equity ETFs plus equity mutual funds (Fig. 9). That’s well below 50%. What are we missing? We are looking for a data series tracking the assets of passively managed mutual funds indexed to the S&P 500. Stay tuned.

(4) 666 Again! As one gets older, one has a tendency to repeat stories that friends and family have heard many times before. Have you heard the one about how I turned bullish on stocks a few days after the S&P 500 fell to an intraday low of 666 on March 6, 2009? As I recounted in my book Predicting the Markets: “On March 16, 2009, I wrote: ‘We’ve been to Hades and back. The S&P 500 bottomed last week on March 6 at an intraday low of 666. This is a number commonly associated with the Devil. ... The latest relief rally was sparked by lots of good news for a refreshing change, which I believe may have some staying power. … I’m rooting for more good news, and hoping that 666 was THE low.’ That very same day, the bullish news included the Fed’s announcement that its QE1 bond-buying program would be expanded to $1.25 trillion in mortgage-related securities and $300 billion in Treasury bonds.”

I recently asked Mali to calculate the daily average of the 10-year US Treasury bond yield since March 23, when the Fed announced QE4ever. It was 0.674% through Monday (Fig. 10). That’s awfully close to 0.666%. I doubt that the bond yield will bounce off that level as fast as the S&P 500 bounced off 666.

Melissa and I expect that at his press conference today, Fed Chair Jerome Powell will reiterate the Fed’s intention to keep interest rates, including bond yields and mortgage rates, near current all-time lows. If the bond yield does start moving higher, the Fed will probably formally adopt “yield-curve control,” which is another way of saying that they will pick a tight range near zero (say 0.50%-0.75%) to which to peg the yield.

(5) New Topical Study. Yesterday, Joe and I announced that our new Topical Study, S&P 500 Earnings, Valuation & the Pandemic, is now available on our website. If you have the time and inclination, please have a look at it and send us your comments.

 Global Inflation I: From the 4-Ds to the 3-Ds? Here I go again, telling a story you might have heard before. In my book, I wrote: “At EF Hutton, I was an early believer in ‘disinflation.’ I first used that word, which means falling inflation, in my June 1981 commentary titled ‘Well on the Road to Disinflation.’” I’ve been a disinflationist ever since. Along the way, I’ve often discussed the “4-Ds,” the deflationary forces that keep a lid on inflation. They are détente (a.k.a. globalization), disruption (attributable to technological innovations), demography (with aging populations), and debt (as in too much of it). (See my Four Deflationary Forces Keeping a Lid on Inflation, excerpted from my other book, Fed Watching for Fund & Profit.)

The question is whether nationalism is making a comeback at the expense of globalization as a result of Trump’s trade wars during 2018 and 2019 and now the pandemic. These events have caused company managements around the world to consider reshoring their supply chains, which would be expensive and reduce competition, putting upward pressure on inflation.

That’s possible. But it’s also possible that technological innovations in robotics, automation, artificial intelligence, and 3-D manufacturing will allow companies to bring their supply chains back home, increasing their productivity more than the increase in their costs of doing so. In other words, technological innovation could offset any inflationary pressures resulting from less globalization.

Just as important is that aging demographic profiles around the world remain very deflationary. Many years ago (here I go again), I developed a simple “Age Wave Model” showing a strong correlation between the percentage of the labor force that is relatively young, i.e., 16–34 years old, and the five-year trends in both CPI inflation and the bond yield (Fig. 11 and Fig. 12). That model remains disinflationary. Demographic profiles are turning increasingly geriatric around the world, helping to keep a lid on global inflation.

Global Inflation II: Modern Monetary Theory in Practice. Of course, the big worry is that the extraordinarily stimulative and rapid responses of fiscal and monetary authorities to the pandemic will revive inflation, especially once the pandemic is over. Governments around the world seem to have embraced Modern Monetary Theory (MMT) ever since the WHO officially declared the pandemic on March 11. The simple notion is that governments must spend as much as necessary to reduce the economic pain caused by the pandemic and that central banks should help to finance the resulting massive fiscal deficits, as long as inflation remains subdued.

In the US, the 12-month federal budget deficit has ballooned to $2.92 trillion over the past 12 months through August, while the Fed’s holdings of Treasury securities is up $2.29 trillion y/y through the September 9 week (Fig. 13). Both swelled after the Fed adopted QE4ever on March 23 and the President signed the CARES Act on March 27.

As a result, the widely followed proxy for the 10-year expected inflation rate jumped from a recent low of 0.50% on March 19 to 1.67% on Tuesday (Fig. 14). It is simply the yield spread between the 10-year US Treasury bond and the comparable TIPS (Treasury inflation-protected securities).

Arguably, both Japan and China have been well ahead of the US and other countries in embracing MMT. Both have engaged in enormous rounds of fiscal spending , financed in Japan by the central bank and in China by state-owned commercial banks. Yet inflation remains subdued in both countries.

 US Inflation: Pandemic Pandemonium. The Federal Reserve Open Market Committee (FOMC) met yesterday and again today for the first time since Fed Chair Powell announced the FOMC’s new approach to inflation targeting, which Melissa and I discussed in detail in our September 2 Morning Briefing. Essentially, the FOMC formally will allow inflation to overshoot its 2.0% inflation goal to “make-up” for past inflation misses until it feels that inflation is well anchored at its target.

More importantly, the Fed has prioritized its mandate to promote maximum employment. The unemployment rate remains extremely high, largely owing to the pandemic and associated lockdowns. We certainly don’t expect that the Fed will make any major changes to policy based on the latest inflation results, which remain subdued.

Nevertheless, interesting pandemic-related pockets of inflation can be found in areas of the US economy, as Randall Forsyth discussed in a recent Barron’s article. But these trends may not be all that meaningful for the long term if a vaccine becomes available and the trends reverse. Dramatic Covid-related spending shifts may have caused the headline data to be less meaningful too. Consider the following:

(1) Tracking a faster pace. The headline CPI was up 1.3% y/y in August, which was higher than July’s 1.0% increase (Fig. 15). The core CPI increase was 1.7% versus July’s 1.6% rate. On a three-month basis, the headline and core CPI rose 6.1% and 5.0% (saar), the fastest pace since August 2008 and March 1991, respectively.

(2) Autos driving inflation. Used automobile prices jumped by 4.0% y/y (Fig. 16). Used car prices are likely up because demand has increased. Also, inventories are low because auto factories were shut in April by the lockdowns. The demand for cars has increased because urban families have been moving to less-populated suburbs and people have been avoiding public transportation, as we discussed in the September 8 Morning Briefing.

(3) Covid spending shifts. After accounting for changes in consumers’ spending during the pandemic, significantly higher rates of overall and core CPI were found by a National Bureau of Economic Research working paper by Alberto Cavallo of the Harvard Business School. He observes: “The difference is significant and growing over time, as social-distancing rules and behaviors are making consumers spend relatively more on food and other categories with rising inflation, and relatively less on transportation and other categories experiencing significant deflation.”

The Labor Department’s standard methodology for calculating inflation involves comparing prices on baskets of goods and services. Changing weightings of the baskets occurs annually, which is sufficient under normal circumstances. But during the pandemic, certain baskets have had a more substantial impact on consumer budgets, as observed an 9/11 NPR article discussing the same Harvard Business School study.

A 9/14 Barron’s article highlighted that there has been a recent massive shift in the way that Americans spend money. As of July, it noted, Americans have spent much more on durable goods—including cars, appliances, and furniture—than prior to the pandemic and much less on services (Fig. 17). It added: “Since 1959, when the monthly data begin, there has never been a bigger divergence in the growth rates of spending for those two categories.”

(4) Groceries bills rising. For example, shifts in spending have been seen in consumer’s food habits, with more dining at home versus eating out. Even though grocery prices have fallen during the post-lockdown months, the cost of food eaten at home is still 4.6% higher than the same time last year. One reason, NPR pointed out, is that the pandemic has changed shopping habits: Many people opt to run in and out of a single store now instead of hitting the sales of multiple stores to limit social contact.

A significant drop in the pace of tenant rent price increases can also be chalked up to the pandemic, as many cost-burdened lower-income renters would be even harder pressed to make rent payments if they continued rising at the pre-pandemic pace (Fig. 18). Indeed, many landlords are still waiting for their tenants to pay their rent.

(5) Dispersion in price changes. Economists at the Federal Reserve Bank of San Francisco estimate that the recent dispersion in price changes is another consequence of the disruption caused by the pandemic. The unusually great shifting of consumer spending among spending categories—both up and down—is near its highest level in over 10 years, noted the 9/14 Barron’s. Some examples cited in the article show that from February to August, the price of college tuition and fees grew at the slowest pace on record, airfares have declined 23%; and appliance prices have increased at a record 6.5%.

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The Magnificent Five Now & Then

September 15 (Tuesday)

Strategy I: S&P 500 Primer. Joe and I often receive requests to explain why we prefer to use forward earnings in our work. That led us to write our latest Topical Study, S&P 500 Earnings, Valuation & the Pandemic: A Primer for Investors. We intend to publish it as another book in my series on “Predicting the Markets,” available on my Amazon homepage. We would welcome any comments before we go to press with our latest study. Here is a brief description of our forthcoming book:

“In this unique primer, Edward Yardeni and Joseph Abbott, two of the world’s most experienced and widely followed investment strategists, provide investors with a practical understanding of the forces that drive the stock market. This study focuses on the S&P 500 stock price index, examining how it is determined by the earnings of the 500 companies that are included in the index and the valuation of those earnings by the stock market. Notwithstanding occasional bear markets, the S&P 500 has been a great investment over the years—so much so that ‘S&P’ could stand for ‘Success & Profit.’

“The first chapter in this study covers the various measures of earnings for the S&P 500 and why we favor forward earnings among them. The second chapter discusses various models of valuation, again focusing on the S&P 500. The final chapter uses the resulting analytical framework to review how it has worked in good times and bad, focusing on the Great Financial Crisis and the Great Virus Crisis.

“The market discounts analysts’ consensus estimates for revenues and earnings this year and next year on a time-weighted basis. Calculating weekly forward revenues and forward earnings from analysts’ estimates can provide very timely insights into the performance of the global economy as well as the underlying trends in quarterly revenues and earnings.

“While this framework provides a disciplined approach to analyzing the macroeconomic fundamentals that are driving earnings, the valuation of those earnings by investors will continue to be much more subjective than objective. Nevertheless, there are fundamental factors that influence valuation multiples. Some, like inflation and interest rates, will always be important in assessing the valuation question. Other factors may be relatively new and worthy of careful analysis.”

Strategy II: US vs. Them. Yesterday, Joe and I reviewed the impact of the Magnificent Five (“Mag-5” for short) stocks on the three major investment styles: LargeCap-vs-SMidCap, Growth-vs-Value, and Stay-Home-vs-Go-Global. Today, we would like to continue our analysis. Currently, the Mag-5 are the FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google). By market-cap size on Friday, the acronym would be “AAMGF”: Apple ($1.9 trillion), Amazon ($1.6 trillion), Microsoft ($1.5 trillion), Google ($1.0 trillion), and Facebook ($0.8 trillion).

On Friday, the Mag-5 accounted for 24.7% of the market capitalization of the S&P 500, down from a record high of 27.2% on September 2, when the S&P 500 hit its latest record high (Fig. 1). The FAAMGs’ collective market-cap share well exceeds the peak 18.5% share of the Mag-5 during the week of March 24, 2000. Back then, the Mag-5 were the MCGIX stocks (Microsoft, Cisco, GE, Intel, and Exxon).

Joe created the Mag-5 market-cap series, which starts in 1993 (Fig. 2). We can use it to assess the extent to which the Mag-5 have outperformed and underperformed various US stock market indexes as well as foreign ones. Consider the following:

(1) LargeCap vs SMidCap. The Mag-5 collectively have outperformed the S&P 500 since the start of 2017. A case can be made that their outperformance since then has been attributable to President Donald Trump moving into the White House at the same time. We are inclined to see that as a coincidence. While Trump has championed reducing regulations on business in general, he often has said that the big-cap Internet companies should face more, not less, regulation. He has been particularly troubled by their dominance of social media.

In any event, the market cap of the Mag-5 is up 193.8% since the start of 2017 through Friday’s close, while the S&P 500 stock price index is up 43.4% with them and 22.8% without them (Fig. 3). Since the start of 2017, the Mag-5 also have handily outpaced the Nasdaq (which includes all five of them), the S&P 400 MidCaps, and the S&P 600 SmallCaps (Fig. 4 and Fig. 5).

Here is the performance derby of the Mag-5 and the major US stock price indexes since the start of 2017 through Friday’s close: FAAMG (193.8%), Nasdaq (101.6), S&P 500 (43.4), S&P 500 ex-FAAMG (22.8), S&P 400 (11.7), S&P 600 (2.9), and S&P 500 Equal-Weighted (25.9).

Now let’s do the same comparison since the start of the bull market on March 9, 2009 through Friday’s close: MAG-5 (647.7%), Nasdaq (755.5), S&P 500 (393.8), S&P 400 (358.4), S&P 600 (374.1), and S&P 500 Equal-Weighted (325.5) (Fig. 6).

(2) Growth vs Value. Since 2017, the Mag-5 clearly have outperformed the S&P 500 Value index and also have outperformed the S&P 500 Growth index, which includes them all (Fig. 7). Here is the performance derby since 2017 through Friday’s close: FAAMG (193.8%), S&P 500 Growth (88.0), and S&P 500 Value (12.0) (Fig. 8).

(3) Stay Home vs Go Global. During most of the bull market since 2009, Joe and I have been recommending a Stay Home (SH) versus a Go Global (GG) investment strategy. We remain in the SH camp, but we have to acknowledge that the success of that approach, especially since 2017, has had a lot to do with the outperformance of the Mag-8 on a global basis. We’ve been monitoring the SH/GG relative performance using the ratio of the US MSCI stock price index divided by the All Country World ex-US MSCI stock price index in both dollars and local currencies (Fig. 9). It’s been no contest.

Here’s the performance derby for the major MSCI stock price indexes since March 9, 2009 through Friday’s close in dollars and in local currencies: US (398.9%), EMU (98.2, 111.7), Japan (112.0, 127.7), UK (50.7, 62.2), and Emerging Markets (125.0, 149.1) (Fig. 10). (See our chart publication S&P 500 Sectors & MSCI Indexes During Bull Markets.)

Here's the comparable performance derby since 2017 through Friday’s close in dollars and in local currencies: US (51.2%), EMU (14.8, 2.4), Japan (19.2, 8.5), UK (-15.5, -18.3), and Emerging Markets (26.6, 31.0). Over this same period, the market cap of the Mag-5 is up 193.8%, while that of the S&P 500 ex-Mag-5 is up 22.8%. In other words, Mag-5 has accounted for much of the outperformance of Stay Home since 2017.

(4) ETFs. It’s widely recognized that the Mag-5 are widely over-owned. After all, they account for a quarter of the market cap of one of the most widely owned portfolios of stocks in the world, namely the S&P 500. It’s the most “crowded trade” in history. It’s widely believed that contributing to this development in recent years has been the proliferation of exchange-traded funds (ETFs). The largest ones tend to track the S&P 500. For example, SPDR S&P 500 has $295.7 billion under management. Vanguard S&P 500 ETF currently has total assets of $560.0 billion. The top five holdings of all such funds are obviously the Mag-5.

According to the Investment Company Institute, “broad-based” total domestic equity ETFs had assets of $2.2 trillion during July (Fig. 11). Even if they all together had 25% of their assets in the FAAMGs, they would only account for $550 billion, or 8% of the current $6.8 trillion market cap of the FAAMGs. This suggests that the remaining $6.2 trillion must be held in portfolios mostly managed by individual and institutional investors. This belies the widely held notion that the Mag-5 have flourished mostly as a result of passive investments by ETFs.

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What in the World Is Going On?

September 14 (Monday)

Global Economy: Global Economic Warming. There has never been a recession like the one that hit the global economy earlier this year. It was truly global because every country in the world experienced an economic downturn as almost all governments around the world responded to the pandemic by imposing lockdown restrictions to slow the spread of the virus. China (in late January) and Italy (in early March) did so before the World Health Organization (WHO) officially declared the pandemic on March 11. Almost everyone else followed suit immediately after the WHO declaration. While the pandemic continues to plague the world with new outbreaks and waves of infection, the global economy has recovered in recent months. Let’s take a world tour to assess the strength and sustainability of the recovery:

(1) Global PMIs and leading indicators. It’s been a V-shaped recovery according to the global PMIs (purchasing managers indexes) for both advanced and emerging economies as well as for both manufacturing and non-manufacturing around the world (Fig. 1 and Fig. 2). The global composite PMI—which combines the global manufacturing indexes (M-PMIs) and non-manufacturing indexes (NM-PMIs)—rebounded from a record low of 26.2 during April to 52.4 during August, the best reading since March 2019. That’s certainly a V-shaped recovery.

Not surprisingly, leading on the way down and on the way up was the NM-PMI for advanced economies. As a result of social distancing, this has been the first-ever global recession led by services-producing industries. It hit the global economy hard during March and April. The gradual easing in lockdown restrictions led to a solid rebound in both non-manufacturing and manufacturing industries since the April bottom.

The index of OECD leading indicators confirms the V-shaped recession and recovery for the advanced economies. It plunged from 99.4 during January to a record low of 93.2 during April, and rebounded to 98.3 during August (Fig. 3). Here are the three readings for January, April, and August for the US (99.3, 92.6, 97.6), Europe (99.5, 90.7, 98.3), and Japan (99.5, 98.3, 98.9). The OECD also compiles leading indicators for the BRIC countries. Here are their three readings for January, April, and August: Brazil (103.1, 93.3, 100.4), China (98.1, 94.9, 98.8), India (100.1, 87.1, 97.1), and Russia (99.7, 91.0, 98.7) (Fig. 4).

(2) Global production and exports. So far, we have data only through June for global industrial production and world exports (Fig. 5). They both show steep declines from December through April of 13.0% and 18.2%, respectively, and have rebounded 5.7% and 8.0% since then, through June.

The most current, and among the most relevant, export series for gauging the global economy is the one reported by China. The data we track are seasonally adjusted and available through August. Chinese exports (in yuan) plunged 42.1% from January through February, then rebounded through July to a record high; it dipped slightly in August, though still exceeded January’s reading by 9.1% (Fig. 6). That’s impressive.

(3) Commodity prices. Also impressive is the rebound in the CRB raw industrials spot price index, led by the price of copper (Fig. 7). Since March 23—when the Fed announced its policy response to the pandemic, which we call “QE4ever”—through last Friday, the former is up 10%, while the latter is up 43%. The price of copper has rebounded from a low of $2.12 per pound on March 23 to $3.03 on Friday, holding near September 4’s $3.05, which was the best reading since June 20, 2018, i.e., when Trump started to escalate his administration’s trade wars.

Debbie and I created a Global Growth Barometer (GGB), which simply averages the CRB index of industrial commodity prices with the price of a barrel of Brent crude oil (Fig. 8). It is very similar to the S&P Goldman Sachs Commodity Index (GSCI), which gives energy commodities a combined weight of 61.71%; that compares with the 50.00% weight that our GGB gives to oil. Last week, the price of oil dropped a bit on concerns about a slowdown in the global economic recovery, which hasn’t been confirmed by either the CRB index or the price of copper. Our GGB and the GSCI are up 19% and 29%, respectively, since March 23.

(4) Currencies. By the way, there continues to be a strong inverse correlation between commodity price indexes (using either our GGB or the GSCI) and the trade-weighted dollar (TWD) (Fig. 9). The relationship between the dollar and commodity prices is quite a bit easier to see on a chart than the relationship between the dollar and US fiscal and monetary policies relative to those of other major economies.

The TWD has dropped 7.5% since peaking this year on March 23. That coincided with the rebound in our GGB. It also nearly reverses the 9.4% surge in the TWD since the start of this year through its recent peak, which coincided with the pandemic-related plunge in commodity prices.

We’ve often observed that the dollar tends to weaken when overseas economies are showing strength relative to the US economy. Rising commodity prices suggest that’s the case relative to countries that are commodity producers. The inverse correlation between the dollar and commodity prices is partly attributable to the strong correlation between commodity prices and the currencies of commodity-producing countries such as Australia and Canada (Fig. 10).

China’s economy fell into the pandemic-related recession earlier this year before the US did the same, and China’s recovery started a couple of months sooner than the recovery in the US. China also seems to have made more progress in ending the spread of the virus than elsewhere in the world. That helps to explain why the Chinese yuan is up 4.7% since May 28 through Friday (Fig. 11).

For a few weeks during the summer, it seemed that Europeans were also making more progress in dealing with the pandemic than have Americans. That explains some of the 9.8% bounce in the euro since May 7 through Friday (Fig. 12). But now that Europeans are returning from their long summer vacations, another wave of infection is hitting Europe.

However, the euro may continue to benefit from the perception that the pandemic has reduced, rather than increased, the likelihood of the disintegration of the European Union (EU) and the Eurozone. On July 20, the 27 EU governments reached a breakthrough agreement authorizing the European Commission, the executive branch of the EU, to raise €750 billion to provide grants and loans to help member countries cover the costs of dealing with the pandemic.

This deal marks a precedent for common debt borrowing at the EU level, something that many countries, including Germany, opposed for a long time. But this oppositional stance had softened in the wake of the COVID-19 crisis.

(5) S&P 500 Materials. Among the biggest losers in the S&P 500 during the 33.9% bear market from February 19 through March 23 were companies in the Materials sector, which fell 36.4% at the same time (Fig. 13). Since March 23, the sector is up 68.9% through Friday’s close. It held up well last week, edging up 0.8%, while the S&P 500 fell 2.5% led by a 4.4% drop in the Information Technology sector (Fig. 14).

Here’s the performance derby for the major industries in the Materials sector since March 23: Copper (201.8%), Diversified Chemicals (108.4), Commodity Chemicals (86.2), Specialty Chemicals (74.6), Industrial Gases (67.9), Steel (61.6), and Gold (59.0). That’s obviously a vote of confidence in the outlook for the global economy.

Strategy: Style Rotation? All of the above suggests that the selloff in the S&P since the September 2 record high is more about a valuation rotation out of the Magnificent 5 stocks rather than an impending recession. The five largest stocks in the S&P 500 by market capitalization are still the FAAMGs (Facebook, Amazon, Apple, Microsoft, and Google). They’ve had an overwhelming influence on the three investment styles. Consider the following recent developments:

(1) LargeCap vs SMidCap. On September 2, the collective market capitalization of these five stocks was $7.8 trillion, accounting for 27.2% of the total market cap of the S&P 500 (Fig. 15). On Friday, their combined market cap had lost $1.0 trillion, falling to $6.8 trillion but still accounting for a hefty 24.7% of the S&P 500.

The five certainly have had a significant impact boosting the performance of the S&P 500 LargeCaps relative to the SMidCaps since the March 23 stock market bottom this year. Here is the performance derby of the FAAMGs and the major US indexes since then through September 2: FAAMGs (89.8%), Nasdaq (75.7), S&P 500 (59.6), Equal-Weighted S&P 500 (58.1) S&P 500 ex-FAAMGs (51.0), S&P 400 (61.4), and S&P 600 (54.5) (Fig. 16).

Here is the performance derby of the same indexes since September 2 through Friday’s close: FAAMGs (-12.7%), Nasdaq (-10.0), S&P 500 (-6.7), Equal-Weighted S&P 500 (-4.5), S&P 500 ex-FAAMGs (-4.6), S&P 400 (-5.7), and S&P 600 (-6.3).

Here are the forward P/Es of these indexes on September 2 and on Friday: FAAMGs (64.6, 55.6), S&P 500 (23.2, 21.5), S&P 500 ex-FAAMGs (19.2, 18.0), S&P 400 (20.3, 19.0), and S&P 600 (21.9, 20.3).

(2) Growth vs Value. We know that all the FAAMGs are included in the S&P 500 Growth index. We also know that on Friday, Amazon accounted for 49.4% of the Consumer Discretionary sector, Apple and Microsoft accounted for 45.6% of the Tech sector, while Facebook and Google accounted for 58.9% of Communication Services.

Here is the performance derby for the relevant indexes from March 23 through September 2 and since then through Friday: FAAMG (89.8%, -12.7%), Growth (73.1, -8.6), and Value (42.7, -3.6). Here is the same for the S&P 500 sectors: Communication Services (56.7, -8.4), Consumer Discretionary (79.8, -6.7), Consumer Staples (36.7, -3.3), Energy (45.3, -7.4), Financials (44.0, -3.2), Health Care (46.2, -4.5), Industrials (63.4, -2.9), Information Technology (80.2, -11.1), Materials (72.1, -1.9), Real Estate (44.5, -3.9), and Utilities (34.1, -2.6).

Here are the forward P/Es of the following indexes at the market’s record high and at the end of last week: FAAMG (64.6, 55.6), Growth (30.2, 27.1), and Value (17.4, 16.4).

(3) Stay Home vs Go Global. Some of the outperformance of the S&P 500 on a global basis has been driven by the FAAMGs in recent years. Since the start of 2015 through the September 2 close, Stay Home has outperformed Go Global and underperformed since then as follows: FAAMG (345.7%, -12.7%), S&P 500 (59.6, -6.7), US MSCI (76.2, -7.0), S&P 500 ex-FAAMGs (51.0, -4.6), All Country World ex-US MSCI (9.9, -1.5 in dollars; 15.4, -1.1 in local currencies).

Here are the relevant forward P/Es on September 2 and on Friday: FAAMG (64.6, 55.6), S&P 500 (23.2, 21.5), S&P 500 ex-FAAMGs (19.2, 18.0), All-Country World ex-US (17.0, 16.3). As we’ve previously observed, both the stock price performance of the MSCI indexes and the valuations of foreign stocks have been closer to the comparable series for the US excluding the Magnificent 5. If the Mag5 continue to underperform for a while, then Go Global could outperform Stay Home for a while too.

Epidemiology: The Virus Is Still Out There. All of the above suggests that the global economy has recovered nicely from the lockdown recession once government-mandated social-distancing restrictions were gradually lifted since April. The problem is that we haven’t fully recovered from the pandemic yet. As noted above, Europeans mingled during their summer vacations and started new outbreaks and waves in their communities when they returned home. In the US, college students are mingling in college towns and starting new outbreaks.

On Friday, USA Today reported: “Of the 25 hottest outbreaks in the U.S., communities heavy with college students represent 19 of them. … The super-spreading nature of the coronavirus is stretching the abilities of universities to quarantine students and halt the virus' progress, leading to drastic consequences.” Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, and Dr. Deborah Birx, head of the White House coronavirus task force, both have said that sending students home could further spread the virus.

On August 26, French President Emmanuel Macron called on citizens to learn to live with the coronavirus after infections spiraled higher in recent weeks. Ruling out another lockdown, he tweeted, “To overcome the health crisis, we must learn to live with the virus.” To do so, French health officials have adapted by quickly moving to extinguish local outbreaks and tightening restrictions as needed. The goal is to prevent local clusters from spiraling out of control and pushing France again into a national lockdown.

Back in the US, Fridays’ Houston Chronicle ran an interesting interview with Dr. Peter Hotez, a professor and dean of the National School of Tropical Medicine at Baylor College of Medicine and co-director of the Texas Children’s Hospital Center for Vaccine Development. He is one of the rare experts who has appeared frequently on both Fox News and MSNBC. But recently, he abandoned his policy of not criticizing the White House. Here are some of the key points he made in his interview:

(1) Phase 3. According to Dr. Hotez, it’s very unlikely that a vaccine will be ready for widespread distribution until sometime during the first half of next year. There are a dozen vaccines in clinical trials, and four to five are moving into Phase 3 testing just now. The three funded by the Trump administration’s “Operation Warp Speed” (OWS) are among those that moved into Phase 3 during July and August. But it will take time to enroll 30,000 volunteers, and they will require two doses, with the second one during late September or early October.

(2) Results. Dr. Hotez said, “Remember, we have absolutely zero evidence that any of these vaccines work.” He projects that we won’t have enough data on whether the OWS vaccines are effective until November or December. If they work and are safe, “we can start rolling them out to the public by, at the earliest, the end of this year, or maybe the beginning of 2021.”

By the way, last Tuesday, the chief executives of nine drug companies pledged not to seek regulatory approval before the safety and efficacy of their experimental coronavirus vaccines have been established in Phase 3 clinical trials. Their statement was clearly aimed at countering President Trump’s push to have a vaccine ready before Election Day.

(3) Emergency use. Dr. Hotez explained, “If the FDA releases a vaccine under Emergency Use Authorization, it’s not really approval. It’s a substandard, lesser review process. In that case, to draw conclusions, I would have to see the Phase 3 data myself. I have no idea whether or not the companies will release that data to the public or people like myself.” By the way, Dr. Hotez isn’t a fan of OWS because it’s “basically letting the pharma companies dictate the message. That’s not wise: It’s letting the fox guard the hen house.”

(4) The Russian fix. The doctor observes that the Russian vaccine (“Sputnik V”) has only gone through Phases 1 and 2. It’s been sent to Venezuela and Nicaragua, essentially for Phase 3 trials on people who aren’t Russians.

(5) Durability of protection. Any vaccines approved by the FDA will probably require two doses to fully immunize a person, according to the doctor. He adds, “There’s a lot of precedent for that. But then whether you need to be boosted the following year and every year after that, or whether you need to be just boosted once every five years, that’s a total unknown.

“When we say the vaccine offers ‘protection,’ does that mean protection that reduces severity of illness or disease, or is it protection against the actual infection, protection that could interrupt transmission and spread of the disease? All those things are unknown.”

(6) Lab rats. Dr. Hotez wasn’t asked about, and didn’t offer a theory for, the origin of COVID-19. However, Friday’s NY Post features an article titled “Chinese virologist claims she has proof COVID-19 was made in Wuhan lab.” Dr. Li-Meng Yan, a virologist who says she did some of the earliest research into COVID-19 last year, accused Beijing of lying about when it learned of the killer bug and engaging in an extensive cover-up of her work. In April, Yan reportedly fled Hong Kong and escaped to America to raise awareness about the pandemic. Yuan Zhiming, the director of the Wuhan Institute of Virology, has previously denied reports that the bug accidentally spread from his facility.

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Survival of the Fittest In Retailing

September 10 (Thursday)

Strategy: Fast and Furious. Could that be it? Could the market selloff be over after just three days? The S&P 500 surged by 67 points on Wednesday after losing 249 points over the prior three trading sessions (Fig. 1). The selloff certainly looked like a valuation correction, with some of the best-performing tech stocks ytd hit hardest and the economically sensitive laggards outperforming. Let’s take a closer look at how the S&P 500 industries and sectors performed from last Wednesday’s close through Tuesday’s close, during which time the S&P 500 dropped by 7.0%:

(1) Not all defensive. Usually big market selloffs send investors running to defensive areas that have steady earnings during good times and bad. While the S&P 500 Utilities sector was the top performer over the recent three-day selloff, other cyclical sectors also turned in surprisingly strong performances. While all sectors fell, the Industrials, Financials, and Materials sectors were among the top performers.

Here’s the performance derby for the S&P 500 sectors during the three-day selloff: Utilities (-2.4%), Real Estate (-3.4), Financials (-3.4), Consumer Staples (-4.1), Industrials (-4.5), Materials (-4.7), Energy (-4.7), Health Care (-5.1), Consumer Discretionary (-6.9), S&P 500 (-7.0), Communication Services (-7.5), and Information Technology (-11.4) (Table).

(2) Consumer industries’ top performers. Along the same lines, the top-performing industries during the correction give little indication that the economy is in trouble. Many consumer-related industries posted positive returns over the three-day swoon, though you’d never guess it by looking at the S&P Consumer Discretionary sector. The sector fell -6.9% over the three days, dragged down by Amazon. Without the Internet retailer, the Consumer Discretionary sector would have dropped just 2.0%.

Here are the 10 top-performing S&P 500 industries during the market selloff: Department Stores (5.6%), Specialized Consumer Services (4.3), Airlines (3.3), Automobile Manufacturers (3.2), Hotels, Resorts & Cruise Lines (2.3), Hotels & Resort REITs (1.9), Apparel, Accessories & Luxury Goods (1.7), Broadcasting (1.2), Retail REITs (1.2), and Housewares & Specialties (0.9). Not far behind are Home Furnishings (-1.9), Diversified Banks (-1.9), Casinos & Gaming (-2.1), and Construction Machinery & Heavy Trucks (-2.3).

(3) Tech rotates to the back of the line. And as you’d expect, the technology-related industries that had led the market for most of the year got hit the hardest during the selloff. Over the three-day period, the S&P 500 Information Technology sector’s forward P/E fell to a six-week low of 25.1 from 28.7.

Here are the S&P 500 industries that sold off hardest during the correction and how they’ve performed ytd through Tuesday’s close: Semiconductor Equipment (-16.3%, -3.2%), Technology Hardware, Storage & Peripherals (-13.8, 47.3), Application Software (-12.5, 36.1), Systems Software (-12.0, 27.6), Internet Services & Infrastructure (-11.6, 9.8), Electronic Equipment & Instruments (-11.1, -11.0), Interactive Media Services (-10.9, 21.0), Semiconductors (-10.8, 17.4), Internet Direct Marketing Retail (-10.3, 60.8), and Interactive Home Entertainment (-9.6, 23.8).

Consumer Discretionary: Who’s Left in Retailing? As you can tell by walking through nearly any mall in America, retailers are filing for bankruptcy protection at an unprecedented pace, hurt by recent COVID-19-related shutdowns and continued depressed demand for clothing given social distancing by most and the financial struggles of many. Catching our eye are the growing number of outright retail liquidations and store closures. After years of being overstored, could enough capacity and capital finally be exiting the retail industry that the remaining players have a fighting chance at survival? Macy’s CEO Jeff Gennette said on the company’s Q2 earnings conference call: “With many competitors closing or struggling, we see the potential to bring new customers into our brands and gain market share.”

Look closely at retail sales charted in Fig.2: In-store and online sales in department stores and all others have rebounded sharply this year while online-only sales have yet to rebound (Fig. 2). After years of online sales taking market share, some of the brick-and-mortar retailers may be holding their own, helped by the push to offer online purchases that can be delivered to doorsteps or picked up in stores (Fig. 3). Let’s take a look at some of the recent industry news:

(1) Bankruptcies abound. Retail bankruptcies are nothing new. They often happen during recessions, and many retailers have gone through the process more than once, in what bankruptcy pros jokingly call “Chapter 22” (Chapter 11 twice). But the volume of bankruptcies is up sharply. Twenty-four retailers have filed for bankruptcy from the start of the year through July 16. That’s more than the 20 retailers that filed during all of 2019, a July 22 WSJ article reported.

Retailers reorganizing under bankruptcy protection and those just trying to stay alive outside of the bankruptcy courts are closing underperforming stores at a shocking pace. “Retailers will likely decide to close as many as 25,000 U.S. stores in 2020, which would be a record, and more than double the 9,832 stores that closed last year, according to global market-research firm Coresight Research. So far this year, major U.S. chains have announced more than 5,400 permanent closures,” the July WSJ article stated.

Here are some of the retailers that have filed for bankruptcy protection and are closing hundreds of storefronts: Ascena—owner of Ann Taylor, Lane Bryant, and other brands—plans to close up to 1,600 of its 2,800 stores, including all of its 264 Catherines stores and all or the majority of its Justice stores. Tailored Brands—owner of Men’s Wearhouse and Jos. A. Bank—plans to close as many as 500 of its 1,450 stores. New York & Co.’s parent, RTW Retailwinds, plans to close most, if not all, of its 378 retail and outlet stores; and Tuesday Morning will close about 230 of its 700 stores.

Closures might have been even more aggressive if the large mall operators hadn’t stepped in and bought some of bankrupt retailers. Yesterday, a WSJ article reported that Simon Property Group and Brookfield Property Partners agreed to buy 490 J.C. Penney stores out of bankruptcy while the store’s lenders will own its remaining 160 locations. Brooks Brothers was sold earlier this summer to Simon Property Group and Authentic Brands Group, which agreed to keep operating at least 125 of the company’s 424 global stores. Simon, Brookfield Property Partners, and Authentic Brands also bought Forever21 out of bankruptcy earlier this year.

(2) Survivors trimming too. Even the retailers who aren’t filing for bankruptcy protection are trimming their store counts, sometimes sharply. Gap is shutting about 230 locations, and L Brands is cutting 250 Victoria’s Secret stores, or about a quarter of them. Chico’s is shuttering 250 locations, and Macy’s has closed more than 125 stores this year. G-III Apparel Group is closing its 110 Wilsons Leather and 89 G.H. Bass stores. And there are only 60 Sears and 35 Kmart stores left, down from a collective total of more than 3,500 at one time.

(3) For some the end has arrived. And then there are the bankrupt companies, unable to find a buyer, that are turning off their lights for good. Among those who have liquidated or plan to do so are home goods retailer Pier 1, Modell’s Sporting Goods, Lord & Taylor (38 department stores), Stein Mart (279 stores), and Stage Stores (738 stores across six brands including Stage department stores).

(4) Dismal data. While some retailers’ stocks have boomed during COVID-19 (think: the S&P 500 Home Improvement Retail stock price index, up 24.7% ytd through Tuesday’s close, or Internet & Direct Marketing Retail, up 60.8%), the pure clothing retailers have had a horrible year. The S&P 500 Department Stores stock price index—which now has only one constituent, Kohl’s—has fallen 55.6% ytd, and the S&P 500 Apparel, Accessories & Luxury Goods stock price index has dropped 34.7% (Fig. 4 and Fig. 5). In fact, these two industries have fallen by 81% and 50% from their 2014-15 peaks.

Revenue for the S&P 500 Department Stores industry is expected to tumble 19.4% this year while its earnings dive to a steep loss (Fig. 6). Likewise, revenue for the S&P 500 Apparel, Accessories & Luxury Goods industry is expected to drop 20.3% this year while its earnings fall 79.0% (Fig. 7 and Fig. 8). With its 2020 and forward expected earnings now at a deep loss, the forward P/E for the Department Stores industry is no longer calculable, and the forward P/E for the Apparel, Accessories & Luxury Goods industry has risen to 13.8 from a thread below 10 in mid-March (Fig. 9).

Disruptive Technologies: Tech Tackles Global Warming. With fires raging on the West Coast and tropical storms pounding the East, it’s hard not to worry that global warming is gaining the upper hand on Mother Nature. However, we remain hopeful that humans will save the planet because there are a bevy of new, green technologies being developed. Some we’ve discussed in the past, including solar, wind power, electric cars, lithium ion batteries, and drones planting trees. But that’s just scratching the surface. We’ll keep updating you on the latest tech tools being developed to reduce the CO2 emissions and fight global warming. Today’s installment includes Jackie’s report on electric construction equipment, a hydrogen powered generator, and a new battery purported to last for 150 hours:

(1) Construction trucks going green. Construction vehicles are normally very large, very loud, and very smelly. They spew large volumes of CO2-containing exhaust. But now manufacturers are starting to introduce electric trucks, particularly for smaller construction vehicles. By 2023, there will be 19 all-electric or hydrogen-fuel-cell-powered heavy duty trucks in production in North America, up from five today, a July 13 article in Greentech Media reported.

European companies seem to be leading this trend, with electric excavators, loaders, and dumpers available from manufacturers including Hitachi, Komatsu, and Volvo. “Oslo launched the world's first zero-emission construction site last year, and Norway's capital city has mandated that by 2025 all public construction sites will operate only zero-emission construction machinery,” the Greentech Media article stated.

Volvo Group’s construction equipment subsidiary has stopped developing diesel engine compact wheel loaders and compact excavators and has introduced electric versions of those trucks instead. The company officially announced that it would begin accepting preorders for those electric powered vehicles in the US in early August. Fifteen states and the District of Columbia have agreed that 100% of all new medium- and heavy-duty truck sales will be emissions free by 2050.

Both Volvo trucks use lithium ion batteries. The mini excavator and the compact wheel loader each can run for eight hours when used for their most common applications. Both can be fully charged overnight or charged to 80% in an hour or two with a fast charger. Faresin Industries, an Italian construction equipment manufacturer, offers an electric telehandler with six hours of battery life that can be recharged in 13 hours, or 2.5 using a fast charger.

(2) Hydrogen fuel cell replaces diesel generator. Siemens Energy has introduced a hydrogen fuel cell system that will be used to generate electricity, heat, and hot water for a construction site in England for at least six to eight months, eliminating the need for diesel generators, a September 3 CNBC article reported.

In general, a hydrogen fuel cell allows hydrogen atoms to enter at the fuel cell’s anode. The atoms are stripped of their electrons, and the positively charged protons pass through a membrane to the cathode. The negatively charged electrons are forced through a circuit, generating electricity. Afterwards, they combine with the protons and oxygen from the air to generate water and heat, explains this primer. Fuel cells are efficient and scalable.

The problem is that hydrogen needs to be made. Often, it’s made by using electrolysis to split water into its components: hydrogen and water. Electrolysis requires energy, and unless that energy is produced using solar or wind power, you’re back to burning natural gas or coal and throwing off carbon dioxide. Some scientists are studying how to use sunlight to fuel electrolysis, and others are trying to harness algae, which naturally produces hydrogen.

(3) Aqueous air batteries on the way. Form Energy, a startup that has raised more than $50 million from investors including Bill Gates’ incubator Breakthrough Energy Ventures and MIT’s The Engine, claims to have developed a new aqueous air battery that lasts 150 hours. The problem: No one knows what an aqueous air battery is, and the company isn’t saying. But if it lasts 150 hours on a single charge as claimed, it would be a huge advance that could make solar and wind power a viable alternative to traditional energy sources.

Form Energy recently received a lot of attention after announcing it’s working with Great River Energy, a Minnesota-based wholesale electric power co-op, to set up its aqueous air battery system for the first time commercially. Form Energy has said that its goal was to use metals or other elements that are lower cost and easier to obtain than the lithium, nickel, cobalt, and other metals used in today’s lithium ion batteries. A May 8 article in CleanTechnica speculated that the aqueous air battery could use sulfur.

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Panic Attack #67?

September 09 (Wednesday)

Strategy I: The Four Seasons. Looks like the stock market made another record-high top on September 2, when the S&P 500 closed at 3580.84 and the Nasdaq closed at 12056.44. That might be it for record-high tops this year for both, which previously topped out at 3386.15 and 9817.18, respectively, on February 19 (Fig. 1). Joe and I expect the next record-high top will be next year on the way to our 2021 year-end target of 3800 for the S&P 500.

I view the latest three-day selloff as Panic Attack #67 in the bull market that started March 9, 2009 (Fig. 2). “Hold on,” you might be thinking. “What about the bear market earlier this year?” That would make it Panic Attack #1 in the new bull market that started on March 24. (See our Table of S&P 500 Panic Attacks Since 2009.)

Technically speaking, the 33.9% plunge in the S&P 500 from February 19 through March 23 was a bear market. It meets the sole requirement to be labeled as such: a 20% or more drop in the S&P 500 on a closing basis. However, as I previously discussed on August 31, the latest bear market lasted only 33 calendar days and 23 trading days from its peak to trough, with the market down more than 20% from its peak during just 18 of those days. That’s not much of a bear market. It’s the shortest one on record. It’s more like a correction, in my opinion. Nevertheless, Joe is a by-the-book quant and insists that we add it to our table of S&P 500 Bear Markets and Corrections Since 1928 as a bear market.

Why quibble over the definition of a bear market? Let’s instead debate whether the action since March 23 has been more in tune with Phase 4 than Phase 1 of bull markets. In 1725, Antonio Vivaldi composed The Four Seasons, a set of four violin concertos. The sounds of each concerto resemble its respective season. So for example, “Winter” is punctuated with pizzicato notes from the high strings, suggesting icy rain. “Summer” sounds like a thunderstorm in its final movement, which is often called “Storm.”

One of the great virtuosos of the investment business was Sir John Templeton. He observed that bull markets experience four phases: pessimism, skepticism, optimism, and euphoria. Similarly, my friend Laszlo Birinyi has identified four phases: reluctance, digestion, acceptance, and exuberance. Where are we now in the current bull market?

Consider the following points excerpted from our October 9, 2017 Morning Briefing titled “FOMO & MAMU”:

“(1) First and second. The first phase [of the current bull market] started on March 9, 2009 and ended after the second and worst correction of the bull market, on October 3, 2011 (Fig. 3). The second phase included three minor corrections, with the last one ending on November 15, 2012.

“(2) Third and fourth. On July 8, 2014, I wrote that the S&P 500 was moving from the third to the fourth phase. Now I’m thinking that the third phase was extended by the energy-led earnings recession. Instead, the third phase might have ended on February 11, 2016, when the S&P 500 fell to the lowest reading since April 11, 2014, taking out some of the optimism that had been building during the third phase. During the fourth phase since then, there have been no significant corrections, which certainly must be contributing to the mounting euphoria/exuberance about stocks.

“(3) P/E phase profile. The S&P 500’s forward P/E also can be used to identify these four phases (Fig. 4). It mostly fell during the first phase, when earnings caught up with the initial bull market euphoria. During the second phase, it rose slightly but remained relatively low as investors continued to fret about another financial crisis and a renewed recession. During the third phase, the forward P/E trended higher, rising to a cyclical peak of 17.2 on February 24, 2015. It was back down to 14.7 on January 20, 2016. It has been above 17.0 ever since January 24, 2017, and was at 18.0 at the end of last week.”

By the way, I concluded: “This is all still Nirvana territory but bordering on meltup terrain, in my opinion. If the P/E rises over 20.0, that would suggest to me that the exuberance phase of the bull market is well underway.”

Again, it was October 2017 when I wrote that. Much has happened since then. There was a significant meltup through September 20, 2018. The S&P 500 then experienced a 19.8% correction through December 24 (which we labeled “Panic Attack #62”). The next big event was the “banana” at the start of the year. Exuberance came back very rapidly after the Fed announced QE4ever on March 23, as the S&P 500 forward P/E soared from 12.9 to peak at a 19-year high of 23.3 on September 2. It still seems like the fourth phase of the bull market.

If the three-day selloff (so far) turns out to be just another panic attack, then it should tamp down the market’s exuberance just enough that the bull market can resume. Joe and I expect that the S&P 500 will stall around current levels, consolidating its gains since March 23 at least through the November 3 elections. That would give earnings some time to catch up with the stock market’s rally. Before the market resumes its climb, investors might want to see more progress on the vaccine front, how the elections play out, and which letter of the alphabet best describes the shape of the economic recovery.

Strategy II: 1999 Interrupted? So far, the Tech Wreck of 2020 is a minor fender bender compared to the multi-stock crash during 2000. The tech-heavy Nasdaq seemed to be on course for a meltup similar to the one that occurred during 1999, setting the stage for the subsequent meltdown. It’s too early to tell, but the three-day tech-led selloff might have derailed a repeat of the 1999 scenario. Besides, the underlying fundamentals for many technology companies are better now than they were back then. Consider the following:

(1) Tech in US GDP. High-tech spending on IT equipment, software, and R&D rose to a record $1.33 trillion (saar) during Q2-2020 (Fig. 5). It jumped to a record 50.1% of total capital spending in nominal GDP during the quarter (Fig. 6). Equipment and software accounted for 31.1% and R&D 19.1% of capital spending in nominal GDP.

Furthermore, US industrial production of high-tech equipment, which has been on an uptrend in record-high territory since mid-2010, rebounded 3.7% from May through July to a new record high, after falling 2.8% from January through May (Fig. 7). Output of communications equipment rose to a record high during July. Output of computers is likely to rise to record highs in coming months given the boost to demand for PCs and laptops attributable to the work-from-home trend that was accelerated by the pandemic.

(2) Semiconductors. US industrial production of semiconductors has been on a solid uptrend since early 2009. During July, it was only 1.3% below its record high. The forward earnings of the S&P 500 Semiconductors industry is highly correlated with the three-month average of worldwide semiconductor sales (Fig. 8). Both have bottomed recently from their minor dips earlier this year, and both remain on solid uptrends.

The peak-to-trough declines in worldwide semiconductor sales and in forward earnings were: 46.3% and 85.7% during the 2000 recession, 38.6% and 87.1% during the 2008 recession, and 0.3% and 7.8% during the latest two-month recession. The S&P 500 Semiconductor industry’s forward earnings is only 5.0% below its record high during the week of November 1, 2018.

(3) Forward revenues & earnings. Now let’s have a look at forward revenues and earnings for the entire S&P 500 Information Technology sector. During the August 27 week, the sector’s forward revenues matched its record high at the end of last year (Fig. 9). So it already has recovered from the 4.6% peak-to-trough decline earlier this year. By comparison, the sector’s forward revenues fell 18.1% from peak to trough during the previous recession and didn’t fully recover to a record high until the September 2 week of 2010.

The S&P 500 Information Technology sector’s forward earnings also has fully recovered its 6.7% dip earlier this year (Fig. 10). That’s impressive compared to the 28.4% drop during the previous recession, with the full recovery taking 49 weeks. It’s even more impressive compared to the 61.4% drop during 2000-01. The full recovery back then didn’t happen until the week of June 7, 2007!

(4) Market capitalization & valuation. All of the above certainly helps to explain why the S&P 500 Tech sector (and the tech-heavy Nasdaq) have been leading the way in the meltup since March 23. They are also leading the way in the three-day mini-meltdown, which Joe and I view as a healthy correction.

During the last week of August, the S&P 500 Information Technology sector accounted for 28.5% of the S&P 500’s market capitalization, the highest share since September 2000 (Fig. 11). That’s still well below the sector’s record-high share of 33.7% during March 2000. Furthermore, back then, the sector’s earnings share peaked at 18.2% during September 2000, well below the latest reading of 23.7% during the August 27 week.

Given all of the above, the Tech sector’s forward P/E of 27.5 during the week of August 27 might have been exuberant, but not irrationally so (Fig. 12). Granted, that’s the highest reading since January 2004, but the 10-year US Treasury bond yield was 4.15% back then. It is under 1.00% now.

Here are the forward P/Es of the Tech sector’s industries during the final week of August: Application Software (51.5), Data Processing & Outsourcing (34.0), Systems Software (31.6), Technology Hardware, Storage & Peripherals (30.1), Semiconductors (20.1), IT Consulting & Other Services (16.8), Semiconductor Equipment (15.7), and Communications Equipment (14.3) (Fig. 13 and Fig. 14).

(5) Magnificent Six. As we’ve previously observed, the S&P 500 Tech sector includes only two of the FAANGM stocks, namely Apple and Microsoft. Of the four others, Amazon is in the S&P 500 Consumer Discretionary sector, while Facebook, Google’s parent Alphabet, and Netflix reside in the S&P 500 Communication Services sector. As of the week of September 4, the FAANGM stocks collectively accounted for 26.3% of the S&P 500’s market-cap share and sported a forward P/E of 42.4. They are down 12.2% over the last three trading days, while the S&P 500 excluding them is down 5.0%.

There has been lots of chatter since Friday about SoftBank’s aggressive purchases of stocks and call options in these names. Unless SoftBank is about to go the way of Long-Term Capital Management (LTCM), which we doubt, it’s possible that some of the recent selling pressure in the Magnificent Six and other techie stocks might be attributable to profit taking rather than forced selling by SoftBank and other investors who recognize that valuation multiples may be too high, even though interest rates are so low. If so, then Panic Attack #67 should turn out to be a buying opportunity, as have all the other panic attacks since March 9, 2009.

(6) 1999 revisited. A repeat of 1999 is still possible. Let’s focus on the tech-heavy Nasdaq because it includes all the FAANGM stocks as well as other high-flyers like NVIDIA and Tesla. The index is up 75.7% from its March 23 low through its recent record high on September 2.

Recall that the Nasdaq fell 29.5% from July 20, 1998 through October 8 of that year. That period included the Russian debt default crisis and LTCM’s collapse. It was back at a record high by November 27, then proceeded to soar 255.8% through March 10, 2000. It then fell 77.8% during the subsequent bear market.

US Economy: The Income Inequality Issue. Since the start of the Great Virus Crisis (GVC), economic inequality has increased in significance as an issue for monetary and fiscal policymakers. Democratic presidential nominee and former Vice President Joe Biden crafted his campaign platform on the issue. US Treasury Secretary Steven Mnuchin recently suggested that there is work to be done on economic disparities. On June 19, Federal Reserve Chairman Jerome Powell said that the economic shock caused by the coronavirus pandemic has exposed “troubling inequalities” that predated the crisis. “A particular cruelty of the pandemic has been its disproportionate effects on many areas that were already suffering,” Powell said, according to the WSJ.

Reducing economic inequalities may soon be a congressionally mandated responsibility of the Fed, as Melissa and I discussed in our August 19 Morning Briefing. Some see the Fed’s policies as having buoyed the value of stocks and bonds, which are disproportionately held by the wealthy, while doing little to benefit lower-income earners who have lost their jobs. The word “inequality” appeared 34 times in the US central bank’s recent FedListens report, which summarized findings from a series of Fed-sponsored events focused on evaluating the Fed’s approach to policy setting. Here are some reasons that inequality suddenly has policymakers’ attention:

(1) Fewer service jobs. “The Service Economy Meltdown” was the title of a September 4 New York Times article. “As companies reconsider their long-term need to have employees on site, low-wage workers depending on office-based businesses stand to lose the most,” the article anecdotally observed. Indeed, the recent “lockdown recession” has caused far more people to lose their jobs than ever before, especially in services-producing industries. Payroll employment plunged 22.2 million from February through April. Although payroll employment rebounded 10.6 million from April through August, it remains 11.6 million below the February 2020 level.

A disproportionate number of leisure and hospitality workers lost their jobs during the lockdowns, reported a May 8 CNBC article, and many remain unemployed. The leisure and hospitality industry lost 8.3 million jobs, or 37% of total positions from February to April. The industry gained just over half those jobs back from April through August, or 4.2 million jobs, but the level remains 4.1 million below February.

(2) Wider income gap. Evidence suggests that the GVC has exacerbated income inequality, as it has disproportionately affected lower-paid service workers. Whether they can regain full employment as the economy recovers is a question mark. Unlike higher-paid professionals, who generally are able to work from home and have earned their usual income during the lockdowns (if not more owing to the pandemic-related fiscal stimulus), lower-paid service workers who can’t work remotely, such as hairdressers and restaurant servers, have lost jobs and income during the lockdowns.

New research shows that the effects on income inequality from the COVID-19 recession have been driven mainly by job losses rather than slowed wage increases, as an Illinois News Bureau report discussed. Using data from the Current Population Survey, the researchers showed that the COVID-19 pandemic led to a loss of aggregate real labor earnings of more than $250 billion from March to July 2020 compared with such earnings a year ago, almost entirely driven by declines in employment, particularly among the lowest-paid.

However, those declines were offset by the federal stimulus provided under the Coronavirus Aid, Relief, and Economic Security (a.k.a. CARES) Act. Individuals from the bottom third of the wage-distribution scale received almost half of all federal dollars from unemployment insurance payments, reversing the increase in wage inequality, according to the paper.

The paper observed, as we discussed in our June 29 Morning Briefing, that many low-wage workers who lost their jobs perversely received an income boost on unemployment insurance, as the federal aid offered an extra $600 per week in addition to state benefits. But that provision expired at the end of July, and now instead of receiving a median replacement to their income of 156%, unemployed workers are receiving 30%-40% of their previous earnings. The people receiving aid are those “who are likely to spend every dollar, so giving them that extra money very likely rescued the economy from a more severe recession,” the Illinois report said.

(3) Personal savings divided. The personal saving rate has increased dramatically over the course of the pandemic, but it seems likely that the distribution of savers between income deciles may have skewed toward higher-income workers able to work from home. That’s supported by many reports of lower-income folks struggling to pay rent, as we recently covered, and evidence that food insecurity is on the rise.

 Further, a September 3 article in The Atlantic observed that reduced spending among the top 25% of earners accounted for over 50% of the estimated reduction in consumer spending reflected in the latest GDP numbers, according to economic researchers at Harvard. The damage done by that lost spending “reflects what happens in a pandemic when high-income people can work at home … but it also reflects the huge growth of inequality of recent decades,” Harvard economist Lawrence Katz said. “Such a large part of our economy, and of employment, has been embedded in servicing high-income people.”

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What If …?

September 08 (Tuesday)

What If …?: MAMU & the Whale. What if the stock market’s tech-led meltup in recent weeks and the tech-led mini-meltdown at the end of last week were caused by SoftBank? Joe and I have been rooting for a consolidation rather than a continuation of the meltup. So we are in the “healthy correction” camp if there is more downside to go this week. There’s still plenty of cash on the sidelines, as we discussed last week, to take advantage of any selloff and limit the downside in the stock market. For now, we are sticking with our year-end 2020 and 2021 targets of 3500 and 3800 for the S&P 500.

Before we revisit the alternative bullish and bearish scenarios, let’s review the latest tale of the whale. Consider the following:

(1) On Friday, the FT reported that “SoftBank is the ‘Nasdaq whale’ that has bought billions of dollars’ worth of US equity derivatives in a move that stoked the fevered rally in big tech stocks before a sharp pullback on Thursday.” The strategy has focused on options related to individual US tech stocks.

(2) On Friday, Barron’s Ben Levisohn reported: “Call option activity in the Nasdaq’s most popular stocks—the FAANG stocks plus Microsoft and Tesla—peaked at about 13 million contracts on Aug 21. That’s up almost 300% from a month ago. About 4.5 million call option contracts traded hands Thursday, down 65% from the recent high.”

Here is the performance derby for the relevant stock market indexes: the Magnificent 6 FAANGM (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft) stocks (74.6% since March 23, 46.9% ytd, -7.4% Thursday and Friday), Nasdaq (64.9, 26.1, -6.2), S&P 500 (52.8, 5.9, -4.3), and S&P 500 ex-FAANGM (46.3, -3.7, -3.1) (Fig. 1 and Fig. 2).

(3) On Sunday, the FT reported that SoftBank was still sitting on unrealized trading gains of $4 billion after giving up some of the gains on its tech bets at the end of last week. The question is whether the selling pressure will continue this week if SoftBank is forced to continue to unwind its long positions in tech stocks.

An even more important question is whether the recent meltup has already morphed into a meltdown comparable to what happened when Long-Term Capital Management blew up in September 1998. A repeat of that scenario could actually set the stage for a repeat of the monster MAMU (Mother of All Meltups) back then. Recall that the Nasdaq fell 29.5% from July 20, 1998 through October 8 of that year (Fig. 3). It was back at a record high by November 27, then proceeded to soar 255.8% through March 10, 2000 (Fig. 4).

What If …?: The Bullish Scenario. What if a vaccine is ready for widespread distribution by the end of this year or early next year? What if death rates fall as medical professionals continue to learn more about the best available treatment protocols to speed up the pace of recovering from COVID-19? What if faster tests for the virus become widely available in coming months?

If we make lots of progress on the health front in the world war against the virus, then we may continue to make progress on the economic front as well. What if the V-shaped recovery continues to be V-shaped? What if productivity is starting a significant secular rebound? What if the labor market recovers as dramatically as it cratered when governments imposed lockdown restrictions?

If the economic news continues to improve significantly during September and October, that should benefit President Donald Trump in his bid to win a second term come November 3. What if Donald Trump is reelected for another four-year term and the Republicans continue to have a majority in the Senate, but not in the House?

What if all of these questions turn out to be rhetorical ones, implying that the outcomes will be bullish? Well then, the outcomes will be bullish. Now consider the following related observations that support staying optimistic on the prospects for the US economy and bullish on the stock market:

(1) Real GDP. It certainly has been a V-shaped recovery so far. Real GDP fell 5.0% (saar) during Q1 and 31.7% during Q2. Real GDP is down 10.2% from its record high during Q4-2019 (Fig. 5). However, the recession lasted just two months, with the Index of Coincident Economic Indicators (CEI), a good monthly proxy for real GDP, having peaked at a record high during February, falling 13.7% through April (Fig. 6).

Virtually all of the key monthly US economic indicators bottomed during April. The CEI is up 6.7% since April through July. That’s still 7.9% below the February peak. However, retail sales rose to a record high during July (Fig. 7). Durable goods orders rebounded 38.0% from April through July, and is running at only 4.3% below its pace at the start of this year (Fig. 8).

On September 3, the latest reading from the Atlanta Fed’s GDPNow model showed that the available economic indicators are tracking a Q3 growth rate of 29.6%. That’s a heck of a rebound! A few weeks ago, we raised our Q3 real GDP estimate from 15% to 20%. We may have to raise it again.

(2) Plenty of stimulus. Debbie and I are not convinced that another round of fiscal stimulus is necessary to keep the economy on a V-shaped trajectory over the rest of this year. Payroll employment has rebounded 10.6 million since bottoming during April through August. Aggregate weekly hours has jumped 10.9% from April through August (Fig. 9). Our Earned Income Proxy for wages and salaries in personal income is up 8.9% over the same period (Fig. 10).

While both employment and wages and salaries have a ways to go to regain all that they lost since the start of the year, consumers are still sitting on lots of cash, as evidenced by personal saving, which was $3.2 trillion (saar) during July (Fig. 11). That’s down from the record high of $6.4 trillion during April, when consumers were stymied from shopping because of the lockdowns. However, it is still well above where it was at the start of this year, around $1.1 trillion. Consumers also have room to charge more on their credit cards after reducing their revolving credit balances by $111.0 billion from February through June (Fig. 12).

Monetary policy remains very stimulative, as evidenced by the meltup in stock prices and the boom in housing activity. The market capitalization of the Wilshire 5000 increased $12.5 trillion since March 23 through the end of last week (Fig. 13). With mortgage rates near record lows, the average of the Housing Market Index (compiled by the National Association of Builders) and the Pending Home Sales Index (compiled by the National Association of Realtors) rose from a low of 64.5 during April to 133.1 during July, the highest readings since July 2005 (Fig. 14).

(3) Auto sales. We’ve recently been writing about the beneficiaries of de-urbanization. The housing industry is a clear winner as long as the houses are in the suburbs or rural areas. Also profiting from the ongoing need to keep our distance from one another are the companies that allow us to work remotely, to shop online, to get educated, and to be entertained from home. They provide their goods and services over the Internet and through the cloud.

My wife and I have been car shopping lately near our home in Long Island. The salespeople all told us that their inventories are low because auto factories were shut in April by the lockdowns. At the same time, demand is very strong. One explanation is that instead of vacationing overseas this summer, many Americans went on road trips around the country and wanted to do so in newer and bigger vehicles. We were also told that some of the recent surge in demand is from households that are buying a second car for commuting rather than be exposed to public transportation.

Sure enough, the data confirm that US motor vehicle sales accelerated from only 8.7 million units (saar) during April to 15.2 million units during August (Fig. 15). Leading the way has been sales of domestic light trucks, which are only 7.7% below January’s pace. It’s interesting to note that retail sales of motor vehicles and parts dealers rose to a record high in June, and remained near that level in July (Fig. 16). A similar surge in motor vehicles and parts new orders accounts for 66% of the increase in new orders for durable goods since April.

All of the above auto-related developments explain the remarkable recovery in gasoline usage (Fig. 17). Since bottoming at 5.3mbd during the April 24 week, it has rebounded to 8.9mbd during the August 28 week. That’s only 0.8mbd below where it was last year at this time!

(4) Productivity. One of the biggest positive surprises resulting from the Great Virus Crisis (GVC) might be a secular rebound in productivity growth. The extraordinary drop in real GDP during Q2 coincided with an even faster drop in employment, resulting in a 10.1% (saar) jump in productivity during the quarter, the best reading since Q1-1971 (Fig. 18). We wouldn’t be surprised if the GVC ushers in a period of better productivity growth.

It will be interesting to see how the government’s bean counters will account for the productivity of possibly millions of workers who continue to work from home either full-time or part-time. The problem is that commuting to work has never been counted as time on the job, while working a longer day at home will be counted. That doesn’t make much sense to us at Yardeni Research, since we have operated virtually since our founding in 2007. Exchanging our commutes for working longer hours from home has been great for our productivity and our lifestyles.

What If …?: The Bearish Scenario. What if the V-shaped recession morphs into a double-dip W-shaped economic pattern? That could happen if the pandemic worsens during the fall and winter. It could also happen if Washington fails to provide another round of stimulus checks as another wave of bankruptcies among services companies leads to another wave of layoffs. Airlines, restaurants, hotels, and public transportation all are especially vulnerable to more distress if their revenues don’t return closer to normal within the next 6-12 months. The result could also be a K-shaped recovery, where the haves continue to do well while the have-nots continue to suffer. That might not cause another recession, but it could cause a growth recession, with real GDP growth stalling around zero.

A double-dip, W-shaped recession or a K-shaped stalling of economic growth combined with more SoftBank-related shocks could mark the September 2 record high of the S&P 500 as the top for the rest of this year, or at least through the November 3 election. If the presidential election result is bitterly contested, that could drive the stock market lower after November 3. If the Democrats win the White House and both congressional chambers, stocks could remain under pressure on expectations of a radical regime change in economic and regulatory policies.

What if inflation makes a surprising comeback? That would be a big surprise if it were to happen over the next 12-18 months. For it to do so would probably require a surprisingly strong continuation of the V-shaped recovery resulting from all the stimulus provided by fiscal and monetary policy so far this year. Home prices are already rising at a faster pace as a result of de-urbanization. The same can be said for used car prices. On the other hand, rent inflation is going down.

In any event, the Fed remains committed to maintaining ultra-easy credit conditions for the foreseeable future even if inflation finally and sustainably rises a bit above the Fed’s 2.0% inflation target. That could fuel a resumption of the meltup in stock prices, which could set the stage for a meltdown down the road.

To paraphrase Bette Davis in the movie “All About Eve” (1950): “Fasten your seatbelts, it’s going to be a bumpy ride.”

Movie. “The Morning Show” (+ + +) (link) is a fast-paced television series produced by Apple TV+ starring Jennifer Aniston and Reese Witherspoon as co-anchors on The Morning Show, a popular breakfast news program broadcast from Manhattan on the UBA network. The two are brought together after the co-host, played by Steve Carell, is fired as a result of a sexual misconduct scandal. It’s obviously reminiscent of the scandal that hit NBC’s Today show. The series has a very good cast, with lots of great acting and dialogue.

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Happy & Unhappy Earnings Hooks

September 03 (Thursday)

Strategy I: On the Way Forward. Our April 7 Morning Briefing was titled “The Way Forward.” We optimistically wrote that “the market’s recent action suggests that investors are betting on an economic recovery … as are we.” The number of COVID-19 cases was slowing in New York State and in Europe. There was some progress in testing for the virus. We nominated Neil Diamond’s song “Sweet Caroline” to be the pandemic’s theme song, and concluded: “Hold off on touching and reaching out for a while longer, wash your hands often, and wear a face mask when you go out. Good times will be back.”

We also observed: “It’s encouraging to see that the forward P/Es of the S&P 500/400/600 have rebounded from their March 23 lows just as industry analysts have started to cut their earnings estimates for both 2020 and 2021.” In subsequent commentaries, we predicted that earnings estimates would be cut rapidly, and would probably bottom by the middle of the year. Let’s review the progress that has been made since then:

(1) Global growth. Our Global Growth Barometer (GGB) has rebounded 35% from April 21, when it bottomed at 50.4, through September 1, when it was up to 68.0 (Fig. 1). Over the same number of days, our GGB rose 29% from 50.6 on December 24, 2008 to 65.2 through May 6, 2009. The current V-shaped rebound in our GGB is confirmed by the V-shaped recovery in the global M-PMI from a cyclical low of 39.6 during April to 51.8 in August (Fig. 2).

(2) Global revenues. The rebound in global economic activity has stopped the freefall during the spring and early summer in MSCI forward revenues around the world (Fig. 3). The forward revenues for the US MSCI seems to have bottomed during the June 4 week, and is up 2.5% since then through the August 27 week. S&P 500 forward revenues has traced out a similar bottom and recovery, suggesting that actual S&P 500 revenues bottomed during Q2 (Fig. 4). If so, then actual revenues dropped 16.3% during the lockdown recession. That compares to the 20.4% fall in revenues during the Great Financial Crisis.

(3) S&P 500 forward earnings. There has been a significant upward hook in analysts’ consensus expected S&P 500 operating earnings for Q2 (Fig. 5). At the start of the current earnings season, earnings were expected to be down 43.3% y/y. The actual result is -32.2%.

The consensus earnings estimates for both 2020 and 2021 started bottoming in recent weeks (Fig. 6). As a result, S&P 500 forward earnings bottomed during the May 14 week, increasing 9.6% through the August 27 week.

Strategy II: More Earnings Hooks. For most of the sectors and industries in the S&P 500, forward earnings bottomed during the May 28 week and have started to gradually inch back upwards. What’s interesting are the outliers, the sectors and industries where earnings are at or approaching new highs or continuing to fall to new lows. Here’s a quick look at some of the industries with the most resilient earnings:

(1) Tech & Health Care lead. Forward earnings-per-share estimates for the S&P 500 Technology and Health Care sectors have rebounded from cuts earlier this year and are at or near new highs. COVID-19 certainly had a hand in this, as businesses, consumers, and schools all have needed technology upgrades to work and learn from home. Forward earnings for the Consumer Staples and Utilities sectors also are close to their highs, but the estimates never really fell by much (Fig. 7).

(2) Home & healthcare benefit. There are also industries with forward earnings-per-share estimates that are hitting all-time highs. Some we’ve discussed in the past, including the S&P 500 Home Improvement Retail industry, which has benefitted from homeowners’ urge to renovate while spending more time at home (Fig. 8). A number of the industries in the S&P 500 Health Care sector—including Managed Health Care, Pharmaceuticals, and Biotechnology—have forward earnings-per-share estimates at or near new highs thanks in part to the money being spent to find a cure for COVID-19 (Fig. 9 and Fig. 10).

(3) Apple & Microsoft propel forecasts. As you’d expect, there are a number of record forward earnings levels in the S&P 500’s tech crowd, including the forward earnings for the Technology Hardware, Storage & Peripherals industry, home to Apple; the Systems Software industry, home to Microsoft; and the Semiconductor Equipment industry (Fig. 11 and Fig. 12). More unexpected are the highs in the Industrial Gases and Metal & Glass Containers industries (Fig. 13 and Fig. 14).

Consumer Discretionary: Travel Industry’s Forecasts Still Falling. A picture may be worth 1,000 words, but the chart of the S&P 500 Hotels, Resorts & Cruise Lines forward earnings per share replaces just one word: “ugly.” Estimates have been falling since February 13, and they have yet to bottom (Fig.15). At their peak during the January 2 week, the industry was expected to earn $39.10 over the next 12 months; now it’s expected to lose $19.50 over the next 12 months.

Here in the US, international travel is out, and domestic road trips are in. Most countries have closed their borders to US residents, and TSA checkpoint travel numbers remain depressed, with 516,000 travelers flying in the US as of September 1, down 77% from on March 1’s 2.3 million (Fig. 16). However, the amount of gasoline usage has rebounded nicely, to 8.9 million barrels per day (four-week ma, sa), down only modestly from last year’s 9.7 million barrels and much higher than the low of 5.3 million barrels in April when we were all quarantined (Fig. 17).

Consumers in countries that have reduced COVID-19 infections appear more mobile and willing to spend. Cruising has restarted in some parts of Europe. Chinese consumers are hitting amusement parks. This implies that once Americans feel safe and restrictions are lifted, the travel industry will fly high again. Let’s look at some of the industry’s recent developments:

(1) Cruising again in Europe. Cruise ships are very, very slowly returning to the seas. In Europe, the authorities in Italy and Greece are allowing cruises to resume, with limitations on where they can go and whose citizens are allowed on board. Americans, for example, are not welcome. Operators of small ships have resumed river cruises in Germany and Central Europe. And domestic cruises have restarted down China’s Yangtze River and out of Taiwan.

MSC Cruises is one of seven cruise lines that has resumed sailing in Europe, an August 28 WSJ article reported. All MSC crew members and travelers were tested for COVID-19 before boarding the 5,000-person ship. Most ships are operating far below capacity to avoid crowding and provide quarantine cabins for anyone who gets sick. Buffets are out, and table service in. Guests are asked to remain socially distant or wear masks.

That said, the cruise business remains a long way from smooth sailing. Cruise lines aren’t docking in Spain because of its COVID-19 resurgence. Norwegian cruise operator Hurtigruten suspended its cruises in early August after 62 people tested positive for COVID-19 on its 530-person Artic cruise ship. In the US and Canada, cruises lines won’t be cruising through October; Australia’s ban goes through September 17.

(2) China’s packed theme parks. The Chinese government’s ban on foreign travel has been a boon for domestic travel, which in August had nearly recovered to pre-COVID-19 levels. Chinese residents are exploring their own country and visiting amusement parks. There are about 160 large-scale theme parks operating in China, triple the number that was operating 10 years ago, an August 29 WSJ article reported.

(3) Hilton & Marriott seeing gradual recovery. Things aren’t great in the hotel industry, but they’re a heck of a lot better than they were in April. Hilton Worldwide Holdings reported that system-wide occupancy rose from a low of 13% to about 45% in early August, with all major regions improving. At Marriott International, global occupancy was 31% in July, up 19 percentage points from April.

China was among the first to emerge from the COVID-19 lockdowns, and its economy and travel industry have recovered the most dramatically. In China, Hilton’s occupancy is around 60%. Marriott’s China operation is improving in leisure travel, business travel, and group travel, and the country’s revenue per available room should return to 2019 levels by 2021.

“With the virus mostly contained at this point, many domestic travel restrictions have been lifted [in China]; and the number of daily passenger domestic flights is now around 80% of pre-COVID-19 levels,” said Marriott CEO Arne Sorenson on the company’s August 10 earnings conference call. “While leisure and drive-to-destinations led the initial recovery; it is encouraging to see business transient as well as group also picking up nicely. Occupancy levels in Greater China have reached 60%, up significantly from the single digit levels in mid-February; and much closer to the 70% we saw at the same time last year.”

Hopefully, the US hotel business will experience the same trajectory enjoyed by China once we have tamed COVID-19. In all, it will probably take two or three years for global hotel demand to return to levels enjoyed in 2018 and 2019, said Hilton CEO Chris Nassetta during the company’s August 6 conference call. The hotel industry’s recent bounce will be followed by a slower grind higher, hampered by a slow economy.

(4) Not a pretty picture. Forward revenue and earnings per share for the S&P 500 Hotels Resorts & Cruise Lines industry remains in a freefall (Fig. 18 and Fig. 19). The industry’s stock price index has bounced 84.1% from its low on April 3, but it remains down 40.8% ytd (Fig. 20).

The cruise lines stocks are dramatically underperforming the hotel stocks in the S&P 500 Hotels Resorts & Cruise Lines industry ytd through Tuesday’s close: Norwegian Cruise Lines Holdings (-71.0%), Carnival (-67.5), Royal Caribbean Group (-48.7), Marriott International (-31.9), and Hilton Worldwide Holdings (-17.3).

Disruptive Technologies: EV Shakeout Ahead? Two megatrends are combining to potentially create the mother of all pileups. First, there’s the race to become the next Tesla. The electric vehicle (EV) pioneer’s shares have climbed 475.05% ytd through Tuesday’s close (versus 9.2% for the S&P 500), giving it a $464.3 billion market capitalization. Car and truck companies old and new are racing to catch up by developing their own EVs. GM, Ford, Volkswagen, Porsche, Jaguar, BMW, Nissan, and Volvo, along with myriad startups, are expected to introduce offerings over the next year or two.

The second trend involves the capital markets. Private investors have raised billions of dollars to fund unspecified future acquisitions by selling shares of special-purpose acquisition companies (SPACs) to the public. SPACs raised $22.5 billion via initial public offerings through the first week in August. That’s almost double the $12.1 billion raised in all of 2019, according to an August 14 WSJ article. Newbie EV companies—most with little or no profit—are tapping into this rich pool of capital by doing reverse mergers with the SPACs and then raising additional funds by selling equity to private investors (this is known as “PIPES,” or private investment in public equity).

As these two megatrends combine, we’re afraid the future will see a traffic jam at best and a four-lane pileup at worst once investors differentiate between companies with proven versus unproven technology and determine which barely profitable companies will or won’t be more profitable in the future.

The good news is that the car industry’s new players are forcing the old players to up their game and innovate as never before. Let’s take a look at some of the deals coming to market:

(1) Second time’s a charm? Fisker Inc. plans to go public later this year through a reverse merger with Spartan Energy Acquisition, a SPAC backed by Apollo Global Management. Fisker aims to release in 2022 an EV SUV with a solar roof and many parts made of recycled materials, including recycled ocean plastic. Fisker plans to provide the car’s design and software and outsource the production of many parts—including batteries and motors—to other manufacturers, an August 7 WSJ article reported. Customers can enter a “subscription-like lease that can be terminated at any time.”

This isn’t CEO Henrik Fisker’s first rodeo. His first EV company, Fisker Automotive, suspended operations before being acquired in 2014 by Chinese auto parts conglomerate Wanxiang Group. Spartan Energy Acquisition shares are up 33.5% ytd.

(2) Electric trucks coming too. Nikola and Lordstown Motors both are developing electric pickup trucks to rival Tesla’s planned offering and the traditional, gas-powered pickups offered by Ford and GM.

Lordstown Motors contends that its offering, the Endurance, costs less to fuel and operate than the Ford F-150 and will be in production during H2-2021. The company has more than 27,000 pre-orders totaling $1.4 billion, and it purchased an auto assembly plant in 2019 from GM, according to its August 3 press release. Lordstown has agreed to do a reverse merger with DiamondPeak Holdings, a SPAC, that’s expected to close in Q4. DiamondPeak shares are up 73.4% ytd.

Nikola plans to build electric trucks for businesses, an electric pickup truck, as well as a hydrogen filling station network. The company has orders for roughly 14,000 trucks, including Anheuser-Busch’s order for 800 hydrogen-electric trucks for delivery in 2021 and Republic Services’ order for 2,500 electric garbage trucks for delivery in 2023.

Nikola’s reverse merger occurred in June with VectoIQ Acquisition Corp. The share price surged more than sevenfold from roughly $11 in April to peak at $79.73 in June, from which they’ve nearly been halved, to $41 as of Tuesday’s close. That still leaves the shares up 297.3% ytd.

(3) Electric vans coming too. Canoo pitches itself as a van designed for urban areas. To Jackie’s eye, the interior looks like a minivan where the seats are set up on the perimeter of the van, like the L-shaped couches that are popular in today’s dens. Offering such a social area would be great for taxis driving groups or parents driving soccer teammates. The company aims to pitch its interesting layout to consumers in 2022 and to those making commercial deliveries in 2023. Canoo is offering a month-to-month subscription model, and it too is opting for an asset-light model, where it will count on other auto makers to build its vehicles.

Canoo announced a reverse merger with Hennessy Capital Acquisition Corp. IV on August 18 that’s expected to close in Q4. In conjunction with the deal, the company will raise an additional $300 million through a PIPE offering. Hennessy shares are up only 5.2% ytd.

(4) Chinese EV coming to US? Net Element, an electronics payments company, agreed to a reverse merger with privately held Mullen Technologies, an EV company headed by a former music executive David Michery. The payments-processing business will be divested, and Mullen shareholders will hold 85% over the new company’s stock. Net Element shares are up 121.5% ytd.

Mullen plans to assemble and sell China’s Qiantu Motors’ electric sports car, the Dragonfly K50, in the US in Q2-2021. Mullen is also developing an electric SUV with a solid-state battery offering more than 500 miles per charge and performance that does not degrade as with lithium ion batteries. It’s scheduled to come on the market in 2023.

(5) All things autonomous and EV are hot. Reverse mergers are also being done by companies that make parts enabling autonomous driving and other parts for EVs. Here’s a sampling: (i) Hyliion makes hybrid and fully electric powertrain solutions for Class 8 trucks. It agreed in June to do a reverse merger with Tortoise Acquisition and raise $325 million through a PIPE offering. Tortoise shares are up 390.2% ytd. (ii) Luminar, which makes LIDAR sensors and other parts used in autonomous vehicles, filed to reverse-merge with Gores Metropoulos, a SPAC. It plans to raise $170 million from private investors including Peter Thiel and Volvo Cars Tech Fund. Gores shares are up 12.8% ytd. (iii) Velodyne Lidar, which develops and manufactures Lidar technology for cars and robots, agreed in July to a reverse merger with Graf Industrial, a SPAC. After the deal’s closing, expected this month, the new company will raise $150 million through a PIPE offering. Graf shares are up 120.3% ytd.

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The Fed Is in Control

September 02 (Wednesday)

Fed I: Keeping a Lid on Bond Yields. Since the pandemic, the Fed’s top priority has been to offset the recessionary forces unleashed by the Great Virus Crisis (GVC) with yet another round of ultra-easy monetary policy. Doing so involved open-ended purchases of fixed-income securities and a return to pegging the federal funds rate at zero. We believe that the Fed is also pegging the 10-year Treasury bond yield below 1.00%. The 10-year US Treasury bond yield has been consistently below 1.00% since March 20 (Fig. 1). It’s possible that market forces are keeping a lid on the bond yield, but we doubt it. Consider the following:

(1) Nominal & real rates. The Fed’s renewed commitment to boost inflation to at least 2.0% should be pushing the nominal bond yield higher. That was the initial knee-jerk reaction in the bond market when Fed Chair Jerome Powell announced last Thursday that the Fed would tolerate overshoots of its 2.0% target. However, the yield remains under 1.00%.

On the other hand, the 10-year TIPS yield fell to -1.08% on Monday from -0.04% on March 23, when the Fed implemented QE4ever (Fig. 2). As a result, the spread between the nominal and TIPS yield, which is widely regarded as a proxy for the market’s expectation for the average annual inflation rate over the next 10 years, jumped from 0.80% on March 23 to 1.80% on Monday (Fig. 3).

(2) Economic surprise index. Since 2003, there has been a relatively good correlation between the Citigroup Economic Surprise Index (CESI) and the 13-week change in the 10-year bond yield (Fig. 4). It worked even earlier this year as both dropped together in response to the lockdown recession. However, while the CESI rebounded from its record low of -144.6 on April 30 to a record high of 270.8 on July 16 (and remains near there), the bond yield is unchanged over the past 13 weeks.

(3) M-PMI. There has also been a good correlation between the 10-year yield and the M-PMI since 2010 (Fig. 5). It’s not so good in recent months. The M-PMI bottomed at a cyclical low of 41.5 during April. It soared to 56.0 during August. The August data were released yesterday and showed broad strength in its new orders (67.6) and production (63.3) components (Fig. 6). The prices-paid index included in the M-PMI survey jumped to 59.5 during August, up from 53.2 during July and a recent low of 35.3 during April (Fig. 7). The bond yield didn’t budge!

(4) Commodity prices. There has been a remarkably close correlation between the bond yield and the ratio of the nearby futures prices of copper and gold (Fig. 8). Currently, that ratio suggests that the yield should be 1.50%, or twice as high as it is currently.

The price of copper isn’t as highly correlated with the bond yield as is the copper-to-gold ratio, but the copper-to-bond relationship is also showing an unusual divergence, as the price of copper has rebounded to a two-year high (Fig. 9). On the other hand, the price of copper remains highly correlated with the inflation spread between the nominal bond yield and the TIPS yield (Fig. 10).

 Fed II: The Phillips Curve Is Flat. Prior to the GVC, the Fed embarked on a year-long strategic review of monetary policy largely to address the challenges in achieving its two key congressional mandates: maximum employment and stable prices. Last week, the Fed amended its inflation-targeting goal from hitting a specific number in favor of flexible average inflation targeting, a.k.a. FAIT, as we touched on yesterday.

Leading up to the pandemic, it was widely believed that full employment, or close to it, had been achieved. However, the Fed has failed to consistently boost inflation up to the its 2.0% inflation target, which was first set in the Federal Open Market Committee’s (FOMC) January 2012 “Statement on Longer-Run Goals and Monetary Policy Strategy,” often referred to as the “consensus statement.”

Considering current developments and to culminate its policy review, the FOMC published a revised consensus statement on August 27, 2020. On its website, the Fed matched the current statement to the previous one. Below is a list of the major changes to the statement, which all add up to the likelihood that the Fed will keep interest rates close to zero for much longer, even if employment significantly improves and even if inflation stabilizes above 2.0%.

But as we suggested yesterday, it’s not obvious that the Fed will be any more successful in hitting its 2.0% target right on average than it has been in getting it up to that rate. In any event, the Fed’s strategic review yielded a revised framework that seems like an incremental and unremarkable change in Fed policymaking. Fed Chair Jerome Powell discussed the new framework in a rather unremarkable speech last Thursday at Jackson Hole. Let’s have a closer look at the tweaks made to latest consensus statement and some of Powell’s related comments:

(1) Introducing FAIT. The 2020 statement introduced the concept of FAIT with this language: “[The FOMC] seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” That may sound like a novel policy concept, but it’s not. Former Fed Chair Ben Bernanke tossed around the idea of a similar shift in policy back in a 2017 Brookings blog. Former Fed Chair Janet Yellen regularly commented that overshoots to inflation likely would be tolerated.

By the way, Fed Board Governor Lael Brainard added an “F” to the beginning of the “AIT” acronym to reflect the “flexible” nature of the new approach in a speech yesterday. She said that a mechanical formula would not be appropriate given uncertainties. Depending on conditions when the next framework review is completed in five years, she said, “the Committee will have the opportunity to tweak FAIT or to make a more fundamental change.” We translate that to mean that she knows the changes thus far did not alter the Fed’s underlying approach all that much. But by adding the “F” word into its jargon, the FOMC has more leeway to do what it wants as conditions evolve.

(2) Replacing symmetry with asymmetry. During January 2016, the FOMC revised the consensus statement to refer to its inflation objective as a “symmetric inflation goal” rather than just an “inflation goal.” The statement added that the Committee “would be concerned if inflation were running persistently above or below this objective.” The phrase “symmetric inflation” was removed from the 2020 statement. It noted that the inflation risks to the downside have increased.

(3) Acknowledging interest-rate constraints. The 2020 statement included this acknowledgement: “[T]he level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past.” But this is old news; in recent years, several current and former Fed officials have obsessed over the proximity of the unobservable natural rate of interest to zero (e.g., New York [formerly San Francisco] Fed President John Williams; see his research on the dramatic decline in the natural rate of interest following the financial crisis).

(4) Emphasizing employment over inflation. The statement reiterated the FOMC’s commitment to the dual mandate. But the bank placed a heightened focus on achieving the employment goal. The employment and inflation goals were separated into two paragraphs, and the order of the discussion put employment before inflation. But the employment mandate was elevated long before the consensus statement was revised.

During July 2019, Powell told members of Congress: “We really have learned that the economy can sustain much lower unemployment than we originally thought without troubling levels of inflation.” For what it’s worth, the FOMC felt it necessary to add the word “shortfalls” to its assessment of the maximum employment outlook to indicate that “employment can run at or above real-time estimates of its maximum level without causing concern,” as Powell noted in his speech.

(5) Accepting that the Phillips Curve is flat. Historically, the inverse relationship between unemployment and inflation, known as the “Phillips Curve,” was considered textbook doctrine and guided the Fed’s approach to monetary policy. Leading up to the Great Virus Crisis, the labor market was the best “we had seen in some time,” Powell said in his speech. However, the strong labor market “did not trigger a significant rise in inflation,” he observed.

Secular forces—including the aging population, slowing population growth, and slowing productivity growth—weighed on inflation, he added. When the Phillips Curve was steeper, it was “sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level” to avoid unwelcome increases in inflation. But Powell suggested that getting ahead of inflation might no longer be appropriate, as the Phillips Curve has flattened relative to levels of past decades.

(6) Deeming maximum employment as subjective. The statement previously noted that maximum employment “may” be changeable and immeasurable, but “may” was removed in the 2020 statement. In other words, the FOMC definitively deems maximum employment to be a subjective matter. And maximum employment never has been a clear-cut state defined by a single variable. Former Fed Chair Janet Yellen tracked a labor market dashboard with nine indicators of employment (low labor force participation rates were a regular pain in her side even while the unemployment picture looked strong).

(7) Adding more employment variables. By the way, “broad based” and “inclusive” were added as qualifiers to the unemployment goal. Powell said that the revised statement “reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.” When Yellen led the Fed, we recall her often confirming that the Fed considers unemployment rates for particular cohorts in making policy decisions.

Fed III: Searching for Meaning. Many Fed watchers have criticized Powell’s speech as overly vague. Melissa and I agree, and the revised statement wasn’t much clearer. But the footnotes were rich with important insights. There, Powell noted that several papers contained “extensive discussion” around the Fed’s new approach. Here are a couple of interesting details:

(1) Yield-curve control is here. Neither Powell nor the statement said anything about implementing a yield-curve-control policy, but that may just be because the Fed didn’t want to make two policy announcements at once. A paper coauthored by Fernando Duarte and others compared recent inflation-overshooting commitments by the Bank of Japan (BOJ) and the Czech National Bank (CNB). While the BOJ remains unsuccessful at supporting inflation, the CNB has had some success.

The authors attribute that difference partly to the public perception that the BOJ’s commitment was “a minor deviation from previous [forward guidance], whereas the CNB’s policy was perceived as a brand-new policy initiative.” Because “the inflation overshooting commitment was introduced together with a major policy initiative, the yield-curve-control policy,” in Japan, BOJ watchers did not perceive the overshooting commitment as a major policy change.

Nevertheless, the Fed may already have adopted an unofficial yield-curve-control (YCC) strategy with its promise to support the bond market during the pandemic. In a July 29 Barron’s article, Randall Forsyth astutely observed: “Not only have Treasury yields been historically low, they have been unusually stable. That would be consistent with ‘yield curve control,’ a method of pegging long-term borrowing costs. This has been among the policies under discussion by the Fed in its review of its policy procedures.” As noted above, the Fed seems to have been doing a good job of pegging the bond yield below 1.00% since March 20.

Federal Reserve Vice Chair Richard Clarida said on Monday that yield caps and targets aren’t warranted currently but “remain an option that the committee could reassess in the future.” He implied that a formal YCC policy isn’t necessary because an informal one is already in place: “We believe that forward guidance and large-scale asset purchases have been and continue to be effective sources of support to the economy when the federal funds rate is at” zero.

(2) Rate hikes on hiatus. Neither the FOMC statement nor Powell’s speech indicated how long the Fed might tolerate an inflation-target overshoot, both merely noting vaguely that the Fed could hold back on rate hikes “for some time” after inflation above 2.0% appeared. But a critical paper by Jonas Arias and others concluded that effective makeup strategies work best over a long time horizon of four to eight years! The researchers found shorter-term approaches to be “not very successful in stabilizing inflation by more than the inertial Taylor rule,” i.e., the formula that the Fed historically has used as a guide in setting interest rates when the Phillips Curve was working. That could mean that we are in for many years of a low federal funds rate to compensate for the inflation-target misses of the past decade or so.

The paper concluded: “Shorter makeup windows may be more credible, but they return inflation less rapidly” to 2.0%, raising “doubts about policymakers’ commitment to their longer-run inflation objective. Longer makeup windows may lead to better stabilization outcomes but require credible promises about the course of monetary policy in the distant future.” Powell said in his July press conference that the Fed isn’t “even thinking about thinking about raising rates.” This paper suggests that thought may remain out of mind for many years to come!

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Lots of Liquidity Left

September 01 (Tuesday)

Strategy: Piles of Cash. The World Health Organization officially declared a pandemic on Wednesday, March 11. The next day, on Thursday, March 12, Joe and I pushed our 3500 year-end target for the S&P 500 to mid-2021. We observed that credit-quality spreads were widening dramatically, with corporate and municipal yields rising rapidly relative to Treasury yields, signaling a credit crunch. We expected that the Fed would respond with helicopter money and ask Congress for permission to buy corporate securities. On Sunday, March 15, the Fed lowered the federal funds rate by 100bps to zero and adopted QE4.

On Monday, March 16, we observed that a “mad dash for cash” was causing widespread illiquidity in the financial markets. That same day, the White House issued new guidelines “for every American to follow over the next 15 days as we combat the virus.” California issued a stay-in-place order on Thursday, March 19; New York followed on Friday, March 20; and the rest of the states did the same during the following few days. On Monday, March 23, the Federal Reserve announced QE4ever, including purchases of corporate bonds. On Friday, March 27, President Trump signed the CARES Act.

The monetary and fiscal policymakers responded to the pandemic by pouring trillions of dollars into the financial markets and the economy. That halted the mad dash for cash. Liquidity improved significantly in the financial markets, as evidenced by the rapid narrowing of credit-quality spreads and the drop in bond yields across the board. The stock market bottomed on March 23 and proceeded to melt up to a new record high by August 18. The recession lasted two months (March and April), with most key economic indicators showing V-shaped recoveries during May, June, and July.

The point of this mad dash through recent events is to assess whether all the cash that was provided by the monetary and fiscal policy responses to the pandemic has been used, increasing the risks of a significant weakening of the economic recovery and limiting the upside for stock prices. We won’t keep you in suspense: There’s still plenty of cash to keep things going forward for a few more months. We continue to monitor the situation in our Mad Dash for Cash In 2020 chart publication. Consider the following:

(1) Bond yields & credit-quality spreads. The 10-year US Treasury bond yield has been trading in record-low territory below 1.00% consistently since March 20 (Fig. 1). The yield on high-yield corporate bonds spiked from this year’s low of 5.02% on February 19 to a recent peak of 11.38% on March 23 (Fig. 2). It was back down to 5.37% on Friday. Over this same period, the spread between this yield on corporate junk bonds and the Treasury bond yield jumped from 346bps to 1,062bps and back down to 463bps (Fig. 3).

(2) Liquid assets & M2. The mad dash for cash caused liquid assets (consisting of total savings deposits, small-time deposits, and total money-market mutual funds held by individuals and institutions) to soar $2.7 trillion from $13.6 trillion during the February 3 week to a record high of $16.3 trillion during the June 1 week (Fig. 4). It remained near that record high during the August 17 week. The growth rate of M2 jumped from 6.5% y/y at the start of the year to 23.6% during the August 17 week (Fig. 5).

(3) Central banks’ balance sheets. The major central banks continue to pour liquidity into the global financial system. Since the start of this year, the balance sheets of the three major central banks are up sharply to record highs as follows: the Fed (up $2.9 trillion to $7.0 trillion during the August 26 week), the European Central Bank (up $2.4 trillion to $7.6 trillion during the August 21 week), and the Bank of Japan (up $1.0 trillion to $6.3 trillion) . The sum of their assets soared $6.3 trillion to a record $20.9 trillion from the start of this year through the August 21 week (Fig. 6).

(4) Government social benefits & personal saving. During July, personal income was $20.0 trillion (saar), down from April’s record high of $21.1 trillion but still up from $19.0 trillion during January (Fig. 7). Government social benefits payments continued to buoy personal income, as personal income excluding those payments rose from $14.5 trillion during April to $15.2 trillion during July, but that was still below the record high of $16.0 trillion during February. The sum of unemployment insurance plus support checks (included in “other” social benefits) jumped from $538 billion (saar) during January to a record high of $3.9 trillion during April and dropped to $2.1 trillion during July (Fig. 8).

Personal consumption expenditures in current dollars rose to $14.2 trillion (saar) during July as spending on goods rose to a new record high; spending on services regained 14.1% since April but remained 9.3% below its record high during February (Fig. 9).

Initially, much of the monetary and fiscal stimulus provided to cushion the economic impact of the pandemic boosted personal saving, which soared from $1.3 trillion (saar) during January to peak at a record $6.4 trillion during April (Fig. 10). The lockdowns limited consumers’ ability to shop for goods and services.

Personal saving subsequently has dropped to $3.2 trillion during July, reflecting the easing of lockdown restrictions, which has enabled consumers to spend the piles of cash they had accumulated. There’s still room for personal saving to fall further in coming months, providing a lift to consumer spending. That should help to offset the end of the pandemic-related government benefits if they are not renewed. Hopefully, wages and salaries will continue to recover, providing the best support for consumer spending.

(5) Stock market indexes. In our May 26 Morning Briefing, we explained that the rebound in stock prices since March 23 was enabled by the latest round of bond buying by the major central banks in response to the pandemic. That enabled investors to rebalance into stocks and out of bonds as those very same monetary policies drove bond yields to record lows. Nevertheless, as we noted above, liquid assets remain in record-high territory, suggesting that the rebalancing out of bonds continues and that liquidity remains amply available to drive stock prices higher.

The result has been a meltup in stock prices that has the potential to turn into the Mother of All Meltups (MAMU). As we noted yesterday, since March 23, the S&P 500 rose 56.8% to a new record high of 3508.01 on Friday. It did so in 158 calendar days. The last time it rebounded so much so fast was during September 1933 (Fig. 11).

The Nasdaq’s 70.5% rally since March 23 through Friday is also impressive. While it pales by comparison to the 255.8% meltup from October 8, 1998 through March 10, 2000, this rally may be on the same trajectory as the one back then (Fig. 12).

US Consumers: Still Spending. The pandemic continues to be bad news for most of the services-producing industries of the economy. But it’s been great for goods-producing industries, especially in the months since the easing of lockdown restrictions. Among the biggest winners have been housing and housing-related industries, owing to the huge increase in the demand for single-family homes in the suburbs and rural areas of the country.

The scramble to de-urbanize has been led by Millennials, who are moving out of rental apartments in cities, with their dense populations, to buy homes with backyards for their kid(s) and enough space for one or even two home offices. Housing-related consumer spending is booming. Demand for passenger vehicles is likely also getting a boost from de-urbanization.

All of these developments are confirmed by July’s personal consumption expenditures (PCE) and PCE price deflators (PCED) data, released on Friday. Consider the following:

(1) Services. As noted above, PCE on services is up 14.1% over the past three months through July but remains 9.3% below its record peak during February. Leading the recovery has been PCE on health care services, up 43.2% over the past three months, and within 7.4% of its record high during February (Fig. 13). PCE on hospital services is down just 4.5% from its recent peak, as elective procedures delayed by the pandemic are getting done.

Here are the recent rebounds and current shortfalls from their recent highs in the PCEs for the other major services industries that have been hard hit by the pandemic: air transportation (769%, -48%), hotels & motels (163, -56), amusement parks, campgrounds, & related recreations (119, -54), and gambling (283, -28) (Fig. 14 and Fig. 15). Not surprisingly, the PCEDs for airfares and for lodging away from home were down 18.9% and 15.3% y/y during July (Fig. 16).

Making no sense is that PCE on tenant-occupied rent has been rising to new record highs all year. It’s been widely reported that many tenants haven’t been able to make their rent payments and that many state and local governments have banned evictions for the duration of the pandemic. The PCED for tenant-occupied rent is down from 3.6% y/y during January to 3.2% during July. It’s probably heading down to zero, as it did during the Great Financial Crisis.

The PCED for college educations has been outpacing the overall PCED for decades (Fig. 17). It was up 2.1% y/y during July. The pandemic has forced almost all colleges to go online. Lots of students and their parents are likely to question why tuitions are so expensive even after the pandemic is over.

(2) Goods. PCE on goods rose to a new record high during July. Here are some of the retail industries that either rebounded to their highs at the start of this year or hit new highs during June and July based on retail sales: building materials, garden equipment & supply dealers; furniture & home furnishing stores; electronic shopping & mail order houses; electronics & appliance stores; and sporting goods, hobby, book & music stores.

Even retail sales of motor vehicles & parts dealers rose to a new record high during July, which is odd since new motor vehicle sales totaled 14.5 million units (saar) during July, down from 17.0 million units during January. It could be that used car sales are getting a big lift from people moving out of cities. That’s confirmed by the 10.2% y/y increase in the PCED for used car prices during July (Fig. 18).

 US Inflation: Fed of La Mancha. Last Thursday, Fed Chair Jerome Powell announced that after a year-long review, the Fed has a new approach to targeting inflation. The Federal Open Market Committee (FOMC) first publicly declared its longer-run goal for inflation in a January 25, 2012 press release, which stated: “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

As we noted yesterday, the FOMC has been mostly undershooting its target ever since. That’s rather embarrassing considering the numerous rounds of monetary easing since the Great Financial Crisis, including three QE programs. Rather than even questioning the premise that inflation is determined mostly by monetary policy, the FOMC instead has chosen to slightly amend its inflation-targeting approach. Rather than aiming to reach 2.0%, the FOMC will tolerate overshoots that offset undershoots as long as the overshoots and undershoots together average around 2.0%. Consider the following:

(1) Keeping the same questionable assumption. The amended “Statement on Longer-Run Goals and Monetary Policy” maintains the language and the conceit that “the inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation.”

(2) The definition of insanity. The big-deal change in the amended statement is that the FOMC now “judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” There’s the rub: If the FOMC couldn’t get inflation up to 2.0% since January 2012, how will it get inflation to overshoot that mark long enough to average 2.0%?

(3) Don’t hold your breath. Perhaps the latest round of monetary easing will finally do the trick. However, don’t hold your breath. The prices of housing-related goods and services will likely come under upward pressure as a result of de-urbanization. Lumber prices have soared to new highs in recent weeks. Used car prices have been increasing at a faster pace too. On the other hand, for the foreseeable future, rent and college tuition inflation rates are likely to move lower, not higher. Inflation rates for airfares and lodging away from home are also likely to remain low.

(4) Counting on inflation to make a comeback. Inflation might move higher if manufacturers respond to trade tensions and the pandemic-related disruptions to their global supply chains by bringing supply chains home. That would be expensive and might force them to raise their prices. Then again, technological innovations in robotics, automation, artificial intelligence, and 3-D manufacturing could make coming home easier and cheaper.

Perhaps aging demographics will push up health care inflation. Perhaps record-low mortgage rates will drive up home prices, making rents look attractive, and also drive them higher. How does pushing health care and rental costs higher make any sense as a sensible goal for monetary policy?

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Anatomy of a Meltup

August 31 (Monday)

Strategy I: Tiger by the Tail. The S&P 500 has soared 56.8% since it bottomed this year on March 23. Our latest suggested theme song for the stock market is “I’ve Got a Tiger by the Tail,” by Buck Owens & His Buckaroos and released in 1964. All together now: “Well, I thought the day I met you, you were meek as a lamb / Just the kind to fit my dreams and plans / But now, the pace we’re livin’ takes the wind from my sails / And it looks like I’ve got a tiger by the tail.”

Did a new bull market start on March 24? Technically speaking, it did, given that the previous bull market was followed by a 33.9% drop in the S&P 500 from February 19 through March 23. That plunge exceeded the 20% demarcation line between a 10%-20% correction and a 20%+ decline during bear markets. However, the latest bear market lasted only 33 calendar days and 23 trading days from its peak to trough, with the market down more than 20% from its peak during just 18 of those days. That’s not much of a bear market. It’s the shortest one on record. It’s more like a correction, in my opinion. Nevertheless, Joe is a by-the-book quant and insists that we add it to our table of S&P 500 Bear Markets and Corrections Since 1928 as a bear market.

I’ve often observed that bear markets are caused by recessions, and there certainly has been a terrible one resulting from government-mandated lockdowns to impose social distancing to slow the spread of the pandemic. I’ve also noted that previous recessions usually were caused by credit crunches. The recent lockdown recession lasted just two months, i.e., March and April. Massive monetary easing averted a credit crunch. The lifting of lockdown restrictions combined with massive fiscal stimulus led to V-shaped rebounds in key economic indicators during May, June, and July.

So I think it makes some sense to view the current meltup to new record highs in the S&P 500 as a continuation of the bull market that started on March 9, 2009. If so, we may now be seeing the beginning of the tail end of that long bull market given that previous bull markets often ended with meltups that set the stage for meltdowns.

Joe and I had hoped that the market would consolidate its gains since March 23, giving earnings a chance to rebound. However, Fed officials continue to drive up stock prices by committing to keeping interest rates close to zero for a very long time, as we discuss below. Consequently, they are fueling the meltup in stock prices.

On March 12, as the pandemic of fear spread rapidly in the financial markets, we pushed our year-end 2020 target of 3500 for the S&P 500 to mid-2021 and targeted 2900 for the end of this year instead. On the morning of Wednesday, March 25, after the S&P 500 stock price index closed at 2447.33 on Tuesday, Joe and I declared that it had bottomed on Monday, March 23 at 2237.40. We maintained our 2900 target for the end of this year. That seemed fairly aggressive considering that the pandemic was raging.

The index blew decisively through our 2900 target on May 18. We had hoped that the market would consolidate its gains around that level, but it kept moving higher. So on August 12, when the S&P 500 was 3380.35, we raised our target to 3500 for the end of this year and to 3800 for the end of next year. It blew through 3500 on Friday. It could easily do the same to our 3800 target well ahead of schedule. As we saw in 1999, it’s impossible to forecast the upside of a meltup.

Honestly, we would still like to see the market consolidate its gains at least through the November 3 election and let earnings catch up with the stock price gains to date. If the meltup continues, the election could be the event that triggers a meltdown if it is bitterly contested or if a Democratic sweep results in a radical regime change.

Meanwhile, as the song goes: “There ain’t no way to slow you down / I’m as ’bout as helpless as a leaf in a gale / And it looks like I’ve got a tiger by the tail.” More accurately, it looks like we’ve got a stampeding bull by the tail.

Strategy II: Zero Interest Rates & Valuation. Joe and I frequently have observed that the stock market rally since March 23 could turn into the Mother of All Meltups (MAMU). Sure enough, since then, the S&P 500 rose 56.8% to a new record high of 3508.01 on Friday (Fig. 1). It did so in 158 calendar days. The tech-heavy Nasdaq is up 70.5% over the same period, also to a new record high of 11695.63 (Fig. 2).

The last time that the S&P 500 rebounded so much in such a short period was during September 1933. While the Nasdaq’s rally is impressive, it pales by comparison to the 255.8% meltup from October 8, 1998 through March 10, 2000, but it may be on the same trajectory now as it was back then.

The forward P/E of the S&P 500 jumped to 22.1 at the end of August, approaching the highs during the tech bubble of 1999 (Fig. 3). The forward price-to-sales ratio of the S&P 500 rose to 2.40 during the August 20 week, the highest on record (Fig. 4).

The stock market is working on answering the question that Joe and I have been asking in recent weeks: “In a world of zero interest rates, what is the fair value of the S&P 500 forward P/E?” Taking our cue from Hamlet, we are simply asking whether stocks should be deemed to be or not to be too expensive when the federal funds rate is zero and the 10-year US Treasury bond yield is less than 1.00%, as both have been since the second half of March.

The market’s answer, so far, is that stocks remain cheap as long as interest rates stay this low. The longer they stay this low, the cheaper stock prices appear to be, and the higher they might potentially go. Last Thursday, Fed Chair Jerome Powell did his best to convince us all that interest rates will stay this low for a very long time. He said so during his speech at Jackson Hole. He officially declared that the Fed no longer is aiming for a 2.0% bullseye on the inflation target but rather for an average around it.

The 2.0% target was officially declared by the Fed in January 2012. During the 102 months since then through July of this year, the headline and core PCED (personal consumption expenditures deflator) inflation rates have averaged 1.4% and 1.6%, rarely hitting the mark and consistently below it (Fig. 5 and Fig. 6). Since January 2012 through July of this year, the PCED has been tracking an annualized growth rate of 1.3% (Fig. 7). As a result, it is currently 5.2% below where it should be by now had it been tracking the Fed’s 2.0% target. To get back on the 2.0% inflation rate track since the start of 2012 certainly leaves the Fed plenty of room to tolerate a pickup in inflation without even “thinking about thinking about raising [interest] rates” under the new AIT approach (quoting Powell from his July 29 presser).

Notwithstanding Powell’s dovishness, bond yields rose in response to his speech on Thursday. Investors seemed more concerned about the inflationary consequences of AIT than about the prospect that the federal funds rate will remain around zero for a longer time under the new regime. However, the fact that the Fed has failed to get inflation sustainably up to 2.0% since January 2012 raises the question of why the Fed would be any more likely to finally do so simply because it has declared that overshoots will be tolerated. In any event, if the bond yield continues to move higher, Melissa and I are certain that the Fed will adopt a policy of “Yield-Curve Control,” which is a fancy term for pegging the bond yield. In that scenario, the meltup in stock prices certainly would continue.

So again, we ask: In a world of zero interest rates, what is the fair value of the S&P 500 forward P/E? The market’s current answer is as follows:

(1) S&P 500 forward P/E. The S&P 500’s forward P/E on Friday was 22.9, up from 12.9 on March 23. The last time it was this high was May 22, 2001, when the 10-year bond yield was 5.42% and the PCED inflation rate was 2.5%. The bond yield was down to 0.74% on Friday. July’s PCED inflation rate was 1.0%.

(2) S&P 500 Growth vs Value forward P/E. As of Friday’s close, the forward P/E of the S&P 500 Growth index rose to 29.4, up from the March 23 low of 16.8 (Fig. 8). The latest reading is the highest since May 2001, when the bond yield was 5.39% and inflation was 2.5%.

The forward P/E of the S&P 500 Value index also jumped from 10.0 on March 23 to 17.3 currently. Interestingly, the ratio of the forward P/Es of Growth to Value has been on an uptrend since early 2017, and is currently at 1.65, which is still well below this ratio’s July 2000 bubble peak at a reading of 2.67 (Fig. 9). Meanwhile, the ratio of the forward earnings of Growth to Value has spiked higher since the start of this year, justifying the widening P/E spread between the two (Fig. 10).

(3) S&P 5 vs S&P 495 forward P/E. Leading the charge higher among the S&P 500 have been the S&P 5 (a.k.a. the Magnificent Five). As of the August 28 week, they accounted for a record 25.9% of the market capitalization of the S&P 500 (Fig. 11). The market-cap share of the comparable S&P 5 during the tech bubble peaked at a then-record high of 18.5% during March 2000.

Today’s Magnificent Five are the so-called FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google). Collectively, their forward P/E rose to 44.3 at the end of last week. Is that nuts, or is it justified by their ability to grow their forward revenues and earnings faster than the S&P 495 in a world of zero interest rates? By the way, just before the S&P 500’s Tech bubble burst during March 2000, the sector’s forward P/E peaked at 48.3, while the bond yield was 6.26% and inflation was 2.9%.

 (4) Bottom line. We are in the midst of a Fed-led meltup in valuation multiples.

 Strategy III: Moving Averages Are Moving. The Fed’s move last week to average-inflation-targeting widened the spread between the S&P 500 and its 200-day moving average to 13.7%, the highest reading since February 2011 (Fig. 12). Here is the performance derby of the comparable spreads for the S&P 500 sectors: Information Technology (28.0%, the highest since April 2000), Consumer Discretionary (25.8, a record high), Communication Services (17.2, the highest since May 1999), Materials (13.6), Industrials (8.8), Consumer Staples (8.4), Health Care (8.0), Real Estate (1.5), Financials (-1.3), Utilities (-3.4),and Energy (-17.2).

The Magnificent Five have been leading the way in this derby. As of Friday’s close, here are their spreads relative to their 200-dmas (200-day moving averages): Facebook (38%), Apple (55), Amazon (47), Microsoft (29), and Google (18). Frequently included in the list of overachievers are Netflix (31) and NVIDIA (70). Tesla (162) isn’t in the S&P 500. Apple, Microsoft, and NVIDIA account for 50.6% of the market cap of the S&P 500 Information Technology sector. Facebook, Google, and Netflix account for 67.7% of Communication Services. Amazon’s share of the Consumer Discretionary sector is a staggering 51.6%.

Movie. “Radioactive” (+) (link) is a biopic about Marie Curie. Together with her husband Pierre, she was awarded half of the Nobel Prize for Physics in 1903, for their study into the spontaneous radiation discovered by Henri Becquerel, who was awarded the other half of the Prize. In 1911, she received a second Nobel Prize, this time in Chemistry, in recognition of discovering two elements, polonium and radium. Despite her great professional accomplishments, the press hounded her about her personal life, mostly for partisan purposes. As the French saying goes, “plus les choses changent, plus elles restent les mêmes.”

Correction. In the advance copy of last Thursday’s Morning Briefing sent Wednesday evening, we incorrectly referred to poet Joyce Kilmer as “she.” Alfred Joyce Kilmer was an American writer and poet mainly remembered for a short poem titled “Trees,” which was published in the collection Trees and Other Poems in 1914.

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Homes & Drones

August 27 (Thursday)

Consumer Discretionary I: Homebuilders Cashing In. As we discussed in yesterday’s Morning Briefing, recent economic data have indicated that the housing market is on fire. Sales are up, prices are up, and inventories are down in both the new and existing home markets. The recent earnings reported by some of the largest homebuilders confirm that the industry not only has recovered from the COVID-19 pandemic’s impacts but indeed is benefiting from some of them—including dependably low interest rates, thanks to the Fed’s pandemic response, and the desire of urbanites to escape city living as they crave more space given the need to social distance and work from home. All these factors have helped the housing industry fare much better than anyone might ever have expected earlier this year.

The S&P 500 Homebuilding stock price index has enjoyed a major V-shaped recovery. The index fell 46.5% from December 31 through March 23. It then rallied 144.5% through Tuesday’s close, leaving it up 30.9% ytd through Tuesday’s close (Fig. 1). The index closed at its first new high on August 10 in 15 years.

Investors certainly should keep an eye on surging lumber prices, rising mortgage delinquency rates, and falling apartment rental rates; respectively, these could add costs, boost housing supply, and offer buyers alternatives. But for now, homebuilders’ CEOs sound awfully optimistic. Here’s a sampling of what they’ve been saying:

(1) Buyers are buying. Homebuilders have been reporting amazing rebounds in their orders in June, July, and August. The latest data point came from Toll Brothers, which reported on Tuesday that $2.21 billion of contracts for 2,830 homes were signed in its fiscal Q3, ending July 31, compared to $1.81 billion of signed contracts for 2,201 homes in Q3 2019. “Our third quarter net signed contracts were our highest third quarter ever in both units and dollars, and our contracts per community, at 8.5, were the highest third quarter in fifteen years. This strength has continued into August,” said CEO Douglas Yearley in the company’s press release.

PulteGroup reported that net new orders fell 53% in April y/y, only to increase 50% in June. Demand remained strong through the first few weeks of July, CEO Ryan Marshall reported in Pulte’s July 23 earnings conference call.

D.R. Horton’s results followed a similar pattern. In April, net sales orders fell 1% y/y as COVID-19-related stay-at-home orders were in place in most of their markets. But as they lifted, business surged: Both May and June saw net sales orders increase by more than 50% y/y, CEO David Auld reported on the company’s July 28 earnings conference call. Activity remained strong in July, with orders “consistent” with May and June’s results.

“We believe the increase in demand after April has been fueled by increased buyer urgency due to lower interest rates, the limited supply of homes at affordable price points, and to some extent, pent-up demand,” said Horton’s CFO Bill Wheat. Sales were also boosted by folks relocating to more affordable and tax-friendly environments, Auld noted.

Pulte has noticed that daily online searches using new-home-related phrases have been growing since mid-March and have been hitting multi-year highs routinely. In addition, ZIP code “analysis of buying patterns points to a movement of renters and homeowners from urban centers into the surrounding suburbs. Based on an internal survey, roughly half of our division presidents report that their business has experienced a modest increase in demand from urban buyers, while several of our divisions referenced a material increase in such demand,” said Pulte’s Marshall.

The difference between the urban condo market and suburban housing market was evident in Toll’s earnings. The company has a City Living division that develops condominiums in what were some of the hottest urban markets, including New York, Hoboken, Seattle, and Los Angeles. The division’s new contracts signed in Q3 fell to three from 40 in the year-ago quarter.

(2) Long-term picture looks good too. As we discussed yesterday, the Millennials are finally moving to the ‘burbs and settling down. The generation has formed households later and had children later, noted Horton’s Auld. And that means there are “just a whole lot of people out there that I think are going to be looking for housing over the next five-plus-years,” he added.

And while it’s just anecdotal, the wedding industry’s loss may be the housing market’s gain. Sad brides and grooms across the country have had to postpone or cancel weddings, as COVID-19 makes large gatherings impossible. Some who have canceled festivities are using the money they (or their parents) originally saved to pay for weddings as down payments for a home purchase instead.

While we haven’t found concrete data on just how many couples have opted for this practical route, the potential pot of money up for grabs is huge. Americans spent $54 billion on more than 2 million weddings in 2019, a March 20 NPR article reported. Theknot.com’s survey found that couples paid $33,900 on average for a wedding, which includes the engagement ring but not the honeymoon. For those living in New York or New Jersey, the figure is closer to $50,000. A perfect down payment.

(3) Gross margins improve. Homebuilders raced to cut costs when COVID-19 shut down the economy this spring. And when demand resurfaced this summer, homebuilders were able to sharply reduce sales incentives, and, in some instances, raise prices. As a result, gross margins have improved. D.R. Horton’s gross profit in the June quarter was 21.6%, up 0.30ppt q/q and 1.3ppt y/y.

Pulte reported that more than half of its divisions have raised prices by 1%-3% in 50% or more of their communities, either by changing the base price and/or reducing incentives. Its gross margin was 23.9%, up 0.80ppt y/y and a 0.20ppt increase from Q1. For next quarter, the company is forecasting a gross margin of 23.9%-24.2%.

(4) Lumber and land costs bear watching. The S&P 500 Homebuilding industry’s forward profit margin (which is a time-weighted calculation of the component companies’ collective profit margin based on analysts’ earnings and revenue forecasts for this year and next) has improved, but not quite as dramatically as forward revenues have (Fig. 2). Analysts may be concerned about the recent surge in lumber prices. The random-length lumber futures price soared to a record high of $830.90 per 1,000 board feet last Friday, and was little changed at $829.30 by Tuesday, up 105% ytd and well above the previous record high of $651.00 hit on May 14, 2018 (Fig. 3).

We expect wood prices to remain elevated as mills try to catch up with demand from home construction and renovation projects. Tariffs only add to the cost of Canadian lumber imports. Horton’s COO Mike Murry said lumber prices could be a “headwind” later this year and early next year. In addition, the rise in land prices could accelerate as homebuilders replenish their inventory as home sales have accelerated.

(5) Watch inventory levels too. The number of homes up for sale is extremely low. The situation may be artificially exacerbated by the hesitancy of folks who want to sell their homes but fear exposure to COVID-19 from potential buyers looking through their homes. If that reverses, a pent-up supply of homes may hit the market.

The number of homes for sale might also increase if foreclosures start to rise. Currently, the percentage of loans that actually are in foreclosure remains extremely low, at 0.68%, down 0.05ppt from the Q1 level. However, the percentage of residential mortgages that are at least one payment past due rose nearly 4ppts q/q to 8.2% in Q2, according to the Mortgage Bankers Association’s National Delinquency Survey. The figures include the 4.2 million homeowners in the forbearance program, which allows those facing financial struggles due to the pandemic to put off mortgage payments for up to one year.

(6) Watch rents. When asked about his firm’s pricing power, Pulte’s Marshall suggested that analysts pay attention to rents, implying that the ability to raise home prices could be limited by falling apartment rents. Among many considerations, first-time home buyers weigh the cost of renting an apartment versus buying a new home. And in many of the nation’s cities, rental prices are falling. Rents for one-bedroom apartments in the 10 priciest US markets fell by an average of 5% y/y in August, according to zumper.com. The biggest y/y rental price drops in August occurred in San Francisco (-11%), New York (-6.9), Boston (-6.0), San Jose, CA (-9.4), and Oakland, CA (-3.5). However, on average across the nation, one-bedroom rents increased by 0.3% y/y.

(7) Homebuilding stock market metrics. The sharp rebound in the housing market caught analysts by surprise. The S&P 500 Homebuilding industry is currently expected to grow revenue by 2.4% this year and 9.6% in 2021. That’s an improvement from April 30, when the estimates stood at -5.1% and 3.8% (Fig. 4). Likewise, the industry’s earnings are forecast to rise 17.8% this year and 10.2% in 2021. But back on April 30, earnings were expected to fall 10.6% this year and rise 4.5% next year (Fig. 5).

The S&P 500 Homebuilding stock price index is trading at a forward P/E of 12.1, in line with its historical readings (Fig. 6). Since 2014, the industry’s P/E bounced between 5.7 in March 2020 and 15.3 in February 2014. If homebuilders can pass on rising lumber costs and Millennials keep moving to the ’burbs, 2020 will be a comeback year to remember for the homebuilding industry.

Consumer Discretionary II: Restaurants’ Deceptive Rally. The S&P 500 Restaurants industry stock price index finally has recouped its losses from earlier this year and turned positive. The index is now up 3.5% ytd through Tuesday’s close (versus 6.6% for the broader S&P 500), an impressive 61.0% comeback since March 18, when it was down by 37.5% ytd (Fig. 7).

Unfortunately, things aren’t quite as rosy as they first appear. Almost all the gains enjoyed by the index come from one stock: Chipotle Mexican Grill. Here’s how the S&P 500 Restaurants industry’s stocks have performed ytd through Tuesday’s close: Chipotle (51.7%), McDonald’s (7.6), Yum! Brands (-4.2), Starbucks (-5.9), and Darden Restaurants (-24.2).

Chipotle has benefited from its online sales and ability to offer drive-through service, takeout, and delivery to customers. Online sales accounted for 60.7% of revenue in Q2, up from 26% in Q1. That has given it an edge over competitors without those services while COVID-19 continues to circulate.

Chipotle may also be benefitting from speculation that it will announce a stock split given that its shares trade hands at $1,277 each. When Tesla and Apple announced stock splits, their shares rallied even though stock splits have no effect on the underlying company’s finances.

Analysts are optimistic that S&P 500 Restaurants industry’s losses this year will reverse in 2021. They’re forecasting forward revenues will drop 6.6% in 2020 and jump 15.1% in 2021, while earnings will drop 33.3% this year only to surge 60.0% in 2021 (Fig. 8 and Fig. 9). That’s good news for all involved.

 Disruptive Technologies: Drones Lend Mother Nature a Hand. Whether or not you believe in climate change, it’s hard to argue against trees. They look good, provide a habitat for our furry friends, and clean the air. They have inspired and even humbled great poets like the late Alfred Joyce Kilmer (1886-1918), who penned the famous poem Trees. “Poems are made by fools like me,” he wrote, “But only God can make a tree.” Maybe so, but drones now are making it possible to plant trees more quickly and cheaper than ever before.

A number of startups have created biodegradable pods that contain a seed and nutrients to increase the odds that the seed grows into a tree. These companies have also built drones that shoot seeds into the ground in areas to be reforested, which the drones have mapped out as well. Potential areas for reforestation include lands that have been scorched by fire or stripped of vegetation after being used for mining or oil and gas operations.

Dendra Services, which operates in the UK and Australia, worked with Glencore in 2019 to plant seeds over land that was previously used to mine coal. The company also has software to provide monitoring and reporting services and estimates there are 2 billion hectares of degraded land across the globe ripe for restoration.

Flash Forest is a similar company located in Canada, which aims to plant 1 billion trees by 2028. It claims that by using its drones, one supervisor can oversee the planting of 100,000 seed pods per day. That’s a vast improvement over the 1,500 trees a day that humans can plant.

This spring, the company planted 40,000 seeds on land north of Toronto that had burned in a wildfire, a May 15 Fast Company article reported. Here’s the process: First, drones survey the area and identify the best places to plant seeds. Then, drones drop the seed pods. In the ensuing months or years, they return to monitor the trees’ progress. “The company aims to bring the cost down to 50 cents per tree, or around a fourth of the cost of some other tree restoration efforts,” the article stated.

Flash Forest has projects planned in Hawaii, Australia, Columbia, and Malaysia. “In some cases, funding comes from forestry companies, government contracts, or mining companies that are required to replant trees; in other cases, the startup plants trees for companies that offer tree-planting as a donation with the sale of products, or for landowners who can get a tax break, in some areas, for planting trees,” the Fast Company article reported.

A third company, DroneSeed, was set to work with The Nature Conservancy in Oregon to reforest an area where trees had been killed by an invasive species. The company also helped plant seeds in Medford, Oregon after a fire burned more than 7,000 acres. “Rather than plant seedlings—which would require a two-year wait while they grew in greenhouses—the timber company overseeing the reforestation effort decided to have DroneSeed plant immediately,” a March 1, 2019 article on the UAV Coach website stated.

Alfred Joyce Kilmer would be pleased.

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The Pandemic & American Demography

August 26 (Wednesday)

US Demography: ’Til Death Do Us Part. During pandemics, there seems to be more time to think about the meaning of life. Doing so is only natural when coronavirus case and death counts are updated daily by the news media, which stand at 24.0 million and 820,230 worldwide as of yesterday afternoon. The US has had the highest number of cases (5.9 million) and deaths (181,822) of any country so far, according to the Coronavirus Worldometer.

Meanwhile, life goes on, as do deaths. Over the past 12 months through March, 3.1 million babies were born in the US, well above the 2.4 million deaths over the same period (Fig. 1). However, the number of births was the lowest since spring 1987, while the number of deaths was a record high. The difference between the number of births and deaths of 0.7 million was the lowest on record going back to 1973 (Fig. 2). This figure may be poised to go lower still as the pandemic raises death counts and the financial effects of associated lockdowns coupled with health concerns lower birth rates.

It will be interesting to see how the pandemic affects births and deaths in the US in coming months and years, and what the economic impacts will be. Let’s consider some of the possible consequences of the pandemic on both, as well as other demographic developments:

(1) Births. The pandemic could lower the number of births by half a million babies over the next year, according to a June 15 Brookings report. When the pandemic lockdowns occurred, there was some speculation that the result would be a baby boom, as young couples shut in together are bound to make babies. But this reasoning doesn’t stand up against historical statistics during periods of economic uncertainty and health crises, the authors argue.

On the contrary, the researchers see the lockdown-provoked economic uncertainty causing couples to delay plans for more kids, with the result that some women will have fewer children over their lifetimes; that’s based on statistics from before and after the previous Great Recession. “In 2007, the birth rate was 69.1 births per 1,000 women ages 15 to 44; in 2012, the rate was 63.0 births per 1,000 women. That nine percent drop meant roughly 400,000 fewer births,” the researchers show. They also find, based on an analysis of state-level data during the Great Recession, that a 1ppt increase in unemployment reduces the birth rate by 1.4%. During the 1918 Spanish flu, large spikes in mortality were matched by large declines in births, they observe. Each wave of the Spanish flu correlated with birth-rate declines of roughly 21 births per 1,000 population, or 12.5%. By the way, the fertility rate dropped to a new record low of 58.2 during 2019 (Fig. 3).

Although the researchers don’t mention this, anecdotal evidence suggests that the challenges of parenting seem more daunting in recent times. Many are questioning how they could possibly manage more children without the help of childcare systems they once relied upon, which in many communities have vanished during the pandemic. Even before the pandemic, many Millennials of child-bearing age were on the fence about having more children, with some deciding to delay childrearing and some deciding not to have children, period. Now, lots of parents of school-age children are hard-pressed to juggle their day jobs and remote schooling for their current children as the pandemic continues to spread. That’s often without the social support networks they knew before the pandemic given the need to socially distance, especially from vulnerable grandparents. And parents who are unable to work from home while their kids are required to learn from there face stark choices indeed.

(2) Deaths. Skeptics may say that many of the deaths attributed to COVID-19 likely would have occurred without it, as the disease is most deadly for the elderly and infirm. Others say that the virus-related deaths may be offset by decreases in deaths from causes such as car accidents, given that people don’t leave their houses as much during the pandemic. But data show that the number of deaths in the US so far this year through July is 8%-12% higher than would have been expected had the coronavirus pandemic never happened, observed The Conversation, an independent news source. Excess deaths are calculated as actual deaths over estimated deaths in the absence of the pandemic using historical data from the Centers for Disease Control and Prevention (CDC).

COVID-19 could be the third-leading cause of death in the US this year behind only cancer and heart disease, CDC statisticians told CNN. Indeed, COVID-19 is on track to kill hundreds of thousands of Americans, up there with the country’s top 10 causes of death in 2018: heart disease (655,381), cancer (599,274), unintentional injury (167,127), chronic lower respiratory disease (159,486), stroke (147,810), Alzheimer’s disease (122,019), diabetes (84,946), flu and pneumonia (59,120), nephritis (51,386), and suicide (48,344).

From 2017 to 2018, however, age-adjusted death rates decreased for six of the 10 leading causes of death and increased for only two. The overall age-adjusted death rate decreased, and the leading causes of death did not change. In fact, during the 20^th century, the US experienced an unprecedented decline in mortality “thanks to improvements in public health, medical advances, and behavioral changes,” as a 2016 Penn Wharton brief demonstrated in a chart. In other words, the recent pre-pandemic rise in deaths to record levels is more likely due to a combination of population growth and population aging. Nevertheless, the pandemic has resulted in—and may continue to result in—more excess deaths until effective treatments and vaccines are found and widely used.

(3) Marriage & divorce. COVID-19 may be leading to a marital crisis for couples with pre-existing relational strains. Even without the virus to worry about, financial stress has been a long-time leading cause of divorce. Combine a new job loss or income loss with being cooped up together for months and the continued loss of face-to-face social support networks due to the virus, and the result is too nasty a cocktail for many married couples to stomach, whether they started out on solid footing or not.

That’s not to mention that the pandemic has forced many married couples with children to rearrange household duties and reverse caregiving roles. So it’s no surprise that there are signs of higher divorce rates and relational strain during the pandemic. Globally, domestic violence has increased. However, any increase in US divorces runs counter to the current trend. Since August 2007 until the latest data through March, the number of divorces has been on the decline (Fig. 4).

In large part, that may be because the number of marriages has declined over the same timeframe. Even prior to the pandemic, many young people were getting married later in life, after hitting educational or career milestones, and many were cohabitating with their partner before marriage. In other words, many young people waited to become more professionally established and personally confident in their potential for long-term compatibility with a partner before getting hitched.

(4) Renters & homeowners. The homeownership rate jumped from 65.3% during Q1 to a cyclical high of 67.9% during Q2. Some of the increase may be explained away by changes in the data collection due to the pandemic, but likely not all of it, as we discussed in our August 5 Morning Briefing. The increase in the rate was evident across all age groups, but particularly pronounced for the age cohorts under 35 and 35-44 (Fig. 5).

In that commentary, we explored how the “virus-related lockdowns may have caused many 30-somethings to value home life more than before the pandemic. And with work-at-home arrangements and historically low mortgage rates facilitating moves from cramped city apartments into the ‘burbs,’ Millennials’ leap into the traditional trappings of adulthood is accelerating. At the same time, many Baby Boomers are opting to stay put in their existing homes for now, tightening the supply of available homes for Millennials.”

We also discussed a brewing perfect storm in the rental segment of the housing market: Not only are renters increasingly cost burdened by rising rents and other costs of living, but many have lost jobs and/or income during the pandemic, and federal legislative actions supporting renters and preventing evictions have expired. Indeed, many low-income workers living in rental units are on the brink of eviction.

US Housing: Suburban Housing Boom. The pandemic clearly has triggered a suburban housing boom as a result of de-urbanization. Contributing to the boom are low mortgage interest rates, which dropped to a record-low 2.88% for a 30-year fixed mortgage during the August 6 week (Fig. 6). Rates were just below 5.0% during mid-2018. Mortgage applications have rebounded along with home sales since both series bottomed during the spring (Fig. 7). Sales of new plus existing single-family homes jumped to 6.18 million units (saar) during July, the best pace since December 2006!

The homebuying stampede has depleted the inventory of homes for sale. A 4.0 months’ supply of new home inventory was available as of the latest data through July (Fig. 8). Single-family existing homes dropped to only a 3.1 months’ supply last month (Fig. 9).

Higher demand for housing tends to boost demand for home improvements and furnishings. Already, a pronounced V-shaped recovery has occurred in retail sales for furniture and home furnishing stores (Fig. 10). Likewise, retail sales of building materials and garden equipment have shot through the roof in recent months to new record highs (Fig. 11). New suburbanites are also boosting the demand for cars.

Here’s more on the impressive pandemic-related boom in the existing and new housing markets:

(1) Existing home sales. According to the National Association of Realtors (NAR), existing home sales, which are based on closings, soared 49.9% from the recent low during May through July to 5.86 million units (saar), the highest since December 2006. The Pending Home Sales Index, based on contract signings for existing homes, soared 16.6% m/m in June to the highest reading since February 2006 (Fig. 12).

(2) Prices of existing homes. The 12-month moving average of the median single-family existing home price was $282,175 in July, up 6.2% y/y. On the same basis, the median price of new houses sold was $325,175 in July, a 2.0% increase (Fig. 13). Prices are likely to be driven higher at a faster pace in coming months by inventory shortages for units across the board.

(3) House starts and new home sales. Sales of new single-family homes soared 58.1% during the three months through July to 901,000 units (saar) the highest pace since December 2006 (Fig. 14). As a result, homebuilders have been scrambling to meet demand. Single-family housing starts jumped 38.4% over the same three months to 940,000 units, still below the 1.034 million units during February.

(4) Traffic. The Housing Market Index compiled by the National Association of Homebuilders (NAHB) is a useful indicator of new home sales (Fig. 15). The NAHB index is highly correlated with the NAR’s Pending Home Sales Index (Fig. 16). Both are higher now than they were just before the pandemic.

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Forward Looking

August 25 (Tuesday)

US Economy: Stalling? If the economic recovery is stalling, someone forgot to tell that to the folks who manage the Atlanta Fed’s GDPNow model, which tracks real GDP based on the latest available economic indicators. As of August 18, it indicated that real GDP was rising at a 25.6% seasonally adjusted annual rate during Q3, a significant recovery from the record quarterly freefall of 32.9% during Q2. Debbie and I are predicting a 20.0% increase during Q3 (Fig. 1). We are still expecting that real GDP will fully recover all that was lost during the Great Virus Crisis (GVC) by the second half of 2022. Consider the following:

(1) Economic surprise index. The Citigroup Economic Surprise Index remained in record-high territory through the August 21 week (Fig. 2). Two weeks ago, retail sales and industrial production were surprisingly strong. Last week, numerous housing indicators were surprisingly strong, as they should have been given record-low mortgage rates and the rush by urban dwellers to move to the suburbs in reaction to the pandemic. Soaring lumber prices are another indicator of the strong demand for new homes and for fixing up existing homes. No wonder that home improvement retailers are reporting gangbuster sales.

(2) Flash PMIs. August’s flash estimates for the US M-PMI and NM-PMI rose to solid readings of 53.6 and 54.8, respectively (Fig. 3). That contrasts with August’s downticks in the Eurozone to 51.7 and 50.1 (Fig. 4).

(3) Regional business surveys. There were slight downticks in August’s regional business surveys conducted by the Federal Reserve banks of New York and Philadelphia (Fig. 5). The labor market remains challenging, as evidenced by the rise in initial unemployment claims back above 1.0 million during the August 15 week. On the other hand, the average of the employment indexes in the NY and Philly Fed districts was 5.7 during August, well above the record low of -51.0 during April.

(4) Leading indicators. Also signaling that the recovery should continue in coming months is the Index of Leading Economic Indicators. It plunged 13.2% from February through April (Fig. 6). Since then through July, it is up 7.6%. The Index of Coincident Indicators also bottomed during April. Both indexes are confirming that real GDP is recovering (Fig. 7 and Fig. 8).

(5) Transportation indicators. Then again, as we noted last week, gasoline usage has been flat around 8.7 million barrels per day during the past four weeks through the August 14 week (Fig. 9). The ATA truck tonnage index dipped 5.1% m/m during July, remaining 8.3% below its record high during March (Fig. 10). Railcar loadings remain weak, though the intermodal series may be starting to bottom (Fig. 11).

 Strategy: Wagons Ho! The popular television series Wagon Train aired from 1957 to 1965. It was noted for the catchphrase: “Wagons ho!” This was said whenever the members of the wagon train set out on their respective journeys.

The Adventures of Rin Tin Tin was a television show that aired from 1954 to 1959 and starred a German Shepherd and his owner Rusty, a boy orphaned by an Indian raid. Together, they were raised by soldiers at a US Cavalry post known as “Fort Apache.” A similar catchphrase, “Forward ho!,” was often heard on the show. John Wayne said the same in a few of his classic cowboy westerns.

The same type of let’s-move-forward outcry is currently emanating from both S&P 500 forward revenues and earnings. Both have been showing signs of recovering in recent weeks. That’s encouraging, since Joe reports that we now have data confirming how bad actual revenues and earnings were during the GVC through Q2. Consider the following:

(1) Revenues. S&P 500 revenues per share fell to an annualized $1,236.32 during Q2 (Fig. 12). It’s down 16.3% from its record high during Q4-2019. That GVC-related fall compares to the 20.4% drop from peak to trough during the Great Financial Crisis (GFC). While S&P 500 weekly forward revenues misleadingly signaled a much less severe drop, it should still be a good coincident indicator of actual revenues. If so, then it suggests that Q2 was the bottom for actual business sales, which should recover during the second half of 2020 along with GDP.

(2) Earnings. S&P 500 operating earnings per share (using I/B/E/S data by Refinitiv) fell to an annualized $110.80, down 34.0% from Q4-2019. That compares to a peak-to-trough drop of 77.0% during the GFC. Again, forward earnings has signaled a much less severe drop, but it too has been recovering since bottoming during the May 15 week. That also suggests that earnings should recover over the rest of the year. Joe and I are still estimating earnings per share of $120 this year, $150 next year, and $175 in 2022.

(3) Profit margin. The S&P 500 profit margin fell to 9.0% during Q2, down from 11.4% during Q4-2019. Again, the forward profit margin didn’t drop as much, but clearly is pointing to a rebound.

(4) Odds & ends. On a y/y basis, S&P 500 revenues and earnings dropped 12.2% and 32.9%, respectively (Fig. 13). S&P calculates that write-offs per share rose to an annualized $36.00 during Q2 (Fig. 14). On the other hand, the I/B/E/S measure of write-offs fell to $40.28 during Q2 after spiking to $85.00 during Q1.

Gold & Bonds: Arch Friends. Auric Goldfinger and James Bond were arch enemies. In the 1964 film Goldfinger, Bond is flat on his back, strapped to a table, and appears to be on the verge of getting sliced in half by a giant laser. The villain tells 007: “This is gold, Mr. Bond. All my life, I have been in love with its color, its brilliance, its divine heaviness. I welcome any enterprise that will increase my stock.” Bond responds, “I think you’ve made your point, Goldfinger. Thank you for the demonstration.” As the laser beam approaches Bond’s lower torso and Goldfinger says “Good night,” our hero asks Goldfinger, “You expect me to talk?” The villain casually responds, “No, Mr. Bond, I expect you to die.”

In the real world, the price of gold and the price of bonds have been in sync for several years. The price of gold has been very highly correlated with the inverse of the yield on 10-year US Treasury Inflation-Protected Security (TIPS) (Fig. 15). That relationship has been a tight one since 2006, when TIPS data became available.

Not surprisingly, the TIPS yield does closely track the nominal yield on 10-year Treasury bonds less the core PCED (personal consumption expenditures deflator) inflation rate. However, using this real bond yield as a proxy for the TIPS yield prior to 2006 doesn’t work as well to explain the price of gold (Fig. 16).

The close relationship between the two since 2006 has been explained by noting that the TIPS yield reflects both the cost of storing gold and also the alternative return available in the fixed-income markets. Gold doesn’t pay a dividend or interest. Lower TIPS yields, especially this year’s negative ones, make it cheaper to store gold and pose less competition for the beloved metal.

That still raises the question of why the inverse relationship between the price of gold and the TIPS yield was weaker prior to 2006 than it is now. For now, that relationship seems to remain a strong one since the price of gold stopped soaring in recent days at the same time as the TIPS yield has drifted sideways.

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The Future Is Coming

August 24 (Monday)

Strategy I: Roaring ’20s, Then & Now. In the August 11 Morning Briefing, we suggested that the 1920s—a.k.a. the “Roaring Twenties”—could be a precedent for the 2020s: “So far, the 2020s has started with the pandemic, but there are plenty of years left for the prosperous 1920s to become a precedent for the current decade. If so, the driver of the coming boom will be technology-enhanced productivity, as it was during the 1920s.”

So we have a whole decade to keep you updated on how the 2020s compare to the 1920s. Both started with lots of woes. World War I was followed by the Spanish Flu pandemic of 1918, which infected an estimated 500 million people and killed as many as 50 million. Given that the world population was 1.8 billion back then, that implied a 28% infection rate and nearly a 3% death rate. Both stats currently are significantly lower for the COVID-19 pandemic. Today, the global population is 7.5 billion. There have been 23.2 million cases and 805,000 deaths worldwide as of yesterday.

Both decades started with recessions. In fact, the Roaring ’20s included three recessions: from January 1920 to July 1921, May 1923 to July 1924, and October 1926 to November 1927 (Fig. 1). The available data compiled by the Fed show that industrial production doubled from January 1921 through the July 1929 peak, which was followed by a 54% plunge through July 1932.

The Dow Jones Industrials Average (DJIA) peaked at 119.62 on November 3, 1919 and dropped 46.6% to 63.90 through August 24, 1921. But then a roaring bull market was afoot, with the DJIA soaring 496.5% to peak at 381.17 on September 3, 1929 (Fig. 2). It then crashed 89.2% to 41.22 on July 8, 1932. The S&P 500 rose 394.9% from August 1921 through September 7, 1929 and then crashed 86.2% through June 1, 1932 (Fig. 3).

So we may need to beware of the 2030s; but for now, let’s focus on the 2020s. It’s hard to imagine that stock prices could increase as much over the rest of this decade as they did during the 1920s, especially given the big 73% jump in the S&P 500 forward P/E from 12.9 on March 23 to 22.3 on Friday. Furthermore, assuming as we do that the bull market that started on March 9, 2009 is still intact, the S&P 500 is already up 402.1% since then. It’s been a roaring bull market for well over a decade before the start of the 2020s. Now, consider the following long-term trend analysis:

(1) S&P 500 earnings & dividends. We have S&P 500 reported earnings data since Q4-1934 (Fig. 4). This series has been trending mostly around a 6% annual growth rate, within a range of 5%-7%, since the start. The same range-bound pattern can be attributed to the S&P 500 dividends series, which starts during Q1-1945 (Fig. 5). Including reinvested dividends, the S&P 500’s total return index has been growing between 10% and 11% during most of the time since 1935 (Fig. 6).

(2) DJIA and S&P 500 stock price indexes. The DJIA stock price index (available monthly since the early 1920s) has been tracking a 6% annual appreciation rate since the late 1990s (Fig. 7). If it continues to do so, the DJIA will rise to 45,000 by the end of 2030. That’s a 61% increase over Friday’s close.

Similarly, the S&P 500 stock price index (available monthly since the early 1920s) also has been hugging a 6% trendline since the late 1990s (Fig. 8). If it continues to do so, it will hit 4320 by the end of 2030. That’s only a 27% increase over Friday’s close. That target can easily be adjusted higher or lower by raising or lowering the long-term appreciation rate for the index and/or doing the same for the forward P/E multiple expected in 2030. For example, a 6.5% growth rate would put the S&P 500 closer to 6000, a gain of over 80%.

In any event, that’s not exactly the Roaring ’20s, but let’s recall that the 1920s ended with a meltup that was followed by a meltdown. That could happen again, though we may be experiencing a meltup now. The bottom line is that while history doesn’t repeat itself, it does rhyme.

 Strategy II: Tech Now & Then. In our August 11 commentary, we discussed the technological innovations that drove the prosperity of the 1920s. Then we discussed the ones that are likely to do the same during the current decade:

“The awesome range of futuristic ‘BRAIN’ technological innovations includes biotechnology, robotics and automation, artificial intelligence, and nanotechnology. There are also significant innovations underway in 3-D manufacturing, electric vehicles [EVs], battery storage, blockchain, and quantum computing.”

In my 2018 book, Predicting the Markets, I observed:

“In the past, technology disrupted animal and manual labor. It sped up activities that were too slow when done by horses, such as pulling a plow or a stagecoach. It automated activities that required lots of workers. Assembly lines required fewer workers and increased their productivity. It allowed for a greater division of labor, but the focus was on brawn. Today’s ‘Great Disruption,’ as I like to call it, is increasingly about technology doing what the brain can do, but faster and with greater focus.”

The future is always coming, of course. However, the future is already here to a large extent. Consider the following awesome technologies that are just starting to proliferate in ways that should boost productivity and prosperity:

(1) Home-based work, education, and entertainment. The pandemic has transformed the way many people work, pursue an education, and get entertained. They can do all these activities from home because of technologies that allow them to carry on their lives over the Internet. When the pandemic is finally over, many people may go back to their old normal routines. Employers, however, may tell their employees to continue to work from home or closer to home in the suburbs. Reducing or eliminating commutes to work certainly increases productivity. It also cuts the costs of urban office space.

A recent study by the National Bureau of Economic Research compared employee behavior over two eight-week periods before and after shelter-in-place mandates were implemented. Looking at email and meeting metadata, the group calculated that the workday lasted 48.5 minutes longer; the number of meetings increased about 13%, and people sent an average of 1.4 more emails per day to their colleagues.

(2) Telemedicine. Telemedicine allows patients to visit with clinicians remotely using virtual technology. Innovative uses of telemedicine are increasing with advances in telehealth platforms and remote patient-monitoring technology. New mobile health apps and wearable monitoring devices help track a patient’s vitals, provide alerts about needed care, and help patients access their physician. Over the last few months, millions of people have relied on video or telephone calls to talk to their doctors.

During the coronavirus pandemic, the Centers for Medicare and Medicaid Services (CMS) has taken unprecedented action to expand telehealth for Medicare beneficiaries. On March 13, 2020, President Trump made an emergency declaration under the Stafford Act and the National Emergencies Act empowering CMS to issue waivers to Medicare program requirements to support healthcare providers and patients during the pandemic. One of the first actions CMS took under that authority was to expand Medicare telehealth on March 17, 2020, allowing all beneficiaries to receive telehealth in any location, including their homes.

Before the public health emergency, approximately 13,000 beneficiaries in fee-for-service Medicare received telemedicine in a week. In the last week of April, nearly 1.7 million did so. In total, over 9 million beneficiaries have received a telehealth service during the public health emergency, mid-March through mid-June, according to a July 15 HealthAffairs blog post.

(3) 6G. An August 21 article in SingularityHub, titled “6G Will Be 100 Times Faster Than 5G—and Now There’s a Chip for It,” reports the following:

“Though 5G—a next-generation speed upgrade to wireless networks—is scarcely up and running (and still nonexistent in many places) researchers are already working on what comes next. It lacks an official name, but they’re calling it 6G for the sake of simplicity (and hey, it’s tradition). 6G promises to be up to 100 times faster than 5G—fast enough to download 142 hours of Netflix in a second—but researchers are still trying to figure out exactly how to make such ultra-speedy connections happen.”

However, this technology probably won’t be available for prime time until 2030. For now, we’ll have to settle for 5G. The pandemic has slowed the rollout of 5G at the same time as it has increased the demand for the technology to facilitate working remotely by boosting data transmission speeds. Nevertheless, the rollout should continue during the second half of this year into 2021. When it becomes truly accessible, it promises to be more than 30 times faster than the average 4G download speed and to revolutionize self-driving cars, augmented reality, and the Internet of Things.

(4) Robotics, automation, and 3D manufacturing. The August 18 issue of National Geographic featured an article titled “The robot revolution has arrived.” The COVID-19 pandemic has significantly boosted the interest in having robots do more of what humans did before the health crisis. In many instances, it is simply the medically wise alternative to using infection-prone humans. The article reports:

“Already, in 2020, robots take inventory and clean floors in Walmart. They shelve goods and fetch them for mailing in warehouses. They cut lettuce and pick apples and even raspberries. They help autistic children socialize and stroke victims regain the use of their limbs. They patrol borders and, in the case of Israel’s Harop drone, attack targets they deem hostile.”

The pandemic disrupted global supply chains. One likely outcome is that manufacturers will increasingly explore ways to work with suppliers closer to home. Instead of just-in-time inventories, companies will be looking for ways to have just-in-case inventories available in the event of future supply disruptions. They are increasingly using 3D printers to produce parts on demand to the exact specification and in the exact numbers required—reducing wait time and safeguarding against external disruptions.

Robots, automation, and 3D printers are revolutionizing manufacturing. An August 21 article in engineering.com reports:

“Mighty Buildings claims to increase the efficiency and reduce the waste in building modern homes. Drawing from foundations in robotics, manufacturing and sustainability, Mighty Buildings’ goal is no less than the reimagination of the construction sector. The company uses a combination of 3D printing and prefab techniques to automate up to 80 percent of the building process for greater productivity. … According to the Oakland, Calif.-based startup, they can build a 350-square-foot studio unit in under 24 hours while using 95 percent fewer labor hours at twice the speed of traditional manufacturing methods.”

If one of the consequences of the pandemic is de-urbanization, there will be more suburbanites who will need to buy one or more cars to get around their small towns. The August 7 Forbes reports:

“A mass shift to single-occupancy vehicles is occurring nationwide according to new research from Cornell University, which poses a major traffic and pollution problem in many cities. The solution, according to today’s most influential automakers, is to accelerate the development of electric, driverless cars programmed by artificial intelligence.”

Volkswagen AG pledged more than a fifth of its vehicles will be electric by 2025, while investing 44 billion euros ($52 billion) on autonomous driving and “mobility services” by 2023.

By the end of the 2020s, autonomous drones carrying passengers and cargo could be as ubiquitous as in the old television cartoon The Jetsons. EHang, a Chinese company, reportedly is ahead of the pack with its autonomous aerial vehicle, or AAV. A user can summon an EHang drone using an app. The drone lands at a predetermined spot near the requested pick-up location. It can carry up to two passengers with a combined weight of under 440 pounds and travel up to 32 kilometers (22 miles) on a single charge.

(5) Batteries. The outlook for EVs and drones depends largely on progress made in increasing the capacity and service lives of large batteries while reducing their weight, as Jackie and I have often discussed in the past. The future may belong to solid-state batteries, which reportedly could be available by 2025. That’s the same year that the world’s biggest automakers plan to launch an array of new electric models.

Strategy III: The S&P 5-8 vs the Rest. High-tech spending on IT equipment, software, and R&D rose to a record $1.33 trillion (saar) during Q2-2020 (Fig. 9). It jumped to a record 50.1% of total capital spending in nominal GDP during the quarter (Fig. 10). Equipment and software accounted for 31.1% and R&D 19.1% of capital spending in nominal GDP.

 This certainly helps to explain why the “S&P 5” now accounts for a record 25.7% of the market capitalization of the S&P 500 (Fig. 11). The S&P 5 is the group of five top companies in the S&P 500 by market capitalization. Currently, they are Apple ($2.1 trillion), Amazon ($1.6 trillion), Microsoft ($1.6 trillion), Google’s parent Alphabet ($1.1 trillion), and Facebook ($0.8 trillion). We also call them the “Magnificent Five,” or the “FAAGMs.”

The previous record high for the Magnificent Five’s market cap share was 18.5% during March 2000, when the five were Microsoft, Cisco, GE, Intel, and Exxon. Often added to the current list is Netflix ($0.2 trillion), resulting in “FAANGM.” The acronym Joe and I use for the Magnificent Seven, including Nvidia ($0.3 trillion), is “FANGMAN.”

Tesla’s ($0.4 trillion) market-cap rise has also caught our eye, even though Tesla isn’t part of the S&P 500. If it is included, the acronym will be “FANGMANT.” Then we can compare the S&P 8 to the S&P 492. Consider the following:

(1) Sector weights. FANGMANT is often considered to be composed wholly of technology stocks. However, only Apple, Microsoft, and Nvidia are in the S&P 500’s Information Technology sector, accounting for a whopping 51.1% of its market cap (Fig. 12). Facebook, Netflix, and Google’s parent Alphabet account for 66.6% of the market cap of the Communication Services sector. Amazon accounts for 51.3% of the Consumer Discretionary sector, which will be home to Tesla if it is added to the S&P 500 as an auto manufacturer.

(2) Revenues and earnings growth. Since the start of 2015 through the August 21 week, the forward revenues and earnings growth rates of the FAANGMs were 126% and 110%, leaving the S&P 494 in the dust with 4.1% and 4.2% growth rates (Fig. 13 and Fig. 14).

(3) Valuation. In a world of near-zero bond yields, what should be the forward P/E of the FAANGMs as well as the rest of the S&P 500? Since 2015, the FAANGMs have generated forward earnings growth of about 20% per year on average. The forward P/E of the FAANGMs is currently 42.9 (Fig. 15). That seems like a reasonable valuation multiple under the circumstances. Excluding the FAANGMs, the multiple of the S&P 494 is currently 19.3 (Fig. 16). That seems a wee bit pricey for very little earnings growth, but dividend-paying stocks remain attractive in a world with bond yields at historic lows.

 Movie. “Fear City: New York vs The Mafia” (+ +) (link) is about the Commission, which essentially hijacked New York City during the 1980s. The Commission consisted of the heads of the five Mafia families that extorted billions of dollars from various New York City industries. Among the most lucrative businesses for the Mob back then was concrete. There was a skyscraper building boom in NYC during the 1980s. Developers like Donald Trump were forced to pay a big markup for the essential building material from the concrete industry that was monopolized by the five families. New York State Attorney General Rudi Giuliani, with the help of lots of wiretap evidence collected by the FBI, was able to charge, arrest, and indict the five Mafia bosses all in one sweep.

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Broadening Earnings Optimism

August 20 (Thursday)

Strategy I: An Earnings Rotation Afoot. With the S&P 500 hitting new records this week, it’s comforting to know that analysts have grown more optimistic about future earnings growth in a wider array of industries, including those hard hit by COVID-19 and other cyclical areas of the market. That’s a major shift from earlier this year when earnings growth was expected only from a few sectors and industries, primarily those that benefitted from our needs to clean every surface possible and order groceries online.

Consider the change in “forward earnings”—or the time-weighted average of analysts’ consensus earnings estimates for this year and next year—from May 28, when earnings estimate revisions bottomed, through August 13. Many beaten-up cyclical S&P 500 sectors have enjoyed some of the best upward revisions to their forward earnings: Energy (238.8%), Consumer Discretionary (26.0), Materials (10.8), Industrials (10.2), Financials (9.5), S&P 500 (8.4), Health Care (7.1), Information Technology (5.3), Communications Services (5.2), Consumer Staples (3.4), Utilities (-0.3), and Real Estate (-5.0) (Table 1).

That’s quite a change from earlier this year when analysts cut earnings estimates less for industries and sectors that benefited from the COVID-19 pandemic and related lockdowns. Here’s the change in forward earnings for the S&P 500 sectors from the day COVID-19 hit the news on January 23 through August 13: Information Technology (3.2%), Health Care (2.5), Utilities (0.2), Consumer Staples (-2.1), Communications Services (-10.4), Materials (-13.0), S&P 500 (-14.2), Real Estate (-20.0), Financials (-24.9), Consumer Discretionary (-27.4), Industrials (-33.5), and Energy (-77.7) (Table 2). Let’s take a look at how S&P 500 industries have been affected by this rotation:

(1) Cyclicals get a second look. Some of the industries hit hardest by the COVID-19 pandemic and resulting contraction of the economy are getting some new respect from analysts. Since earnings estimates stopped falling on May 28, there have been some surprising names among industries with the strongest improvements in forward earnings.

Here are a few of the names that have enjoyed the biggest upward revisions in forward earnings after suffering through some of the largest reductions in forward earnings earlier this year. We’ve listed the percentage changes of both their upward earnings estimate revisions enjoyed since May 28 and their revisions since COVID-19 hit the headlines on January 23: Automobile Manufacturers (2,382.0%, -55.7%), Apparel Retail (41.7, -46.6), Steel (23.2, -32.9), Investment Banking & Brokerage (20.0, -15.9), Construction & Farm Machinery (19.4, -29.3), Regional Banks (16.0, -30.4), Electronic Components (15.1, -11.1), Restaurants (14.3, -17.6), and Industrial Machinery (16.2, -15.6).

(2) Work-from-home winners. Another group that has enjoyed some of the strongest upward estimate revisions are industries that benefit from the surges in numbers of people working from home and city dwellers moving out to the suburbs. The trend has benefitted homebuilders, car manufacturers, retailers, and companies providing anything related to working or shopping from home.

Here are some of the S&P 500 industries related to working from home that have enjoyed the strongest upward earnings estimate revisions since May 28: Automobile Manufacturers (2382.0%), Home Furnishings (51.6), Internet & Direct Marketing Retail (42.7), Homebuilding (41.2), Household Appliances (33.2), Building Products (18.1), Consumer Electronics (18.1), Interactive Home Entertainment (14.4), Automotive Retail (12.6), and Interactive Media & Services (11.4).

(3) From the front of the pack to the back. Meanwhile, the earnings estimate revisions for industries that benefitted the most from COVID-19 earlier this year may still be positive, but they aren’t large enough to land them at the top of our listing anymore. Analysts have boosted their earnings estimates for Hypermarkets & Super Centers (by 2.7%) since May 28, and the same is true for Packaged Foods (3.9) and Personal Products (3.4). But that puts those industries on the bottom half of the earnings revisions listing. In the first half of the year, they were in the top half.

(4) Winners still. Perhaps the most interesting S&P 500 industries are those that had the strongest earnings revisions throughout this year. Here are the industries that have had the strongest earnings revisions since earnings bottomed on May 28 and since COVID-19 hit the headlines on January 23: Homebuilding (41.2%, 14.5%), Gold (35.2, 67.6), Life Sciences Tools & Services (13.2, 5.4), and Semiconductor Equipment (12.3, 13.7).

Strategy II: Helicopter Money in Europe. Money can’t buy happiness. Nevertheless, governments around the world have been printing and spending money like crazy, hoping to make us all feel a little bit better during the COVID-19 pandemic. In Europe, even Germany and the other frugal northern states have opened their wallets to bolster their own economies as well as those of the poorer nations in the region. So far, all the fiscal and monetary support together with COVID-19 containment efforts have helped the European economy begin to recover this summer. Here’s Jackie’s report on how the European Central Bank (ECB) and the European Union (EU) have responded to one of the world’s biggest crises:

(1) ECB gives the economy some PEPP. The European Central Bank (ECB) announced in June that it would buy up to €1.35 trillion of eurozone government and corporate debt through June 2021. The program—dubbed “PEPP,” or “Pandemic Emergency Purchase Program”—expanded an existing €750 billion bond-buying program.

Other steps taken by the ECB include leaving its key interest rate at -0.5% and calling on banks to freeze dividend payments until at least January to prepare for a wave of expected loan losses.

This follows the ECB’s April announcement that it would offer three-year loans to banks at interest rates as low as -1.0%. To receive the below-market rate, banks have to agree to maintain their lending to households and business at the same level as the previous year, a June 18 FT article explained. The ECB reported in June that 742 banks had applied to borrow €1.31 trillion under the program, with plans to use about half of the funding to repay existing ECB loans and the remainder to buy bonds issued by their own governments.

 (2) The EU supports workers. In April, the EU put forward a €540 billion emergency support package that targeted workers, businesses, and member states. To support workers, the EU introduced SURE, temporary support to mitigate unemployment risks in an emergency. The program makes €100 billion of temporary EU loans available to fund countries’ employment furlough programs.

Many European countries allow companies to furlough employees instead of firing them, which is expensive due to European labor laws. Furloughed employees are paid some percentage of their prior salary by their employers. In return, they work reduced hours or don’t work but remain available to return to the company when better times arrive. The employers are reimbursed for their furlough payments by the government. The programs do not cover those who work off the books.

ERTE, Spain’s temporary leave system, covers 70% of employees’ salaries. Roughly 1.2 million Spanish workers are on furlough, down from a high of 3.4 million, an August 6 FT article reported. Spain has requested more than €20 billion from the SURE funds to finance the furloughs and to aid businesses and the self-employed.

As COVID-19 drags on, European countries have been extending their furlough benefits. In Spain, the duration of furloughs was extended through September, and it is expected to be extended again through the end of the year. Companies catering to tourists would prefer an extension through next spring when the tourist season hopefully resumes.

Because of the furlough program, the Eurozone unemployment rate has risen only slightly to 7.8% in June from 7.2% in February and March, which was a record low (Fig. 1). Without furloughs, that figure would be far higher. The ECB’s July 30 Economic Bulletin includes a chart that compares the small increase in Eurozone unemployment to the major decline in the region’s Purchasing Manager’s Index (PMI) for employment, which fell to its lowest level on record in April before recouping about half of its losses in the following months. The PMI for employment likely presents a more accurate picture of Europe’s employment situation.

(3) EU supports businesses and governments too. Another element of the EU emergency support package is the European Investment Bank Group’s pan-European guarantee fund, which could support loans totaling up to €200 billion to companies, with a focus on small and medium-sized companies throughout the EU.

And to support governments, the EU set up the European Stability Mechanism. It can provide loans to all EU member states worth up to 2% of their GDP up to a total value of €240 billion. So far, no country has drawn on its credit lines.

(4) More EU funding on the way. EU leaders agreed in July to create a new €750 billion pandemic recovery fund. The deal is historic because the EU will issue bonds to raise the money for the fund. The EU has historically avoided issuing bonds and only has about €50 billion of debt currently outstanding. Member nations historically have funded themselves independently. But this deal recognized that the poorer nations need funding from their wealthier counterparts—without which the EU possibly could splinter apart.

The pandemic recovery fund can make €390 billion of grants to economically weak EU members, with the rest of the funding made available through loans. To repay the debt, which must be done by 2058, the EU will propose a “digital levy” for technology companies and consider a new tax on financial transactions.

In addition to the new recovery fund, EU leaders also agreed to a €1.1 trillion budget. Both the fund and the budget need approval by the EU Parliament, and that could lead to some changes. Parliament President David Sassoli has said he doesn’t want to cut the budget for research or for the Erasmus student-exchange program, as is currently envisioned by the budget. He also wanted the agreement to include a mechanism to limit recovery funds to countries that have failed to uphold media freedoms and human rights, such as Hungary and Poland, a July 22 Reuters’ article reported. But it’s unclear whether these changes can be made without putting the entire agreement in jeopardy.

Proceeds from the pandemic recovery fund will benefit the southern European nations far more than the wealthier northern nations. The southern nations, which were in weaker financial condition entering the current downturn, need the funding to supplement their own stimulus plans. Germany’s financial stimulus measures amount to 9.4% of its GDP, while the program announced by Italy is 3.5% of its GDP, and the financing plan announced by Spain 3.4% of GDP, a July 21 WSJ article reported.

(5) Hope in July economic data. The Eurozone’s economy was hit hard by COVID-19 in Q2, but there are glimmers that the economy may be edging toward recovery in the most recent economic data.

Eurozone GDP fell 15.0% in Q2 y/y, the largest drop on record, and it followed a 3.1% drop in Q1. The southern countries, which are among the most dependent on tourism, took the biggest hits. In Greece, Portugal, Italy, and Spain, 14% or more of jobs are related to tourism. GDP in Spain contracted by 22.1% in Q2 y/y, in France by 19.0%, in Italy by 17.3%, and in Germany by 11.6% (Fig. 2).

As COVID-19 cases have fallen and many companies have reopened for business, the economic data in July has improved. The Eurozone’s manufacturing PMI rose to 51.8 in July, a sharp recovery from its low of 33.4 in April. The recovery in the nonmanufacturing PMI was even more impressive, jumping to 54.7 in July from 12.0 in April (Fig. 3). Eurozone retail sales excluding motor vehicles also rebounded, rising 1.5% y/y in June, up from the 19.6% drop in April (Fig. 4).

Enthusiasm about Europe’s fiscal stimulus, its ability to tame COVID-19—so far—and its improving economy have helped bolster the euro. The EU currency relative to the dollar is up 6.2% ytd (Fig. 5). And yields on the government-issued bonds of Italy and Spain have fallen from their highs of 2.50% and 1.26% on March 18 down to 0.98% and 0.32% (Fig. 6).

Stocks too have responded. The Dow Jones Stoxx 50, which tracks the Eurozone’s largest companies, has risen 39.1% off of its March 18 low but remains 14.2% off of its February 19 high (Fig. 7). To head higher, the Eurozone will need to keep COVID-19 cases to a minimum so that tourism and global trade can recover.

(6) Keeping an eye on COVID-19 cases. Of course, all of this monetary and fiscal spending will be for naught if there’s a resurgence of COVID-19 cases in Europe that forces another economic shutdown. As in the US, the numbers are creeping up in some European countries as young adults socialize.

The seven-day average of new cases in France has jumped to more than 2,000 in August, after falling as low as 387 in June and peaking north of 4,000 in April, according to the NYT’s handy database. Likewise, Spain’s seven-day average of new cases has jumped to north of 5,000 in August from 8,000 in April; while that’s an improvement, the situation has worsened from Spain’s best seven-day average of 248 cases in June. Fortunately, in both countries even as the numbers of cases have risen, the numbers of deaths have stayed incredibly low, with the seven-day average at 11 in France and 15 in Spain.

Europe has done a far better job than the US at containing COVID-19. The seven-day average of new cases in the US is 49,102, down from 70,000 or more in July but still stunningly high. The seven-day average deaths from COVID-19 also has fallen in the US, to 1,047. That’s less than half the death rate we saw in April, but still far higher than death rates in Europe.

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Fed Watching for Fun & Profit: Inflation, Fedcoin & Inequality

August 19 (Wednesday)

Fed I: Lots of Content. I published my book Fed Watching for Fun & Profit on March 9. At the time, I regretted that I hadn’t thought to write a book about pandemics instead. Then, the Fed responded to the Great Virus Crisis (GVC) with QE4Ever on March 23. That certainly boosted my book sales.

Now, I’m already working on a sequel tentatively titled The Fed Fights the Virus. There’s already plenty of material. Fortunately, this project coincides with my day job. In addition, my colleague Melissa Tagg has turned into a top-notch Fed watcher under my tutelage and continues to work with me on regularly updating the latest developments in the world of the world’s major central banks.

Today, our focus is threefold: the Fed’s latest thinking on inflation targeting, its thinking on digital currencies, and the role of monetary policy in dealing with income inequities.

Fed II: Averaging Inflation. Inflation rebounded slightly during July, according to CPI data released last week, but certainly not enough for Fed officials who would like to see it move even higher. Let us explain.

The Fed remains committed to the ultra-easy monetary-policy stance it adopted in reaction to the GVC. In fact, we think the Fed will soon confirm that commitment by effectively raising its tolerance for higher inflation. Specifically, we see the Fed embracing the long-standing (pre-pandemic) analysis of someone who is very influential to the Fed: Senior Fellow at the Peterson Institute for International Economics and MIT Professor Olivier Blanchard. His conclusion: Don’t tighten until you see “the whites of inflation’s eyes.”

In other words, we see the Fed letting go of its typical approach of raising rates preemptively, before inflation heats up. As we wrote on August 4, we believe the Fed would welcome inflation running above its 2% inflation target for a while as a long-overdue offset to rates that have run below that pace since January 2012, when the Fed publicly started targeting inflation at 2%. We expect this change to be announced publicly soon as the Fed synthesizes its year-long monetary policy strategic review.

There’s plenty of recent evidence informing our expectation:

(1) Averaging inflation. At the start of the Fed’s policy review during December 2018, we outlined several options for inflation targeting that Fed officials have discussed. In May of last year, we wrote that Fed officials were leaning toward average inflation targeting, whereby the Fed would seek an average inflation rate over a period of time, making up for “misses” that may have occurred with future “overshoots” that average inflation levels out. That sort of approach seems to be in line with the recent comments from two Fed officials.

On August 14, Dallas Fed President Robert Kaplan suggested that he is for the average-inflation-targeting approach in the current environment: “I would be willing to see inflation run moderately above 2.0% in the aftermath of periods where we’ve been running persistently below.” Specifically, Kaplan said he would be comfortable with inflation rising to 2.25% or 2.38%.

Chicago Fed President Charles Evans is also comfortable with inflation rising above 2.0%. He told reporters virtually on August 5 that he could see inflation moving up to 2.5% before the Fed considers raising rates again. Kaplan is a voter on the Federal Open Market Committee this year while Evans is a non-voting participant in the Committee’s meetings.

The two regional Fed bank governors are clearly involved in the Fed’s latest strategic policy review. Fed Chair Jerome Powell said at a July 29 press conference that the review would be wrapped up in the “near future.” Powell also said on that occasion that the central bank is “not even thinking about—thinking about raising rates.” By the way, former Fed Chair Janet Yellen (who reportedly has briefed Democratic presidential nominee Joe Biden) has advocated for average inflation targeting.

(2) Muted inflation. Considering the amount of monetary stimulus that the Fed has injected since the pandemic hit, inflation remains relatively muted, particularly so compared with the Fed’s apparently higher goalpost. The core CPI excluding food and energy increased 1.2% y/y in June and 1.6% in July. The headline CPI rose to 1.0% y/y during July from 0.6% during June. So inflation remains below the Fed’s stated 2% inflation target and even further below the rates Fed bank presidents Kaplan and Evans wouldn’t mind seeing, as noted above.

(3) Fed of La Mancha. Frankly, we are mystified why Fed officials are discussing tolerating inflation above their 2% target when they haven’t been able to get it consistently up to that level since they officially adopted that inflation target during January 2012! It reminds us of the theme song “Dreaming the Impossible Dream” from Man of La Mancha. Here are the relevant lyrics: “This is my Quest, to follow that star, No matter how hopeless, no matter how far … To reach the unreachable stars!”

Fed III: Going Digital? The race for a COVID-19 vaccine isn’t the only high-stakes time-is-of-the-essence contest playing out on the global stage. There’s also the central bank digital currency (CBDC) race. China has revealed that it wants to win the CBDC race to usurp the US dollar’s global currency supremacy. Other countries have joined so as not to be left behind.

“One in 10 central banks surveyed in 2019 said it was likely to offer digital currencies within the next three years, covering about 20% of the world’s population according to a report from the Bank for International Settlements [BIS],” reported the January 23 WSJ. On January 21, the BIS issued a press release announcing that the “Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank, together with the [BIS], have created a group to share experiences as they assess the potential cases for [CBDC] in their home jurisdictions.”

Until recently, Fed officials were lukewarm on the idea of a US digital dollar. Just last year, Fed Chair Powell wrote in a November 19 letter to congressional leaders that the US central bank has no plans to launch a digital currency, adding that doing so for general use “would raise important legal, monetary policy, payments policy, financial stability, supervision and operational questions that need to be considered carefully.”

Nevertheless, the Fed has begun to prioritize its own CBDC research in recent months, given China’s significant progress. Whether the Fed will go all the way to implementing a CBDC is uncertain; but if the other major central banks’ currencies go digital, would the Fed have much of a choice? Interestingly, CBDC could provide the Fed with more monetary policy leverage, as we discuss below. Consider the following:

(1) FedNow in the game. On August 13, the Fed announced that it had undertaken research “to enhance its understanding of the opportunities and risks associated with central bank digital currencies.”

The same day, Fed Board Governor Lael Brainard spoke on the topic, stressing that “China has moved ahead rapidly on its version of a CBDC.” She added: “Given the dollar's important role, it is essential that the Federal Reserve remain on the frontier of research and policy development regarding CBDCs. As part of this research, central banks are exploring the potential of innovative technologies to offer a digital equivalent of cash.” Research on CBDC will go together with the Fed’s FedNow Service, currently underway. It will “enable millions of American households and small businesses to get instant access to funds rather than waiting days for checks to clear.”

Brainard summed up some of the opportunities and risks presented by CBDCs as follows: “[B]anks, fintech companies, and technology firms are all exploring the use of innovative technologies to enhance payments efficiency, expand financial inclusion, speed up settlement flows, and reduce end-user costs. Digital currencies …present opportunities but also risks associated with privacy, illicit activity, and financial stability. The introduction of Bitcoin and the subsequent emergence of stablecoins with potentially global reach, such as Facebook's Libra, have raised fundamental questions about legal and regulatory safeguards, financial stability, and the role of currency in society. This prospect has intensified calls for CBDCs to maintain the sovereign currency as the anchor of the nation's payment systems.”

(2) Dollar decoupling threat. Japanese lawmakers have pushed for the discussion of cooperation on CBDCs to be on the agenda of the upcoming annual G7 summit. The impetus for the discussion is the threat that China’s CBDC might pose to the US dollar’s dominance. In February, Japanese Minister Akira Amari said: “We live in a stable world led by dollar settlement. How should we respond if such a foundation collapses and if (China’s move) gives rise to a struggle for currency supremacy?”

Indeed, China likely has plans to leverage its digital currency prowess to challenge the US dollar. Zhou Li, a former deputy director of the Communist Party’s International Liaison Department, recently wrote that “By taking advantage of the dollar’s global monopoly position in the financial sector, the US will pose an increasingly severe threat to China’s further development.”

(3) China in first place. At the forefront of the digital currency race, China’s “big four state-owned commercial banks have started large-scale internal testing of what would be the world’s first sovereign digital currency, as the launch of the digital yuan appeared to move a step closer” reported the August 6 South China Morning Post, according to the 21st Century Business Herald. The People’s Bank of China (PBOC) has suggested that it could be ready for testing at the venues for the 2022 Winter Olympics. Former PBOC VP Wang Yongli said last week that the digital currency would eventually replace not just M0, but all currencies in circulation.

(4) Back below zero. One reason for the Fed to consider a US CBDC now is an issue Melissa and I discussed a few years back, in the October 16, 2017 Morning Briefing, reviewing a quarterly BIS report. We noted: “If cash were to become obsolete, that could effectively free the Fed from the dreaded ZLB, i.e., the zero lower bound. The ZLB is feared by monetary policy makers because it’s the point at which interest-rate tools become ineffective at creating stimulus. Cash can become a nuisance for monetary policy if the Fed needs to implement a negative interest rate policy (NIRP) in order to meet its goals for employment and inflation. Under NIRP, cash would be in higher demand as it would be cheaper to hold onto cash than to deposit it in a savings account with a negative interest rate.”

JP Koning explored how the Fed might get around this problem with the introduction of a hypothetical “Fedcoin” in a 2014 blog post that was cited by the 2017 BIS report. Koning hypothesized that interest could be paid on each Fedcoin at a rate determined by the Fed. “After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store” bills available, Koning theorized. So just as interest could be earned on Fedcoin, a negative rate could be imposed on Fedcoin.

The Fed has not said that it would go to a NIRP to combat the GVC, but as we have all learned since March 23, 2020, anything is possible.

(For more background, also see Jackie’s earlier notes on a Swedish digital currency, as well as her initial report on China’s initial progress here and here.)

Fed IV: The New Third Mandate. Currently, the Fed has two congressional mandates to follow: maintaining a balance of stable inflation and maximum employment. But on August 5, Democrats introduced a bill that would create a third mandate for the Fed: reducing economic inequality. We think that this matter, though pressing, is better handled by fiscal authorities. Powell thinks so too, as he said during his July 29 press conference that the Fed doesn’t “really have tools that can address distributional, disparate outcomes as well as fiscal policy.” This view is nothing new; it was shared by former Fed Chair Ben Bernanke in a 2015 Brookings blog post. Here’s more:

(1) Monetary problems. Historically, monetary policy has been used as a blunt tool that aims to raise the standard of living broadly. Of course, we are in unprecedented times, and the Fed and US Treasury jointly have undertaken highly unconventional policy measures targeting specific groups. But were the Fed to target income inequality routinely going forward, wouldn’t that complicate the broad objective of monetary policy? Wouldn’t it also necessitate that the Fed become more intertwined with fiscal agencies, jeopardizing its important independence? How would the Fed even address income inequality with its current (albeit expanding) toolkit? We have no answers but will be watching to see how far the Democrats’ bill goes in the legislative process.

(2) Mandate alteration. Cowritten by Senator Elizabeth Warren (D-MA), Senator Kirsten Gillibrand (D-NY), and Representative Maxine Waters (D-CA) and cosponsored by Senator Bernie Sanders (I-VT) and 17 other Democratic leaders, the Federal Reserve Racial and Economic Equity Act requires the central bank to take action “to minimize and eliminate racial disparities in employment, wages, wealth, and access to affordable credit.” It would be the first major change to the Fed’s mandate since 1977.

Similarly, Joe Biden recently called on the Fed to “aggressively enhance” its monitoring and targeting of “persistent racial gaps in jobs, wages, and wealth.” But the bill goes further, explicitly requiring the Fed to address such gaps. That’s all as reported by the August 5 Washington Post.

(3) Overshooting for broader opportunity. Average inflation targeting arguably might serve a Fed “equity mandate,” implied a 2019 article in Medium, as the unemployed might face better odds of being hired if the Fed were to wait longer before tightening monetary policy. On the other hand, higher price inflation could reduce the purchasing power of the nominal wages of everyone who has a job. Such a mandate would certainly throw the Fed into the boiling cauldron of our nation’s extremely partisan political debates.

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More Comparisons of GVC and GFC

August 18 (Tuesday)

US Economy: Inventory Wipeout. We received lots of positive comments about yesterday’s Morning Briefing, in which we compared the economic and financial consequences of the Great Virus Crisis (GVC) to those of the Great Financial Crisis (GFC). So today, we’ll continue the exercise.

As we noted yesterday, ”[t]he GFC was to a large extent a typical business-cycle downturn. It was preceded by an economic boom that was led by speculative excesses, particularly in the housing industry. When that bubble burst, a credit crunch worsened the resulting recession. … The GVC is unique. In many ways, it’s like a major natural disaster that hit the entire world economy. Initially, it did trigger a credit crunch, but the world’s major central banks stopped that from happening by pouring liquidity into global financial markets.” It could turn out to be a two-month recession, we noted and observed: “A recession that short is unprecedented, but that’s because there is no precedent for a recession caused by government-mandated lockdowns around the world to slow the spread of the virus.”

Debbie and I believe that the V-shaped recovery in the US will continue through September, but then slow along the lines of the Nike swoosh logo. Real GDP fell 5.0% (saar) during Q1, with all of the weakness occurring during March, when state governors issued stay-in-place executive orders (Fig. 1). The resulting lockdown recession saw real GDP plunge 32.9% during Q2. While the brunt of the recession occurred during only two months, i.e., during March and April, real GDP fell 10.6% from Q4-2019 through Q2-2020, more than twice as much as during the GFC recession’s 4.0% decline.

We are projecting a 15% rebound during Q3 and a 5% increase during Q4. The pace of growth slows during 2021 and 2022 in our forecast, with real GDP recovering to its Q4-2019 record high during Q4-2022.

Using the monthly series for the Index of Coincident Economic Indicators as a proxy for real GDP, we expect that the full recovery from the GVC recession will take 32 months, which is the average recovery period following the past six recessions (Fig. 2). By comparison, the GFC recovery took 68 months.

High-frequency indicators are starting to show a slowing, and even a possible stalling, in the recovery. For example, gasoline usage has stalled around 8.7mbd for the past four weeks through the August 7 week (Fig. 3). Also stalling during July was consumer credit- and debit-card spending (Fig. 4).

On the other hand, the Weekly Economic Indicator compiled by the Federal Reserve Bank of New York bottomed at -11.5% during the week of April 25 and rebounded to -5.5% during the August 8 week (Fig. 5). It is a good proxy for the y/y growth in real GDP and jibes with the Atlanta Fed’s GDPNow tracking model shows Q3’s real GDP increasing 26.2% as of August 14 (up from 20.5% on August 7) following the release on Friday of July’s retail sales, June’s manufacturing and trade sales and inventories, and July’s industrial production. Let’s compare these latest stats to their performances during the GFC:

(1) Manufacturing & trade sales. As we’ve previously observed, retail sales rebounded dramatically by 29.9% from April through July to a new record high (Fig. 6). Retail sales took 29 months to fully recover from the GFC. The huge difference during this crisis was the huge increase in government social benefits that more than offset the drop in wages and salaries in personal income.

Along with July data for retail sales, June sales data were released for manufacturers, wholesalers, and retailers. The aggregate of these business sales of goods rebounded 17.6% over the past two months through June (Fig. 7). They are still 5.1% below the record peak during January. However, excluding petroleum products, they are up 16.7% and just 1.3% below the record high during February! The business sales series is highly correlated with aggregate S&P 500 revenues, which is on track to fall not much more than it did during the GFC (Fig. 8).

(2) Business inventories. The 14.7% plunge in business inventories from peak to trough during the GFC lasted 13 months. So far, the fall during the GVC has been 7.4% over the past six months through June (Fig. 9). The recent round of inventory liquidation has been led by retailers (Fig. 10).

The unprecedented rebound in retail sales suggests that inventory investment, which accounted for 3.98 percentage points of the 32.9% drop in real GDP during Q2 should be a big contributor to the rebound in real GDP during Q3 and Q4.

(3) Industrial production. Manufacturing production plunged 20.1% from February through April (Fig. 11). It rebounded 15.2% since then through July but remains 8.0% below the pre-pandemic level. The V-shaped pattern now contrasts sharply with the more typical U-shaped pattern during the GFC.

Remaining down-and-out despite their recent rebounds are the industrial production indexes for aerospace, construction supplies, and energy and non-energy industrial materials. Making a huge comeback is motor vehicle assemblies, which plunged from 11.4 million units (saar) during February to just 0.1 million units during April, and rebounded since then to 11.9 million units during July (Fig. 12). The output index for high-tech industries held up very well during the first half of this year, with communications equipment rising to a new record high during July. (Fig. 13).

 Global Economy: V-Shaped Indicators. Yesterday, we observed that both global PMIs and leading indicators for the 36 members of the OECD and the four BRIC emerging economies have staged V-shaped recoveries in recent months. Today, let’s focus on China, the Eurozone, and emerging economies:

(1) China. China’s official M-PMI dropped from 59.2 during April 2008 to a low of 38.8 during November 2008 (Fig. 14). It rebounded to a 2009 high of 56.6 during December. This time, it dropped from 50.2 during December of last year to a record low of 35.7 during February. So far, it has rebounded to 51.1 during July. China’s official NM-PMI fell from 60.2 during January 2008 to a low of 50.8 during December 2008, remaining above 50.0. This time, the lockdowns over there caused the NM-PMI to plunge from 54.1 during January to a record low of 29.6 during February. It has rebounded to 54.2 as of July.

On a y/y basis, China’s industrial production rebounded from a low of -13.6% during January to 4.9% during July (Fig. 15). Somewhat less impressive is the comparable rebound in inflation-adjusted retail sales from -20.1% during March to -3.8% during July.

Over the past couple of years, Debbie and I have observed that China’s rapidly aging population—a result of the fall in the fertility rate below replacement as a result of urbanization and the one-child policy—would weigh on consumer spending in China. The government, run by the Chinese Communist Party, is scrambling to stimulate domestic demand, as the country’s export-led growth is vulnerable to rising trade tensions, especially with the US. However, this effort is likely to be stymied by the nation’s increasingly geriatric demographic profile, which will be more of a challenge to China’s recovery coming out of the GVC than it was coming out of the GFC.

(2) Eurozone. Industrial production in the Eurozone plunged 27.8% from January through April of this year and regained about 22.5% of that loss through June (Fig. 16). However, it’s only back to around the low recorded during the GFC!

Remarkably, the Eurozone has had a similar V-shaped recovery in retail sales as the US has. The index for the volume of retail sales (excluding motor vehicles) plunged 21.2% in the region from February through April (Fig. 17). Over the past two months through June, the index is up 27.1%, just above its previous record high during February! Following the GFC, the index was on a downtrend that lasted until 2012. The indexes are in new record-high territory in Germany and France and have recovered most of the ground lost earlier this year in Italy and Spain. (See our Eurozone Retail Sales chart publication.)

German industrial indicators are following the V-shaped recovery in the Eurozone’s retail sales volume index. The IFO business confidence index jumped from a record low of 74.3 during April to 90.5 during July (Fig. 18). This series is highly correlated with German manufacturing orders, which are up  41.2% over the past two months through June. Both are still below their levels at the beginning of the year, but they’ve regained more than half their losses since then.

(3) Emerging economies. Data available through May show that industrial production in the advanced economies fell slightly below the trough of this series during the GFC (Fig. 19). Interestingly, industrial production in emerging economies has remained well above its low back then. That’s mostly because the recent low in China’s value-added output index during January remained 113.3% above where it was at the end of 2008 (Fig. 20). Also remaining well above their 2008 lows have been output indexes in Indonesia, Singapore, South Korea, and Taiwan (Fig. 21). Bungee-like roundtrips in output indexes can be found for India, Malaysia, Brazil, and Mexico (Fig. 22).

Strategy: FAANGM Update. Joe and I continue to respond to lots of questions about the FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft). More often than not, the answers can be found in our FAANGM chart book, which is automatically updated. Here are a few recent developments:

(1) Market cap. As of August 14, the Magnificent Six had a record market cap of $7.1 trillion, accounting for a near-record 25.5% of the S&P 500’s market cap.

(2) Performance. On a ytd basis, the FAANGM stocks collectively are up 40.0% (Fig. 23). Over the same period, the S&P 500 is up 4.2% with them but down 4.1% without them. Since March 23 through Friday’s close, here are the comparable performance stats: 66.4%, 50.4%, and 45.6%.

(3) Valuation. During the week of August 7, the collective forward P/E of the FAANGM stocks was 40.9. The S&P 500 forward P/E with and without them was 22.0 and 18.9. The Buffett Ratio, using the weekly forward price-to-sales ratio, was 6.0 for the FAANGM stocks. It was 2.37 and 1.96 for the S&P 500 with and without them. These are all historically high readings.

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Comparing the Great Virus Crisis & the Great Financial Crisis

August 17 (Monday)

Global Economy: Pain Relief. It’s been a world of pain since the World Health Organization (WHO) declared the global pandemic on March 11. However, there are mounting signs that the worst is over for the global economy. The economic pain during the Great Virus Crisis (GVC) has been similar in scale to that during the Great Financial Crisis (GFC). The question is whether the recovery this time will be faster or slower than before. Consider the following:

(1) Global exports & global production. The most calamitous event that exacerbated the GFC was the collapse of Lehman on September 15, 2008. The results were a global credit crunch and a severe recession. Similarly, the WHO declaration on March 11 of this year precipitated the GVC as governments around the world locked down their economies to slow the spread of the virus. The result was a severe recession, as evidenced by freefalls in world production and in the volume of world exports, which are highly correlated (Fig. 1). The growth rate of the latter fell more steeply because it tends to be more volatile than that of the former (Fig. 2).

In both episodes, global production peaked before the calamities occurred. During the GFC, it peaked at a then-record high during February 2008 and fell 2.0% through August 2008. It then plunged 10.8% through February 2009. During the GVC, it peaked at a record high during December 2019 and dropped 12.8% through April of this year.

Similarly, during the GFC, the volume of world exports peaked at a record high during January 2008 and fell 1.0% through August 2008. It then fell 20.0% through January 2009. During the GVC, exports peaked at a record high during October 2018 and decreased 2.9% through February of this year. Since then through May, the volume of world exports is down 17.1%.

The weakness prior to Lehman was attributable to the worsening subprime mortgage crisis. The weakness prior to the WHO pandemic announcement was attributable to President Trump’s trade wars.

So far during the GVC, both world production and exports seem to have bottomed during May, according to the available data compiled by CPB Netherlands Bureau for Economic Policy. If so, the drop in both lasted just three months, from March to May. During the GFC post-Lehman, they dropped for seven months, from September 2008 through March 2009.

During the GFC, there was a U-shaped recovery in both that started at the beginning of 2009. The recoveries in world production and exports took 21 and 22 months, respectively, to return to their respective record highs that preceded the GFC. A similar pattern, which seems plausible to Debbie and me, suggests that the full recovery from the GVC will take until late 2022, as noted above.

(2) Global PMIs and leading indicators. Then again, the rebound in global PMIs has been quite impressive from May through July (Fig. 3). The global composite PMI has rebounded from a record low of 26.2 during April to 50.8 during July. We don’t have access to comparable data during the GFC. However, the rebounds in the US M-PMI and NM-PMI have been much faster in recent months than they were in 2009 (Fig. 4 and Fig. 5). The same can be said about China’s M-PMI and NM-PMI, as we will discuss tomorrow.

On the other hand, we do have OECD data series for leading indicators around the world, starting during mid-1961. The composite index for the 36 members of the OECD plunged from 99.5 at the beginning of the year to a new record low of 93.3 during April. It rebounded sharply to 98.0 during July (Fig. 6). Similar patterns can be seen in the OECD’s leading indicators for the US, Europe, Japan, as well as the BRICs (Brazil, China, India, and Russia) (Fig. 7).

(3) US & world revenues & earnings. The most remarkable difference so far between the GVC and the GFC is that the virus crisis didn’t see S&P 500 forward revenues or S&P 500 forward earnings fall as hard or for as long as they did during the financial crisis. Indeed, both metrics seem to have bottomed during the May 28 week and started to recover already (Fig. 8 and Fig. 9). Forward revenues is up 3.3% since then through the August 6 week, and forward earnings is up 8.4%. Analysts’ consensus estimates for S&P 500 revenues and earnings for this year and next year are also showing signs of bottoming.

The same can be said about the weekly forward revenues and forward earnings of the Emerging Markets MSCI stock price index (Fig. 10 and Fig. 11). If they indeed are bottoming, then their downturns have been slightly less severe during the GVC than the GFC. On the other hand, there are no signs of bottoms yet in the forward revenues or forward earnings of the Developed World ex-US MSCI stock price indexes.

(4) Global response of monetary & fiscal authorities. The responses of the three major central banks—i.e., the Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ)—to the GVC so far have been similar to their responses to the GFC nearly 12 years ago. Their combined balance sheets initially jumped 64.5% over the 14-week period after Lehman hit the fan through the week of December 19, 2008 (Fig. 12). This time, their combined balance sheets jumped 43.6% from the WHO’s pandemic declaration through the start of August. During the GFC, however, the Fed provided most of the initial monetary stimulus; this time, both the ECB and BOJ also have expanded their balance sheets significantly (Fig. 13).

In the US, government social benefits provided much more and much faster government support to households during the GVC—support that more than offset households’ drop in wages and salaries—than benefits did during the GFC (Fig. 14). That explains the remarkable rebound in retail sales to a record high during July (Fig. 15). In contrast, retail sales after the GFC took 29 months to recover to their level of August 2008, just before the Lehman meltdown.

(5) Labor market. The most obvious difference between the GFC and the GVC so far has been in the labor market. The recent “lockdown recession” has cost far more people their jobs much faster than jobs have been lost ever before, especially in services-producing industries. Payroll employment plunged 22.2 million from February through April (Fig. 16). In comparison, payrolls fell 7.5 million over the 18 months from August 2008 through February 2010. It took another 45 months through November 2013 for payrolls to return to the August 2008 level.

Although payroll employment rebounded 9.3 million from April through July, it remains 12.9 million below the February 2020 level. It is very unlikely to get back to that level this year. It might do so next year if an effective vaccine or a cure for COVID-19 is discovered.

During the GFC, the unemployment rate rose from 6.1% during August 2008 to peak at 10.0% during October 2009 (Fig. 17). During the current virus crisis, it soared from 3.5% during February 2020 to peak at 14.7% during April. It was back down to 10.2% during July.

(6) Big differences. The GFC was to a large extent a typical business-cycle downturn. It was preceded by an economic boom that was led by speculative excesses, particularly in the housing industry. When that bubble burst, a credit crunch worsened the resulting recession, with real GDP falling 4.0% from Q4-2007 through Q2-2009. The Dating Committee of the National Bureau of Economic Research (NBER) ruled that it lasted 18 months, from December 2007 through June 2009.

The GVC is unique. In many ways, it’s like a major natural disaster that hit the entire world economy. Initially, it did trigger a credit crunch, but the world’s major central banks stopped that from happening by pouring liquidity into global financial markets.

The NBER’s Dating Committee has already determined that the US economy peaked during February of this year. Indeed, real GDP dropped 10.6% from Q4-2019 through Q2-2020. Numerous economic indicators bottomed during April. That would make it a two-month recession. A recession that short is unprecedented, but that’s because there is no precedent for a recession caused by government-mandated lockdowns around the world to slow the spread of the virus.

Global Inflation: Still Missing in Action. Recessions depress economic demand relative to supply, which tends to put downward pressure on inflation. Typically during recessions, there’s lots more chatter about the possibility of deflation than reflation. But that’s not always so. The 1970s were exceptional in that two oil price shocks both caused recessions and boosted inflation. Back then, the chatter was about “stagflation.” By the early 2000s, Fed officials were fretting publicly about deflation, as most famously expressed by then-Fed Governor Ben Bernanke in a November 21, 2002 speech titled “Deflation: Making Sure ‘It’ Doesn't Happen Here.”

The Fed has officially targeted a 2.0% inflation rate since January 2012, and ever since then, the Fed has failed most of the time to get inflation that high—despite ultra-easy monetary policies that started during the GFC and continue to this very day. But surely now that the GVC has caused the Fed and the other major central banks to adopt even more ultra-easy monetary policies, inflation must make a comeback. Or not: Let’s not forget what Benjamin Franklin once observed: “Nothing is certain except for death and taxes.” And both are inherently deflationary! Nevertheless, there is more chatter now about reflation than deflation.

Prior to the GVC, I argued that Détente (a.k.a. globalization), (technological) Disruption, Demography, and Debt were inherently deflationary. The “4-Ds” still are, though the escalating Cold War between the US and China is a threat to globalization. However, the other three forces remain powerfully deflationary, in my opinion.

In any case, for now, inflation remains subdued. Consider the following:

(1) OECD CPI inflation. The CPI among the 36 members nations of the OECD was just 1.1% y/y during June (Fig. 18). Excluding food and energy, it was 1.6%. This core rate has been fluctuating in a relatively tight range between 1.1% and 2.4% since the start of 2009.

(2) US CPI inflation rates. In the US, the CPI inflation rate remained well under 2.0% during July, coming in at 1.0% for the headline measure and 1.6% for the core measure. As we noted last week, rent of shelter has a disproportionately large weight of 33.0% in the CPI (Fig. 19). It rose 2.4% during July, the lowest since November 2013, and most likely will fall slightly below zero, as it did during the GFC. It includes tenant rent (up 3.1% y/y, the lowest since May 2014) and owner-occupied rent (up 2.8%, the lowest since May 2015) as well as lodging away from home (down 13.4%, near May’s record low) (Fig. 20).

(3) Other CPI inflation rates. Here is a sampling of July CPI headline and core inflation rates in major economies around the world: Eurozone (0.4%, 1.2%), Germany (0.0, 0.7), France (0.9, 1.5), Italy (0.9, 2.1), Spain (-0.7, 0.8), Japan (0.1, 0.2, June), China (2.7, 0.5), South Korea (0.3, 0.4), and Mexico (3.6, 3.9) (Fig. 21).

Movie. “Summerland” (+ +) (link) is a feel-good summertime movie about an Englishwoman, Alice Lamb (played by Gemma Arterton), who lives alone in a rural cottage with a spectacular view of the English Channel and the Cliffs of Dover. During World War II, young children were evacuated from London to the English countryside to live with families who volunteered to take them in for the duration of the war. Alice is surprised when a young lad shows up at her door. Initially, she responds to the apparent mistake by arranging to have him sent to another family. But she changes her mind, and the result is summertime magic.

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Material Information

August 13 (Thursday)

S&P 500 Materials I: Betting on Economic Revival. The S&P 500 Materials sector contributes only 2.6% to the S&P 500’s market capitalization, but its health is often used to divine the broader economy’s direction.

After tumbling 37.4% from the start of the year through the S&P 500’s bottom on March 23, the Materials sector subsequently became the second-best-performing sector, up 61.9% and trailing only the Amazon-driven Consumer Discretionary sector. The sector is in positive territory ytd, up 1.4% through Tuesday’s close and follows only Consumer Discretionary (18.4%), Communications Services (6.8), and Health Care (3.3) (Fig. 1). The Materials sector’s major rebound appears to be signaling that the worst of the Great Virus Crisis (GVC) has passed and confirms that the S&P 500 deserves to be just shy of its all-time high. Let’s take a deeper look at the sector’s performance this year in the context of how its peers performed:

(1) On the way down. During the market’s downdraft from the start of the year through March 23, the Materials sector underperformed the broader S&P 500 index and seven other sectors, beating only three. Here’s the S&P 500 sector performance derby: Consumer Staples (-22.6%), Information Technology (-23.1), Communication Services (-24.2), Health Care (-26.7), Consumer Discretionary (-27.6), Utilities (-30.6), S&P 500 (-30.7), Real Estate (-34.0), Materials (-37.4), Industrials (-40.1), Financials (-42.6), and Energy (-60.3) (Table 1).

(2) On the way up. Since the market’s March bottom, however, Materials along with Consumer Discretionary have led the way up. Here’s the performance derby for the S&P 500’s sectors from the March 23 low through Tuesday’s close: Consumer Discretionary (63.6%), Materials (61.9), Energy (59.4), Industrials (58.6), Information Technology (57.9), S&P 500 (49.0), Financials (43.1), Health Care (40.9), Communication Services (40.8), Real Estate (39.8), and Utilities (34.0) (Table 2).

(3) Industries leading the way. While the Gold industry helped cushion the Materials sector’s performance during the early-year downdraft, other industries have fueled the sector’s outperformance since the March low. In particular, the S&P 500 Copper industry has risen 159.0% since March 23; Diversified Chemicals (95.8%), Commodity Chemicals (70.2), and Specialty Chemicals (67.3) also have helped catapult Materials’ performance since March. Companies that cut costs sharply this spring to survive the market downdraft are now being rewarded as economies reopen and volumes start to improve.

S&P 500 Materials II: Digging Deeper. Let’s look now at some of the underlying factors that have driven the S&P 500 Materials sector’s market-beating rebound:

(1) Gold losing its shine? The price of gold—and silver for that matter—have gone straight up for most of this year, helped first by the onset of COVID-19 and the related economic uncertainty and then by the ballooning deficit (Fig. 2 and Fig. 3). The dollar, which has fallen in value by 6% since March 23, further buttressed the metals (Fig. 4). Only this week did the metals lose some of their luster as optimism grew about a vaccine and the economy. That optimism combined with ever-larger Treasury auctions to fund the deficit sent the 10-year yield up to 0.69% yesterday from its low of 0.52% on August 4 , which also weighed on precious metals (Fig. 5).

The price of gold has fallen 6% from its peak on August 6 through Tuesday; but even after those losses, it remains up 27% ytd. The price of silver dropped even more dramatically from its peak (Monday), by 11% on Tuesday. Still, it is up 46% ytd. The market’s uneasiness about the metals is reflected in the CBOE Gold ETF Volatility index, which has risen 65% over the past month, though “well below” its recent peak in March, an August 12 WSJ article reported.

(2) Dr. Copper says all’s well. Freeport McMoRan, the sole constituent in the S&P 500 Copper industry, mines, copper, gold, and molybdenum, an alloy used in steel and other materials. The price of copper fell sharply, by 26%, from January 14 through March 23. It has since rebounded 37%, leaving it up 3% ytd (Fig. 6).

Freeport responded to the tumbling price of copper by slashing costs and eliminating its dividend in March. It has not increased spending as the price of copper has rebounded. As a result, adjusted Q2 earnings per share was three cents compared to a loss of four cents in the same quarter last year.

CEO Richard Adkerson said during the Q2 conference call on July 23 that he doesn’t see the company returning to its old ways of doing business. “As a company, we’ll never work in the same way that we did before. ... There's going to be less office space, less meetings, less travel. … We did not go back to work in Phoenix when the Governor opened the state up. The halls are and offices are empty in our headquarters. And yet, you can see the results from this core about how effectively we can operate in this kind of environment.”

The prices of commodities have been boosted by the strong and steady recovery of China’s economy from the Q1 low, led by its industrial sector, infrastructure spending, and government stimulus, observed Adkerson. He also mentioned “positive signs” in Western economies, helped by the restart of auto production.

Lastly, Adkerson noted that in traditional commodity downturns, inventories rise and then need to be worked off when a recovery arrives. This year was different, as inventories remained low throughout the downturn. “Currently low inventories are a good omen for copper,” he said, “as it positions the metal for material gains as economic activity rebounds.”

Going forward, demand for copper will grow because it’s used in many of the electronic items that are growing in popularity, including electric vehicles (EVs) and charging stations, windmills, solar energy, and 5G technologies. He also predicted that copper’s use in healthcare equipment, facilities, and public places would grow because COVID-19 and other viruses die much more quickly when they land on copper compared to other materials, like glass and stainless steel. Its killing powers are laid out in this April 14 Smithsonian article. In all, the company forecasted that its copper-mining volume would jump by 21% next year and mining volume for gold would increase 75%.

The S&P 500 Copper stock price index is up 6.4% ytd (Fig. 7). After falling 9.3% this year, the industry’s revenue is expected to jump 29.2% in 2021 (Fig. 8). Earnings are expected to improve this year from near-breakeven results last year and increase 470.1% next year (Fig. 9). After suffering through negative net earnings revisions for much of the past two years, the industry enjoyed positive net revisions of 33.2 in July (Fig. 10). And while investors may have missed the low of this cycle, the forward P/E remains elevated and could fall further if the industry’s earnings continue to improve, which historically has been good news for the industry’s price performance (Fig. 11).

(3) EVs drive specialty chemicals. The S&P 500 Specialty Chemicals industry has been among the top performers in the Materials sector since the market bottomed in March. The industry’s stock price index has risen 67.3% since March (Fig. 12). Driving much of that improvement is Albemarle, up 73% from the March low.

Albemarle makes lithium used in batteries for EVs. With COVID-19 stopping vehicle production cold, demand for lithium dropped sharply, and its price sank. The lithium division’s Q3 EBITDA will still be down by 10% to 20% q/q, after falling by 33% in Q2 y/y. CEO Kent Masters believes that COVID-19 did not destroy demand for lithium, but it did result in elevated inventories and pushed out demand by a year.

The company also has a bromine business, which it sells to make flame retardants and to the oil industry. That division’s Q2 EBIDA fell 10% and is expected to be flat in Q3 q/q as strength in construction offsets continued weakness in flame retardants and drilling fluids used in oil fields. Albemarle actually raised its dividend in Q2, by 5% y/y.

Other companies in the Specialty Chemicals industry have also performed well since the S&P 500’s March bottom: Sherwin-Williams (58.1%), PPG (51.6), Ecolab (38.3), and International Flavors and Fragrances (22.3). After an expected revenue drop of 9.2% this year, the Specialty Chemicals industry’s revenue is forecast to increase by 6.4% in 2021 (Fig. 13). Earnings are forecast to improve even more dramatically, from an 18.6% drop this year to a 19.8% jump in 2021 (Fig. 14). With earnings still depressed, the industry’s forward P/E is a lofty 22.2 (Fig. 15).

(4) Cost cutting aids Eastman Chemical too. Like others in the chemicals industries, Eastman Chemical’s Q2 results were hurt by the drop in volumes as economies closed in response to COVID-19. Eastman’s Q2 revenue dropped 19% y/y, and adjusted earnings fell by more than half to 85 cents per share. The company responded by working toward removing more than $150 million of costs this year.

While visibility remains limited, Eastman Chemical said in its Q2 earnings presentation that demand “likely” bottomed in May. As volumes recover, Eastman is expecting to see a “substantial increase” in earnings in Q3, helped in part by the leverage resulting from cost cuts. The company, which is the only member of the S&P 500 Diversified Chemicals industry, did not give more specific earnings guidance.

Investors aren’t waiting for more detailed guidance. The S&P 500 Diversified Chemicals industry’s stock price index has jumped 95.8% since the March low (Fig. 16). And while analysts continue to expect revenue will fall 10.5% this year, it’s expected to grow 6.5% in 2021 (Fig. 17). Earnings are forecast to follow a similar path, falling 21.4% in 2020 and jumping 23.8% next year (Fig. 18).

Disruptive Technologies: The Battery Battleground. New EV company Lucid Motors has made an audacious announcement: Its Lucid Air sedan can run for 517 miles on a single charge, roughly 200 miles more than most Tesla cars on the road today. The catch is that the car will be priced north of $100,000. More details will be revealed on September 9. But the point is that battery life will be one of the main items on which EVs compete. So let’s take a look at some of the new technology being developed to help EVs drive farther before needing to plug in and power up.

(1) Imagine: 1,000 miles on a charge. Phinergy, an Israeli company, and Alcoa Canada have developed a souped-up battery that uses an aluminium-air battery to move an EV for 1,000 miles on one charge. Indian Oil bought a minority stake in Phinergy in March and is talking with EV makers about starting to test the battery, a March 2 article in The Economic Times reported.

The article explained: “Aluminium-based metal-air battery uses oxygen from the air and combines it with the metal to create an aluminum hydroxide, which activates the electrolysis process and creates an electric current. These batteries are lighter and compact with high energy density.” The aluminium hydroxide can be recycled to make new batteries every few months.

(2) Graphene batteries. Grabat has developed graphene batteries that could allow EVs to drive up to 500 miles on a charge and can be fully charged in a few minutes, a July 21 article in Pocket-Lint reported. Graphene is a material that tightly binds carbon atoms in a honeycomb-like structure, and it’s only one atomic layer thick. The company, which is working with several car and airplane companies, says the price point is similar to that of a lithium ion battery, but the graphene battery lasts four times larger, a February 4 press release stated.

(3) Could silicon be the answer? Sila Nanotechnologies has developed an anode made of silicon that replaces the graphite now used in lithium ion batteries. The company says that by using silicon anodes, a battery’s energy density is improved by 20%, and there’s the potential to improve it by 40%. Silicon is also cheaper to use than graphite.

The company’s employees include CEO and co-founder Gene Berdichevsky, an early Tesla employee who led the development of Tesla’s Roadster battery system, and Alex Jacobs, Sila’s co-founder and VP of Engineering, who previously developed battery packs at Tesla. Last year, Kurt Kelty, former Tesla director of Battery Technology, joined as Sila’s VP of Automotive. Bill Mulligan, former SunPower executive VP of Global Operations, became Sila’s first COO.

(4) IBM is in the running too. IBM has developed a battery that uses materials extracted from sea water in its cathode instead of cobalt and nickel, which are difficult to mine and considered more environmentally harmful. It also uses a safe liquid electrolyte with a high flash point, a December 18 IBM blog post stated.

The new IBM battery costs less than lithium-ion batteries, charges faster, and has a higher power and energy density. It can be 80% charged in under five minutes, the blog boasts. IBM Research is working with Mercedes-Benz Research and Development North America, Central Glass, and battery manufacturer Sidus on creating a new battery ecosystem

(5) Don’t count Telsa out. Tesla’s CEO Elon Musk undoubtedly knows that battery power will make or break the company’s future, and investors are hoping to get more information on Tesla’s plans during its self-named Battery Day on September 15 at the company’s California factory. The company is expected to use the day to disclose more efficient EVs.

There’s been speculation that Tesla will use batteries from Contemporary Amperex Technology (CATL), which has said it has a battery for EVs that will last up to 1.2 million miles. Current EV batteries last about 150,000 miles and have an eight-year warranty. While it is 10% more expensive than batteries currently on the market, CATL’s battery theoretically could be used in multiple cars over its lifespan.

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Sputnik V

August 12 (Wednesday)

Strategy: It Isn’t Rocket Science. The S&P 500 stock price index rose yesterday morning but closed down slightly on the day (Fig. 1). It needs only to increase by 1.6% to be back at its February 19 record high. Our 3500 S&P 500 target for the end of next year is likely to be hit before the end of this year—well ahead of schedule.

Joe and I therefore are raising our year-end 2020 target from 2900 to 3500. We remain bullish on 2021 as well. Our new target for the end of next year is 3800 (Fig. 2). It seems to us that the stock market already has discounted lots of the good news likely to occur through the end of next year.

The market is experiencing a meltup, making it hard to predict the upside and also raising the risk of a meltdown along the way up. The meltup that started on Don’t Fight the Fed Day (DFFD) continues. DFFD was Monday, March 23, the day that the Fed implemented QE4Ever with open-ended, open-market purchases of fixed-income securities (Fig. 3). That’s after the Fed lowered the federal funds rate by 100bps to zero on March 15 (Fig. 4).

The US Treasury joined the Fed’s stimulus party on Friday, March 27, when President Donald Trump’s signing of the CARES Act provided $2.2 trillion in fiscal stimulus (Fig. 5). Federal government spending on income redistribution jumped $1.48 trillion during Q2 to $4.64 trillion (saar) from $3.16 trillion during Q1. That more than offset the $795 billion drop in labor compensation during the quarter (Fig. 6). Now consider the following:

(1) Not-so-secret formula. The simple formula for what is happening is DFFD + CARES = MMT, where “MMT” is Modern Monetary Theory. Furthermore, MMT + TINA = MAMU, where “TINA” stands for “there is no alternative” to stocks when bond yields are close to zero and “MAMU” stands for the “Mother of All Meltups.” Our equations aren’t worthy of a Nobel Prize like Einstein’s E = MC², but they explain why stocks have rebounded so dramatically since March 23.

(2) Stock market equation. The other relevant equation is P = P/E x E. That’s the stock market equation where “P” is the S&P 500 stock price index, “E” is the forward earnings of the S&P 500, and “P/E” is the forward valuation multiple. Joe and I weren’t surprised that forward earnings bottomed during the May 15 week and has increased every week since then through the week of August 7 (Fig. 7). However, it is up just 5.3% so far. Also bottoming in recent weeks are S&P 500 forward revenues and analysts’ consensus revenues estimates for this year and next year (Fig. 8).

The meltup has been led by the 74% jump in the forward P/E from a low of 12.9 on March 23 to 22.5 yesterday (Fig. 9). In recent weeks, we’ve attributed this remarkable jump in the forward P/E to the decisive drop in the 10-year Treasury bond yield below 1.00% on March 20 (Fig. 10). Along the way, Fed officials have reiterated their intention to keep interest rates near zero for the foreseeable future. For example, Fed Chair Jerome Powell famously stated at his June 10 press conference, “[W]e’re not thinking about raising rates. We're not even thinking about thinking about raising rates.”

(3) “Sputnik V” is here. Yesterday’s stock market action was driven by Russian President Vladimir Putin, who claimed that Russian scientists achieved a breakthrough in the global vaccine race. He announced that the country has become the first to approve an experimental COVID-19 vaccine and that his own daughter has already taken a dose. The vaccine is named “Sputnik V,” a reference to the first orbital satellite, which was launched by the Soviet Union in 1957 and set off the global space race.

The vaccine hasn’t had a Phase 3 trial yet. It has been tested in small, early clinical trials designed to find the right dose and assess any safety concerns. It was given to scientists who developed it, in self-experimentation that is unusual in modern science, as well as to 50 members of the Russian military and a handful of other volunteers.

Nevertheless, the stock market reacted positively to the vaccine news yesterday morning. It sold off late in the day, with weakness in the share prices of companies that have benefited from the pandemic’s economic impacts more than offsetting strength in those that have suffered from them. The FANGMANT stocks (Facebook, Amazon, Netflix, Google’s parent Alphabet, Microsoft, Apple, NVIDIA, and Tesla) sold off, while bank stocks rallied. Also worth mentioning is that precious metals prices dipped on the news out of Russia. Furthermore, bond yields rose.

 US Credit I: Fed Can’t Solve Solvency. The credit markets also have rebounded since DFFD. For example, the yield on US high-yield corporate bonds plunged from 11.38% on that day, March 23, to 5.41% on Monday (Fig. 11). That’s not far from its record low for the series of 5.02% recorded on February 19! Also on Monday, aluminum can maker Ball raised $1.3 billion through a 10-year bond, paying an annual coupon of 2.875%, the lowest borrowing cost clinched in the junk debt market for a 10-year bond, according to financial data provider Refinitiv.

Nevertheless, the Great Virus Crisis (GVC) still has the potential to roil the credit markets. Fed Chair Powell said in a May 13 speech for the Peterson Institute for International Economics: “A loan from a Fed facility can provide a bridge across temporary interruptions to liquidity, and those loans will help many borrowers get through the current crisis. But the recovery may take some time to gather momentum, and the passage of time can turn liquidity problems into solvency problems.” While the Fed can provide liquidity, it can’t produce cash flow for distressed companies to service their debts.

Let’s consider some of the signs of stress in the credit markets:

(1) High-yield defaults. Fitch Ratings reported that the trailing-twelve-month (TTM) high-yield default rate in the US rose to 5.1% at the end of June. June’s default volume was $8.3 billion, of which almost 80% came from the energy sector. Default volume totaled $41.1 billion during Q2, exceeding the previous record of $39.5 billion set back in 2009.

Frontier Communications and Chesapeake Energy made up nearly half of the current default volume. Energy and telecom companies accounted for 70% of the recent quarters’ default volume. Fitch forecasts a 5%-6% (base case) to 7%-10% (severe case) default rate for 2020 and about two percentage points higher for 2021. That’s all according to “Fitch U.S. High Yield Default Insight” July special report.

(2) Big bankruptcies. Data from Epiq reveal that 3,604 companies filed for Chapter 11 bankruptcy during the first six months of this year, an annual increase of 26%. Some large household names that have gone bankrupt this year include Chesapeake Energy, Brooks Brothers Group, J. Crew, Neiman Marcus, and Hertz.

Bloomberg reports that more than 30 US companies with liabilities exceeding $1 billion have filed for Chapter 11 since the beginning of the year, according to Edward Altman, creator of the Z-score and professor emeritus at NYU’s Stern School of Business, and there are likely to be 30 more mega-bankruptcies by the end of the year.

(3) Rising loan loss reserves. We continue to watch an item labeled “allowance for loan & lease losses” on the Fed’s weekly data report on the balance sheets of commercial banks. It jumped from $115.1 billion at the end of February to $184.7 billion during the July 29 week (Fig. 12). It peaked at a record $235.2 billion over a decade ago (the week of April 21, 2010).

(4) Fed facilities unused. Corporate lending activity through the Fed’s myriad facilities has been scarce relative to the lending capacity stipulated in the facilities’ term sheets (linked below). The facilities originally were slated to expire on September 30, but that recently has been extended to December 31. The extension comes as the take-up for Fed lending has been slow.

As of July 31, the Fed had purchased $12 billion in corporate bonds of its up to $750 billion in lending capacity under the corporate credit facilities (CCFs), according to its latest update report to Congress dated August 8. All loans were extended under the secondary-market CCF. The primary-market CCF was operational but had not yet closed any transactions as of the end of July. The total outstanding amount of the Fed’s loans under the term asset-backed securities liquidity facility was $1.6 billion of its up to $100 billion in lending capacity. Outstanding loans under the Fed’s Main Street Lending Program totaled just $87.6 million out of $600 billion in lending capacity.

(5) Survey says. Despite all the recent monetary support from the Fed, banks are tightening their lending standards. Lending conditions are getting tougher for industries ranging from commercial real estate to credit cards and autos. Overall, demand for loans has decreased at the same time (Fig. 13).

“Major net shares of banks that reported reasons for tightening lending standards or terms cited a less favorable or more uncertain economic outlook, worsening of industry-specific problems, and reduced tolerance for risk as important reasons for doing so,” said the Fed’s July 2020 Senior Loan Officer Opinion Survey on Bank Lending Practices. Meanwhile, loan demand for residential real estate has increased, although standards have tightened for these loans as well.

(6) Corporations cutting capex & opex. Large and mid-cap firms globally are expected to slash capital spending by an average 12% this year, reported Reuters, according to data compiled by Refinitiv. That’s larger than the 11.3% decline that occurred in 2009 and potentially the steepest drop in the 14 years for which data are available.

By sector, the biggest cuts to capital expenditures are forecasted for energy (25%), consumer discretionary (23), and real estate (20), respectively. Major companies announcing significant reductions include BP, Exxon Mobil, and General Electric. Each has said they will slash 2020 capital spending by at least 20%. Citing permanent changes in consumer behavior, analysts expect companies to cut operating costs by 19.7%, noted Reuters. Lots of major companies have announced that they are permanently reducing their workforces as a result of the GVC.

US Credit II: Tale of Two Sectors. Big-name companies in sectors such as retail and energy showed signs of corporate earnings vulnerability leading up to the GVC and have filed for bankruptcy during its course. So too have large companies in sectors that have lost a lot of their social and economic value owing to the pandemic—and will continue to do so as it persists—including the hospitality, airline, and cruise industries as well as small, poorly capitalized businesses in a variety of industries.

The longer that the GVC continues, the more likely are the ranks of insolvent firms to swell, Melissa and I figure, unless the fiscal authorities step in with more corporate bailouts and aid for consumers. Retail and energy are two of the sectors that have produced large bankruptcies thus far; here’s more:

(1) Energy bloodbath. Not only did the pandemic wipe out oil demand, but disagreement among the OPEC nations resulted in an oversupply of oil just as the GVC began to hit home hard. Forbes listed several of the big energy bankruptcies this year, including Chesapeake Energy, Ultra Petroleum, Whiting Petroleum, Denbury Resources, and Extraction Oil & Gas.

Since the start of the year, 22 energy companies have defaulted on their leveraged loans, high-yield bonds, and in some cases both, reported Forbes, citing Fitch Ratings data. The energy sector represented 26% of total leveraged loan and high-yield bond defaults so far this year, of $96 billion. In Fitch’s July Top Bonds of Concern report, more than half of the bonds cited are in the energy sector.

(2) Retail crash & burn. Even before the GVC, retailers were crashing under the weight of overhead from running underpopulated stores and competing with the likes of fully online e-commerce retailers such as Amazon. The GVC only exacerbated their plight by boosting consumers’ preference for shopping online and sharpening their appetites for lower-cost items. Many retail companies also have suffered from the GVC’s remote-work trend, as workwear demand has gone out the window.

Forbes’ list of retailers that have gone bankrupt this year includes Brooks Brothers, Lord & Taylor, Neiman Marcus, J.C. Penney, J. Crew, Lane Bryant (the parent company of Ann Taylor, Loft), Tailored Brands (which owns Men's Wearhouse), Lucky Brand, Lucky Dungarees, True Religion, and Catherines stores.

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Another Roaring Twenties May Still Be Ahead

August 11 (Tuesday)

Strategy I: Good Times Follow Bad Times. We seem to be living in unprecedented times. We always seem to be living in unprecedented times, according to conventional wisdom, mostly because we don’t spend enough time studying history. There’s certainly a precedent for our current times in the past, one that was truly unprecedented back then.

World War I was followed by the Spanish Flu pandemic of 1918, which infected an estimated 500 million people and killed as many as 50 million. Given that the world population was 1.8 billion back then, that implied a 28% infection rate and nearly a 3% death rate. Both stats are currently significantly lower for the COVID-19 pandemic. Today, the global population is 7.5 billion. There have been 20 million cases and 735,000 deaths worldwide as of yesterday.

The good news is that the bad news during the previous precedent was followed by the Roaring Twenties. So far, the 2020s has started with the pandemic, but there are plenty of years left for the prosperous 1920s to become a precedent for the current decade. If so, the driver of the coming boom will be technology-enhanced productivity, as it was during the 1920s.

Before we go there, let’s go back to the late 1700s and recall the grim forecasts of Thomas Malthus. He was the first economist, and he was a pessimist. In other words, he was the first Malthusian. During the late 1700s, he predicted that populations would grow faster than food production; the result would be a regular cycle of starvation and death. He was dead wrong. Agriculture was among the industries that benefitted the most from the Industrial Revolution of the 1800s. Technological progress always confounds the pessimists by solving scarce-resource problems. It also fuels productivity and prosperity, as it did in the 1920s and could do again in the 2020s. Consider the following:

(1) Technology during the 1920s. In 1920, 51% of the US population lived in cities, up from 23% in 1870. This remarkable urbanization was enabled by innovations in electricity and plumbing. Electric grids provided clean, bright light without emitting smoke. Urban water networks supplied clean water, and sewer systems removed waste without the pungent odors of chamber pots and outhouses. Telephones allowed people to converse with distant friends.

Henry Ford’s Model T, built between 1908 and 1927, was the first car invented and helped people to live an easier life by making transportation easier and faster. In 1900, just 8,000 motorcars were registered in the US, but there were 9 million in 1920 and 23 million in 1929. Streetcars and subways, unheard of in 1870, were in all the major cities by 1920. Intercity trains were becoming steadily faster and more reliable. Detroit Police Officer William Potts came up with the idea of traffic lights, taking inspiration from railroad traffic signals. General Electric bought the idea for $40,000, and traffic lights soon were everywhere.

Ford’s assembly line innovation boosted productivity in many manufacturing industries, including the processed food industry. National food brands—including Heinz, Campbell’s, Quaker Oats, Jell-O, and Coca-Cola—began to fill cupboards. Refrigerated railroad cars and in-home iceboxes meant that vegetables were available in winter. Restaurants began to proliferate early in the 20^th century. When people out and about in their Model Ts got hungry, their options were few, but the first fast-food chain opened its doors in 1919, an A&W (better known today for its root beer). White Castle hamburger stands opened in 1921, and the first Howard Johnson’s restaurant in 1925.

Increasingly, anything not available in a local store could be obtained by a mail-order catalog. The Montgomery Ward catalog was first issued in 1872, the Sears catalog in 1894. By 1900, Sears was fulfilling 100,000 orders a day, and its catalog featured fur coats, furnaces, furniture, and much more—including homes. Sears sold more than 70,000 mail-order homes between 1908 and 1940. The catalog business was helped along by Parcel Post, which arrived in 1913.

Penicillin is considered one of the most important inventions to come out of the 1920s. It was created by Sir Alexander Fleming, Professor of Bacteriology at St. Mary’s Hospital in London, after studying bacteria in 1928. The antibiotic kills or prevents the growth of bacteria.

The bulldozer—used today in all kinds of construction the world over—was invented in 1923 by James Cummings and J. Earl McLeod, originally to dig canals.

Another popular invention found in almost every home by the mid-1900s was the radio. Listening to the radio became a national pastime, and many families gathered in their living rooms to listen to sports news, concerts, sermons, and “Red Menace” news. The phonograph—invented in 1877 and widely used by the 1920s—offered another entertainment option: listening to professional-quality music at home, unheard-of in earlier generations. Outside the home, going to motion picture shows—which were silent until 1927—was a very affordable and popular pastime.

(2) Technology during the 2020s. Today’s doomsters could be confounded by biotechnological innovations that deliver not only a vaccine for COVID-19 but for all coronaviruses. In the March 5 Morning Briefing, we discussed technology using messenger RNA (mRNA) to instruct our cells to make antibody-producing proteins that provide immunity to viruses.

Last Thursday, Jackie and I observed: “Scientists are investigating a dizzying array of approaches to fight COVID-19. Hopefully, beyond finding a cure or a vaccine, one of beneficial outcomes of all this research will be that scientists learn many more ways to combat illnesses in general and viruses in particular.” Typically, it takes roughly a decade for a new vaccine to go through the various stages of development and testing. However, the urgency of the pandemic has mobilized global medical resources as rarely seen in human history. Billions of dollars, provided by both the public and the private sectors, are funding the global campaign to develop tests, vaccines, and cures for the virus.

Jackie and I have been writing about disruptive technologies for some time, usually in our Thursday commentaries. (See our archive of Disruptive Technologies Briefings.) The awesome range of futuristic “BRAIN” technological innovations includes biotechnology, robotics and automation, artificial intelligence, and nanotechnology. There are also significant innovations underway in 3-D manufacturing, electric vehicles, battery storage, blockchain, and quantum computing. As I wrote in my 2018 book Predicting the Markets:

“Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentives to motivate innovators to solve this problem. As they do so, consumer prices tend to fall, driven by their innovations. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity.”

Now consider the follow stats on technology capital spending in the US: High-tech spending on IT equipment, software, and R&D rose to a record $1.32 trillion (saar) during Q2-2020 (Fig. 1). It jumped to a record 50.1% of total capital spending in nominal GDP during the quarter (Fig. 2). Equipment and software accounted for 31.1%, while R&D accounted for 19.1% of capital spending in nominal GDP (Fig. 3).

 Strategy II: More Socialism, and Crony Capitalism Too. The 2020s differ from the 1920s in several important ways. As noted above, urbanization increased significantly during the 1920s. It’s too soon to be sure, but one of the initial reactions to the COVID-19 pandemic could be de-urbanization, which has already sparked a boom in demand for existing and new homes in the suburbs and rural areas of the country. If that trend continues, it might contribute to the Roaring 2020s. De-urbanization could also boost auto sales, especially of hybrids and electric vehicles.

Perhaps the biggest difference between the 1920s and the 2020s are the structure of the US economy and the size of our government. During the 1920s, the White House was occupied by two laissez-faire Republican presidents. Warren Harding (1921-23) took the advice of his Treasury Secretary Andrew Mellon and cut marginal tax rates and deregulated business. By late 1922, the economy started to rebound from the recession at the start of the decade. Calvin Coolidge (1923-29) was Harding’s vice president and replaced him when Harding died suddenly. “Silent Cal” didn’t say much, but he clearly believed in small government. One thing he famously said: “The business of America is business!” While the President remained relatively silent, the economy roared. (By the way, what he actually said was: “After all, the chief business of the American people is business. They are profoundly concerned with producing, buying, selling, investing and prospering in the world.”)

President Donald Trump certainly isn’t the silent type. But he has cut taxes and deregulated business, carrying on the tradition of his predecessors of the 1920s. However, he is hardly a believer in laissez-faire economics, as evident from his trade policies and his various economic interventions. In addition, unlike Harding and Coolidge, he isn’t troubled by Big Government and huge federal deficits (Fig. 4).

Trump actually may have set the stage for bigger deficits, a Universal Basic Income (UBI), and the fiscal and monetary excesses championed by advocates of Modern Monetary Theory (MMT). Indeed, under Trump, government social benefits soared this year to offset the damage to earned incomes wrought by the pandemic (Fig. 5). If Trump loses the November 3 presidential election, a radical regime change could lead to higher taxes, more regulation, a Green New Deal, a UBI, more MMT policies, and lots more socialism.

It all adds up to Big Government getting bigger. When that happens, crony capitalism proliferates as Big Business and Big Government pursue their mutual interests. The business of American businesses, to adapt Coolidge’s famous one-liner, becomes to do more business with the government. Doing business with the government has become increasingly essential for companies, as the government has become a bigger customer for many of them and also more powerful in regulating all of their businesses. Despite recurring promises by presidential candidates to banish “special interests” from running Washington, the lobbying industry continues to flourish and grow in our nation’s capital, reflecting the symbiotic growth of Big Business and Big Government, i.e., the triumph of crony capitalism.

This isn’t a new development, but it is getting a boost from the Great Virus Crisis (GVC). This must be very depressing for proponents of entrepreneurial capitalism and free markets. However, it isn’t necessarily bearish for the stock market. As we’ve discussed in our recent commentaries (most recently in the August 5 Morning Briefing titled “Survival of the Fittest?”), the GVC has naturally selected certain industries as winners and others as losers from the pandemic’s fallout. The winners literally have carried the most weight in the S&P 500 and led the 50.2% rally in the index since it bottomed on March 23 through Monday’s close of 3360.47. That’s a hair below the February record high of 3386.15. That’s truly remarkable.

Stock investors can rejoice that Big Government is their friend—for now. The risk is that the stock market’s exuberance turns increasingly irrational, resulting in the Mother of All Meltups (MAMU). That could be followed by the Mother of All Meltdowns (MAMD). It’s not too hard to imagine what could possibly go wrong to convert MAMU into MAMD: i) vaccines don’t work to stop the pandemic; ii) violent civil unrest worsens; iii) extreme political partisanship gets more extreme; iv) the Cold War between the US and China rapidly heats up; v) a game of chicken between the US and Iran in the Strait of Hormuz leads to a military confrontation; vi) out-of-control MMT fiscal and monetary policies get even more out-of-control; vii) a radical left-wing regime change occurs on November 3; and viii) inflation makes a surprising comeback.

The 1920s ended with a stock market meltup followed by a meltdown. The 2020s may already be seeing a meltup, begun on March 23. We live in interesting, though not unprecedented, times. The Roaring 1920s could be a precedent for the Roaring 2020s. As Mark Twain observed: “History doesn’t repeat itself, but it often rhymes.”

Strategy III: Valuation One More Time. Yesterday, we pondered the valuation question, asking what the fair-value forward P/E of the S&P 500 is in a zero-bond-yield world. We concluded the obvious: It should be higher than the historical mean of this valuation metric, when inflation and interest rates were well above zero (Fig. 6). Today, let’s examine the valuation issue based on the dividend yield of the S&P 500, again in a zero-bond-yield world:

(1) The dividend yield has hovered around 2.00% since the start of the current bull market in 2009 (Fig. 7 and Fig. 8). The 10-year Treasury bond yield consistently exceeded the dividend yield from Q3-1958 through Q3-2008. Since then, the bond yield has mostly fluctuated around the dividend yield. This year, the bond yield fell to a record low of 0.52% last week. That’s decisively below the Q2-2020 dividend yield of 1.92% based on the four-quarter moving sum of dividends and 1.85% using the actual annualized result for the latest quarter.

(2) During Q2-2020, the S&P 500 quarterly dividend fell 6.6% from the record high during the previous quarter (Fig. 9). During the Great Financial Crisis (GFC), the four-quarter sum of dividends fell 22.7% from the peak during Q3-2008 to the trough during Q1-2010. A similar decline is likely during the GVC.

(3) Our Blue Angels analysis of the actual versus the implied price of the S&P 500 (based on the four-quarter sum of dividends divided by hypothetical dividend yields) shows that the S&P 500 has been closely hugging the trajectory based on a 2.00% dividend yield since 2010 (Fig. 10). The S&P 500 dividend yield is likely to be closer to 1.00% in coming quarters assuming that the S&P 500 either holds its price gains or moves still higher while dividends decline during the GVC, as they did during the GFC. That still beats a bond yield that is getting very close to zero.

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Stock Valuation in a Zero-Bond-Yield World

August 10 (Monday)

Strategy: Hamlet & the Valuation Question. William Shakespeare’s protagonist Hamlet, in his play of the same name, asked the most basic question about the value of life: “To be, or not to be?” Joe and I have been asking: “In a world of zero interest rates, what is the fair value of the S&P 500 forward P/E?” Our question certainly doesn’t imply anything about whether living is worth the pain it can entail, as Hamlet discussed in his famous soliloquy. We are simply asking whether stocks should be deemed to be or not to be too expensive.

Nevertheless, investors can get killed if the current valuation multiple—22.1 on the S&P 500 as of Friday’s close—is too high and headed lower. Alternatively, investors who cash out of equities now because they deem stocks to be too expensive could turn suicidal if stock prices continue to soar along with their P/Es. After all, with bond yields near zero, the notion that there is no alternative (TINA) to stocks makes more sense than ever before. Consider the following:

(1) Historical average and reversion to the mean. The average of the S&P 500’s P/E since 1960 has been around 15.0 (Fig. 1). We are using the trailing average P/E based on quarterly reported earnings from 1960 to 1978 and the P/E based on monthly forward earnings from January 1979 through April 1994, then weekly forward earnings from May 1994 to now.

The average over this period doesn’t mean much since inflation and interest rates trended upwards from the 1960s through the 1980s, and then both trended downwards since the 1980s (Fig. 2 and Fig. 3). The P/E was generally below the historical average when inflation and interest rates were rising and high. It was generally above the average when inflation and interest rates were falling and low.

Nevertheless, it is widely believed that the P/E tends to revert to its historical mean. It certainly did so during the bear market of 2000, when a rapid tumble took the P/E to its historical average mean (Fig. 4). It fell below its mean during the bear market of the Great Financial Crisis (GFC) and reverted above the mean during the subsequent bull market. Now it is the highest since December 2001.

(2) Is it different this time? While the current P/E undoubtedly will revert to the mean eventually, that might not be a very useful insight if the mean has moved higher when adjusted for record-low bond yields. In other words, it could just as easily revert to a higher P/E as to a lower one, which would still be above the historical average.

In a world of zero interest rates, maybe the new normal mean P/E is 30, twice what it was during the old normal. We don’t have a model that says that 30 is the new normal. All we are saying is that the new normal mean P/E might be higher than the current reading of 22.1 rather than lower and closer to the old normal’s 15.0 average.

(3) Bond yields and valuation. Many years ago, from the late 1970s through the late 1990s, there was a reasonably good correlation between the 10-year US Treasury bond yield and the forward earnings yield, which is simply the reciprocal of the forward P/E (Fig. 5). In 1997, I called this relationship the “Fed’s Stock Valuation Model” (FSVM), and the name stuck, as discussed in Investopedia. Needless to say, I must have cursed it, since it hasn’t worked as a useful valuation model since the early 2000s.

Maybe it is starting to work again now. The FSVM has been signaling that stocks are increasingly cheap relative to bonds since the early 2000s (Fig. 6). Over the past 22 weeks through the end of July, stocks have been undervalued relative to bonds by a record 86%.

After all, the bond’s recent record-low yield of 0.50% on August 4 implies a P/E for the bond of 200 (!), using the reciprocal of the yield. In other words, the FSVM is clearly signaling the S&P 500’s current forward P/E is too low relative to the bond’s P/E. Take that for what it’s worth considering that it is just as easy to argue that bonds are ridiculously overvalued relative to stocks. The truth may lie somewhere in between, i.e., stocks are relatively cheap, while bonds are relatively expensive. Indeed, if the bond yield would be, say, 1.50% but for the Fed’s ZIRP and QE4Ever (i.e., zero interest-rate policy and quantitative easing forever) interventions in the bond market, its P/E would be 66—still high.

(4) Recent correlations. Since the start of the current bull market, there has been a relatively good (but not great) correlation between the S&P 500 forward P/E and the inverse of the bond yield (Fig. 7). This correlation seems to have gotten much tighter since the bond yield fell below 1.00% on August 4 to a record low of 0.50%, while the forward P/E has soared from a recent low of 12.9 on March 23 to 22.1 on Friday.

(5) Growth & Value. Leading the charge higher has been the forward P/E of S&P 500 Growth composite from 16.8 on March 23 to 28.7 on Friday (Fig. 8). The ratio of the Growth to the Value components of the S&P 500 Growth index has been rising since the start of the bull market during 2009 (Fig. 9). It’s been soaring to new record highs since April 14. Again, that coincides with the bond yield falling close to zero. As we’ve previously observed, much of the outperformance in the Growth index in recent years has been attributable to the FANGMAN (Facebook, Amazon, Netflix, Google’s parent Alphabet, Microsoft, Apple, and Netflix) stocks.

(By the way, Hamlet arguably was leaning toward the notion of TINA to life when his anguished soliloquy was cut short by the entry of Ophelia.)

US Economy: Booming or Stalling? There are still plenty of economic indicators showing V-shaped recoveries from the severe lockdown recession imposed by state governors to slow the spread of the COVID-19 virus. They all tumbled during March and April and since have rebounded during May through July. Here’s a quick update of the upbeat ones and a couple of downbeat ones:

(1) Purchasing managers indexes. Both the M-PMI and NM-PMI in the US have bounced back smartly in recent months. At 54.2 and 58.1 during July, both exceeded their January readings of 50.9 and 55.5 (Fig. 10 and Fig. 11). Their orders indexes at 61.5 and 67.7 were very strong, as were the production indexes at 62.1 and 67.2. Lagging behind were the employment indexes at 44.3 and 42.1.

These numbers suggest that one of the consequences of the Great Virus Crisis (GVC) could be a big cyclical, and maybe even a big secular, rebound in productivity, as companies scramble to produce more goods and services with fewer employees.

(2) Housing. As we discussed last Wednesday, the GVC has convinced lots of urban renters that now may be the time for them to purchase new and existing homes in the suburbs and rural areas. The resulting surge in housing activity has boosted home prices. Offsetting that development are record-low mortgage interest rates. The Pending Home Sales Index compiled by the National Association of Realtors has soared from a recent low of 69.0 during April to 116.1 during June, the highest reading since February 2006 (Fig. 12). It is highly correlated with existing home sales. A similar rebound has occurred in the Housing Market Index compiled by the National Association of Homebuilders.

(3) CEO confidence. All those upbeat purchasing managers should schedule interventions with their depressed CEOs. The Business Roundtable’s CEO Outlook Index fell to 34.3 during Q2, the lowest reading since Q2-2009 (Fig. 13). That doesn’t augur well for capital spending over the rest of the year unless CEO confidence recovers soon, as we expect it will.

(4) Gasoline usage. Our favorite high-frequency indicator for gauging the economic recovery is the weekly series on gasoline usage. It bottomed during the week of April 24 and rose 62% without stop through the week of July 10 (Fig. 14). It has stalled around 8.7mbd for the three weeks through the July 31 week.

 US Inflation: Falling Rents. While we are thinking more about the potential for inflation to finally make a comeback and exceed the Fed’s 2.0% target, we aren’t fretting that it will happen anytime soon. As we discussed last Wednesday, lots of renters haven’t been able to pay their rent during the GVC. Many may face eviction. Rents are falling as a result. Consider the following:

(1) Rent in the CPI. Rent of shelter accounts for 33.1% of the CPI, with tenant rent at 7.9% and owner-occupied rent at 24.3% (Fig. 15). Here are the June y/y inflation readings for these three measures of rent compared to last June: total (2.4%, down from 3.5%), tenant (3.2, down from 3.9), and owner (2.8, down from 3.4) (Fig. 16).

(2) Rent in the PCED. The comparable rent inflation rates in the PCED (personal consumption expenditures deflator) are identical. The weights are different than in the CPI, with rent of shelter accounting for 17.4% of the PCED, tenant rent 4.7%, and owner-occupied rent 12.7%.

There’s no prospect of a V-shaped recovery in rent inflation. On the contrary, it may still have much lower to go based on what happened right after the GFC: Rent of shelter inflation fell slightly below zero during 2010. This suggests that the bottom of rent inflation might not occur until 2022. If so, that will weigh on both the CPI and PCED measures of inflation.

In case you missed it, here is what we wrote about this subject in last Wednesday’s Morning Briefing:

“While the picture may be rosy for those with the freedom and ability to afford a white-picket fence, that’s not the case for all. A dichotomy is growing in the housing market. Many low-income workers living in rental units are on the brink of eviction. Not only are renters increasingly cost burdened by rising rents and other costs of living, but the moratorium on evictions for federally assisted housing put into place by the Coronavirus Aid, Relief, and Economic Security (CARES) Act recently has expired.

“The share of income lost from the pandemic has been disproportionately huge for low-income workers. Displaced hospitality and food services workers have limited earning prospects in the near future. Also lapsed is the generous weekly federal $600 boost to state unemployment insurance afforded by the CARES Act. Some level of aid is likely to be reinstated, but it’s currently unclear how much. On Monday, as leaders on both sides of the aisle met to continue to negotiate the next virus-relief plan, President Trump said that he might act to stop evictions, reported Bloomberg. While Trump offered no details, the eviction crisis clearly has become a national concern.

“The problem preceded the pandemic, but the pandemic has made it worse. ‘Of America’s nearly 43 million renters, about 20.8 million—almost half—were “cost-burdened,” meaning more than 30 percent of their income went to housing costs, according to the Joint Center for Housing Studies of Harvard University. Of those, about 10.9 million renter households were “severely burdened,” spending more than 50 percent of their income on rent,’ reported Vox. The article added: ‘The Covid-19 Eviction Defense Project, a Colorado-based legal project, estimates that between 19 million and 23 million renters are at risk of eviction by the end of September.’”

Movie. “The Last Narc” (+ + +) (link) is a TV mini-series documentary about the kidnapping, torture, and murder of “Kiki” Camarena, an agent for the Drug Enforcement Agency. The blood-chilling story is told by Hector Berrellez, a DEA investigator assigned to determine who committed the crime in Mexico. Three of his informants, who were witnesses to the kidnapping, are interviewed. Drug money has a powerfully corrupting influence on everyone involved in the enterprise including not only the narcos but also the narcs, the police, and many politicians on both sides of the southern border of the US. Like Hamlet’s epiphany about who killed his father, Hector uncovers the unbearable truth about what really happened to Kiki.

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Health Is the Key To Happiness

August 06 (Thursday)

Health Care: Healthy Earnings, Reasonably Priced. The S&P 500 Health Care sector is arguably one of the stock market’s most attractive, with strong earnings growth and reasonable P/E multiples. As in other areas of the market, COVID-19 has created winners and losers among industries and companies within the sector. Winners include some of the biotechnology companies working on cures and vaccines for COVID-19, while businesses that have been disrupted by COVID-19—think providers of standard medical care and dental practices—have had a tougher time.

With the presidential election just three months away, expect politics to play a growing role in the sector’s fortunes. A future President Biden certainly would mean much different policies than have been enacted by current President Trump. Here’s Jackie’s take on the sector:

(1) Top performer. The S&P 500 Health Care sector has been one of the best-performing non-tech sectors this year. Here’s the S&P 500 sectors’ performance derby ytd through Tuesday’s close: Information Technology (23.8%), Consumer Discretionary (16.5), Communication Services (5.9), Health Care (4.0), S&P 500 (2.3), Consumer Staples (0.3), Materials (-0.9), Utilities (-5.9), Real Estate (-6.6), Industrials (-11.3), Financials (-22.2), and Energy (-38.8) (Fig. 1).

The Health Care sector’s performance is even more remarkable because it doesn’t contain any of the FANGMANT rock stars. Information Technology has Apple, NVIDIA, and Microsoft pushing it higher; Consumer Discretionary includes Amazon; and Communication Services is boosted by Facebook, Google, and Netflix. Tesla may soon be included in the S&P 500, presumably in the Auto Manufacturing industry in the S&P 500 Consumer Discretionary sector. Without the FANGMANT stocks, the ytd returns would look like this: Information Technology (8.8%, down from 23.8%), Communication Services (-9.7, 5.9), and Consumer Discretionary (-13.8, 16.5).

(2) COVID creates winners and losers. Within health care, COVID-19 is determining which industries are performing best. Investors have been buying shares of biotechnology companies looking for COVID cures as well as the life sciences companies providing the biotech industry with the picks and shovels needed to find that cure. On Tuesday, for example, Novavax announced that in a small, early trial its vaccine candidate produced neutralizing antibodies and the vaccine was well tolerated by patients. Yesterday, the shares jumped by more than 10.4% versus a 0.6% gain for the S&P 500.

Meanwhile, patients have pushed off their annual visits to the doctors and dentists along with any elective surgeries, which has put financial pressure on companies in the health care facilities and services industry. Here’s how some of the S&P 500 Health Care industries have performed ytd: Life Sciences Tools & Services (19.7%), Health Care Distributors (14.2), Biotechnology (10.2), Heath Care Equipment (6.0), Managed Health Care (1.3), Pharmaceuticals (-0.3), Health Care Supplies (-1.7), Health Care Technology (-6.1), Health Care Services (-8.3), and Health Care Facilities (-15.9) (Fig. 2).

(3) Steady earnings. The S&P 500 Heath Care sector is expected to have the strongest earnings growth of all S&P 500 sectors this year. If the economic recovery takes shape as expected next year, analysts forecast solid earnings growth for the S&P 500 Health Care sector again in 2021; but other, more cyclical sectors should generate stronger earnings growth because of easier comparisons and a larger earnings bounce.

Here are the earnings growth estimates for the S&P 500 sectors for this year and 2021: Health Care (3.0%, 15.5%), Information Technology (1.8, 15.5), Utilities (0.1, 5.4), Consumer Staples (-1.5, 8.2), Communication Services (-16.0, 23.0), Materials (-19.6, 29.4), S&P 500 (-21.5, 28.3), Financials (-32.9, 29.3), Real Estate (-34.1, 6.3), Consumer Discretionary (-52.5, 104.6), Industrials (-54.6, 84.8), and Energy (-103.8, return to profit) (Table).

What makes the Health Care sector attractive is that its solid earnings growth is accompanied by a reasonable forward P/E of 16.7, the second lowest P/E of all the S&P 500 sectors and well within its range of the past five years (Fig. 3). Information Technology, which is forecasted to have similar positive earnings growth, has a much higher forward earnings multiple of 24.7.

(4) Elections bring uncertainty. No doubt part of the reason that the S&P 500 Health Care sector has a reasonable P/E is because this is an election year and former Vice President Joe Biden leads in most polls. In addition, there’s a chance that Democrats will capture the currently Republican-controlled Senate.

Biden undoubtedly is considered a lower risk to health care stocks than Senator Bernie Sanders (D-VT) and his “Medicare for All” single-payer proposal. But if a so-called “blue wave” captures the Congress, left-leaning liberals in the Democratic party could exert a strong influence over a President Biden and his policies—and that would be negative for the sector, contends Kim Monk, an analyst with Capital Alpha Partners, in a July 30 research report.

A “Unity Task Force,” created by Biden and Sanders, published a set of policy recommendations for the Biden team should it win the election in November. When it was first delivered, the report was easily available on the Biden for President website. Links to the report no longer work. Deduce what you may.

Recommendations in the report include setting up a public-option health care insurance plan to be administered by Medicare, according to a July 9 VOX article. The public-option plan would cover low-income Americans who are eligible for Medicaid, anyone buying insurance on the Affordable Care Act exchange, and people who have employer-provided health care. Biden’s website lays out similar intentions to offer Americans a public insurance option like Medicare. The option would “reduce costs for patients by negotiating lower prices from hospitals and other health care providers. It also will better coordinate among all of a patient’s doctors to improve the efficacy and quality of their care, and cover primary care without any co-payments.” The public option would also be available for free to low-income people not currently covered by Medicaid.

Such an offering could be bad news for the managed health care industry; but so far, investors don’t seem too worried. The S&P 500 Managed Health Care stock price index is up only 1.3% ytd, but it remains near all-time highs (Fig. 4). Analysts remain optimistic, forecasting industry revenues to climb 15.0% this year and 8.0% in 2021 (Fig. 5). Likewise, earnings are forecast to climb 10.4% in 2020 and 13.2% in 2021 (Fig. 6). The industry’s forward P/E at 15.8 is relatively high given its history over the past two decades, and perhaps at risk if liberal democratic forces hold sway (Fig. 7).

The Biden/Sanders task force also recommended that Medicare negotiate the cost of prescription drug prices for all public and private purchasers under the plan. The plan on Biden’s website also allows Medicare to negotiate drug prices; it will limit the price of new drugs that have no competition and will limit price increases for all branded biotech and generic drugs to the rate of inflation. Biden also proposes letting Americans buy drugs from abroad and intends to prevent branded drug companies from delaying the introduction of generic alternatives. This is all potentially bad news for the pharmaceutical industry—which already was playing defense under President Trump, who has also talked about getting tough on high drug prices. And finally, under Biden’s proposal, the age to enroll in Medicare would be lowered to 60 from 65, which would reduce the incidence of customers’ having to pay full price to doctors and hospitals.

The S&P 500 Pharmaceuticals industry has modestly underperformed the broader S&P 500 ytd, dropping 0.3% versus the index’s 2.3% gain (Fig. 8). The industry’s earnings growth rate is expected to pick up from 2.8% this year to 15.1% in 2021 (Fig. 9). And its forward P/E is a reasonable 14.3, perhaps because of the political uncertainties (Fig. 10).

COVID-19: Race for the Cure Continues. Scientists are investigating a dizzying array of approaches to fight COVID-19. Hopefully, beyond finding a cure or a vaccine, one of beneficial outcomes of all this research will be that scientists learn many more ways to combat illnesses in general and viruses in particular. Here’s a summary of some of the latest news reports on the battle against COVID-19:

(1) Tapping antibodies. A number of companies are using the antibodies from patients who have survived COVID-19 to make preventatives and treatments for current COVID patients. Scientists have used the technique, dubbed “monoclonal antibody therapy,” or “mAbs,” in the US since 1986. It was first used to help kidney transplant patients accept their new organ and has since been used to treat cancers such as leukemia and autoimmune disorders such as rheumatoid arthritis and Crohn’s disease, an August 4 WSJ article explained.

AbCellera, which is working with Eli Lilly, acquired a blood sample from one of the first US patients who recovered from COVID-19 and found hundreds of antibodies. It selected the ones deemed the most potent, and, in the lab, the drug blocked the ability of the virus to infect cells. The drug could be used both to help sick patients recover and prevent healthy individuals from getting sick, a June 2 CNN article reported. The National Institutes of Health announced on Tuesday that their Accelerating COVID-19 Therapeutic Interventions and Vaccines program is starting two trials on the drug.

Regeneron Pharmaceuticals, which is also developing an mAbs antibody drug, said its offering prevented and treated the disease in monkeys and hamsters, an August 4 CNBC article reported. While positive results in animals don’t guarantee success in humans, the company noted that the drug “almost completely” blocked the virus.

Dr. Conrad Chan, a scientist with the DSO National Laboratories in Singapore, also used blood samples from recovered COVID-19 patients to find antibodies. His team took the one deemed most effective, cloned it, tested it in a lab, and next will try it in humans. The downside is that the immunity may last only about one month per dose, but it could be used to protect high-risk individuals, such as health care workers or people with immunodeficiency disorders, the August 4 WSJ article explained.

(2) Protecting the lungs. A new drug therapy that protects the lungs has allowed patients to recover rapidly from COVID-19-related respiratory failure. A 54-year-old man who developed COVID-19 while being treated for rejection of a double-lung transplant came off a ventilator within four days of using the drug, RLF-100. Similar results subsequently were seen in more than 15 patients treated with the drug at the Houston Methodist Hospital, an August 2 Reuters article reported.

The drug was developed by Relief Therapeutics Holdings, a Geneva-based company, which has partnered with NeuroRX, a US-Israeli company, to develop it in the US. The drug, which is in Phase 2/3 (2 and 3 combined) clinical trials and has been approved for emergency use in the US, is a synthetic form of a natural peptide that protects the lung.

(3) Scientists turned guinea pigs. At least 20 researchers, technologists, and science enthusiasts—many connected to Harvard University and MIT—are injecting themselves with an experimental vaccine to protect themselves against COVID-19. The group is called the “Rapid Deployment Vaccine Collaborative” and formed in March as a do-it-yourself project.

They developed a vaccine that “consists of fragments of the pathogen—in this case peptides, which are essentially short bits of protein that match part of the coronavirus but can’t cause the disease on their own,” a July 29 MIT Technology review article reported. Vaccines made like this exist for hepatitis B and the human papillomavirus. Novavax is using this technique to develop a COVID-19 vaccine too.

The group hasn’t reported whether the nasal vaccine has generated antibodies, but it believes taking the vaccine is a legitimate way to reduce infection. The group does not charge for the vaccine, and users mix the ingredients to make the vaccine themselves. But the legality of taking the vaccine, which has not been approved by the US Food and Drug Administration, is questionable.

Russian officials reportedly are also trying out a vaccine on themselves before it is officially approved, according to an August 2 article in Futurism. The vaccine was developed by Russia’s state-operated Gamaleya Research Institute, which says the vaccine is ready for Phase 3 trials even though it never published results from a small Phase 1 trial. The vaccine uses human adenovirus vectors that are made weaker so that they don’t replicate.

Kirill Dmitriev, chief executive of the Russian Direct Investment Fund, said that in Phase 1 and 2 trials, 100% of 100 people generated very high level of antibodies, according to the article. The fund is financing Russia’s vaccine research. He and his parents have already taken the vaccine, and Russia reportedly wants to begin mass inoculations in September or October.

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Survival of the Fittest?

August 05 (Wednesday)

Strategy I: Natural Selection. Have you noticed that human civilization has gotten less civil since the Great Virus Crisis (GVC) was declared a pandemic by the World Health Organization on March 11? Actually, it’s been getting less civil for a while, all around the world. And it wasn’t all that civil in the past.

On the other hand, it’s not like the virus has presented humankind with a Darwinian survival-of-the-fittest existential challenge. Despite all our troubles, we still aren’t living through anything like the miseries of World War I, the Spanish Flu, and World War II. Since the end of the Cold War, life has been much better for lots of people who had been behind the Iron Curtain and the Bamboo Curtain. In the US, our extreme partisanship isn’t really that extreme in the context of American history. If we can just develop an effective vaccine soon, maybe we can go back to our old normal, which wasn’t so bad, all things considered.

For now, the virus continues to plague our society, increasing tensions, which might account for some of the lack of civility. In every nation, no matter the economic system, there are always haves and have-nots as reflected in measures of income and wealth inequality. The virus has sliced the collective pie in whole new ways, with widening divides between people who remain employed and those who have lost their jobs as well as between businesses benefitting from increased demand thanks to the pandemic and those hit so hard by it that they may not survive.

The virus has caused a very odd kind of Darwinian struggle, because there is no real struggle. The virus has naturally selected certain businesses and their workers to prosper while others have been naturally selected to struggle to survive. Consider the following winners and losers selected by the virus:

(1) Internet-related businesses. In the economy and the stock market, the selected winners are the FAANGM companies (i.e., Facebook, Amazon, Apple, Netflix, Google, and Microsoft). They benefit as more of us use the Internet to work and study from home and to be entertained by movie- and game-streaming services. Cloud providers and technology companies that provide the hardware and software to maintain and expand the cloud are booming.

(2) Home, sweet home. Online retailers and delivery services are also flourishing as more people prefer to stay home and out of stores. Homebuilders and realtors are profiting from the booming demand for new and existing homes in the suburbs and rural areas as a result of de-urbanization. Lumber yards are scrambling to meet demand. Home furnishings and appliance makers and retailers are also making lots of money.

In the transportation sector, commuter rail and air transportation companies have lost lots of passengers as more Americans work from home, prefer to drive to work, and replace business trips and meetings with Zoom calls. Most trucking services remain in high gear, delivering all the goods ordered online to warehouses and customers’ front doors.

(3) Investors gaining and losing. In the financial sector, stock investors have recovered almost all their February 19-March 23 losses since then. They are actually up for the year if they’ve invested in the Nasdaq. The losers are investors who relied on fixed-income securities and can no longer do so with interest rates so close to zero.

(4) Healthy and not so. In the health care sector, drug companies and biotech companies are being showered with billions of dollars from private and public investors hoping to expedite the development of vaccines, treatments, cures, and tests for the virus. Meanwhile, the bread-and-butter business of elective surgery for physicians and hospitals has suffered.

The stress on our nation’s mental health remains severe. While the press is monitoring the cases, hospitalizations, and deaths related to the virus, drug abuse, depression, and suicides are mounting and taking a long-term toll on our society.

Strategy II: 800-Pound Gorillas. As Joe and I have been discussing in recent months, the clear winners are the FAANGM companies, as evidenced by the outperformance of their stock prices during the GVC. They’ve had a significant impact on the three major investment styles: LargeCaps versus SMidCaps, Growth versus Value, and Stay Home versus Go Global. Here are a few updates of points we’ve made in the past along with a couple of new insights:

(1) Market-cap & earnings shares, and valuation. The FAANGMs’ collective current market capitalization is a record $6.9 trillion, accounting for a record 25.6% of the S&P 500’s market cap (Fig. 1 and Fig. 2). Their share of S&P 500 forward earnings rose to 13.5% during the week of July 31 (Fig. 3).

The FAANGMs aren’t cheap by historical standards of valuation. Their forward P/E rose to 40.7 during the July 31 week (Fig. 4).They’ve led the rebound in the forward P/Es of the S&P 500 and the S&P 500 Growth indexes to 22.3 and 28.2 currently. Meanwhile, the forward P/E of the S&P 500 Value index is currently relatively cheap at 17.1.

Then again, the growth rates of the forward revenues and forward earnings of the FAANGMs continue to outpace that of the S&P 500 excluding them (Fig. 5 and Fig. 6). With interest rates near zero all across the yield curve, investors have been willing to pay much higher forward P/Es for Growth stocks than in the past.

(2) Big impact on Stay Home vs Go Global. Joe and I monitor the relative performance of Stay Home versus Go Global by tracking the ratios of the market caps of the US MSCI to the All Country World ex-US MSCI in dollars and in local currencies (Fig. 7). While the former has underperformed the latter in recent week, the trends of both ratios remain solidly to the upside.

Then again, when we calculate the ratios excluding the FAANGMs plus NVIDIA and Tesla, we see that they have been relatively flat since late 2018 (Fig. 8).

US Economy I: From Big To Small. While the Magnificent Six are gobbling up more of the economy, market cap, and earnings, everyone else is losing their relative shares. Certain service-providing companies have been especially hard hit by lockdowns, the slow lifting of lockdown restrictions, and ongoing social-distancing requirements. Consumer spending on services plunged by 20% from a record high of $10.3 trillion (saar) during February to $8.2 trillion during April and bounced back up by 11% to $9.1 trillion during June (Fig. 9). Let’s review how the GVC has impacted current-dollar spending by consumers on the various categories of services:

(1) Health care services. While hospital ICUs in some parts of the country have been overwhelmed by COVID-19 patients, spending on health care services in general and on hospitals in particular plunged 44% during March and April as hospitals prepared for the expected onslaught of such patients by cancelling all elective procedures (Fig. 10). Health care services has rebounded 42% since then through June.

(2) Restaurants. Consumer spending on food consumed in restaurants and bars plunged 48% from a record high of $863.8 billion during January to $452.8 billion during April (Fig. 11). Meanwhile, food consumed at home jumped 23% from $1,033 billion during January to $1,273 billion by March. Since the recent low, spending on food in dining establishments rebounded 50% to $680.7 billion during June.

(3) Travel. Among the hardest-hit services industries have been hotels and air transportation. People are traveling less for business, tourism, and entertainment. Consumer spending on hotels and motels plunged 83% from a record high of $123.5 billion (saar) during December to $20.5 billion during April (Fig. 12). Over the same period, consumer outlays on air transportation dropped 96% from $120.8 billion to $5.1 billion. Since then through June, both have barely rebounded.

(4) Recreation. Consumer spending on recreation services plunged 62% from a record high of $598.7 billion (saar) during January to $229.2 billion during April. It has recovered just 49% since then through June. Looking at some of the components of the total: amusement parks, campgrounds & related recreation and admissions to specified spectator amusements fell 79% and 100%, respectively, from their December peaks through April, with the latter barely budging from its record low. Gambling was down 82% from its January peak through April, though appears to be on an upswing (Fig. 13).

(5) Rent. Last, but not least, tenant-occupied rent rose to a record $647.3 billion (saar) during June (Fig. 14). That figure is bound to be revised sharply down once the government’s statisticians can assess the magnitude of the eviction problem caused by the inability of millions of unemployed workers to pay their rent, as discussed below.

US Economy II: Staying-Home Economy. The pandemic has accelerated previously developing demographic and lifestyle trends, which have boosted the housing market despite the virus-ridden climate. Millennials (born 1981-96) are notorious for delaying the natural middle-class American progression of adulthood from getting married to having kids to moving to the suburbs. But virus-related lockdowns may have caused many 30-somethings to value home life more than before the pandemic. And with work-at-home arrangements and historically low mortgage rates facilitating moves from cramped city apartments into the ’burbs, Millennials’ leap into the traditional trappings of adulthood is accelerating.

At the same time, many Baby Boomers are opting to stay put in their existing homes for now, tightening the supply of available homes for Millennials. Let’s anecdotally consider some of the likely demographic drivers of the housing market expansion:

(1) Betting on the farm. Redfin’s CEO, discussing the effects of the pandemic on housing markets recently, said that homebuyers have undergone a “profound, psychological change” that has flipped demand toward rural areas and away from cities. Folks were forced to spend nearly all their time at home during the pandemic-related lockdowns. Many continue to socially distance, staying home as much as possible, as the virus spread accelerates in many communities after the lifting of lockdowns.

Many folks want to leave densely populated areas hit hard by the pandemic and head for the hills. They’ve been cooped up and are dreaming of large interiors, with designated spaces for work and school, as well as nice backyards and pools. Many workers who were able to work from home during lockdowns suffered no income loss and indeed received an income boost from the first round of pandemic-aid stimulus checks. With many of their employers still operating remotely and some planning to do so permanently, these workers are enjoying freedom from a commute-free lifestyle.

Some parents of school-aged children may have become disenchanted with previously sought-after school districts. Many school buildings remain closed for the foreseeable future. Lots of children are either set to learn remotely or to be homeschooled at least through the fall until who-knows-when. Homeschooling, previously considered atypical education, may become more commonplace. Our very own Melissa, an older Millennial, half-jokingly has considered moving her young family out of a suburban area north of Atlanta to a rural town in Tennessee, zoned for chickens and ideal for homeschooling on the homestead. Just like Little House on the Prairie.

(2) Millennials buying homes. Melissa is far from alone among Millennials in reevaluating where to put down roots. The trickle of urban exodus that the generation has been noted for may be accelerating. The Millennials overtook the Baby Boomers as the largest generation during 2019, and now they are at the prime age range for homebuying (24-39 years old in 2020). The median age of first-time homebuyers is 31, a July 31 Forbes article noted. First-time buyers were responsible for 35% of sales in June as compared to an annual share of 33% during 2019, according to the National Association of Realtors.

(3) Boomers staying put. Even before the pandemic, an “aging-in-place” trend was evident among the Baby Boomers. Since the pandemic hit, Baby Boomers mostly have continued to stay put in their current homes given the increased risks COVID-19 poses to them, particularly older Boomers living in communal arrangements. Data from the National Association of Home Builders showed that homebuilder confidence for 55+ communities or assisted living dove during Q1 but has rebounded during Q2. That may indicate that existing housing inventory could open up for Millennials if more Boomers retire and trade their homes for community living down the line. Many Boomers may be retiring earlier, said a recent AARP blog, which pointed to evidence that those aged 65 are leaving the labor force at an expedited pace.

By the way, the homeownership rate skyrocketed in Q2 from Q1 to a record 67.9% from 65.3%. Some of the increase may be explained away by changes to the data collection due to the pandemic, but likely not all of it. Nevertheless, the monthly average response rates to the survey for Q2-2020 were about 15ppts below those of Q2-2019. The US Census Bureau’s release noted that data users should “exercise caution when comparing the second quarter estimates to previous quarters.”

US Economy III: Eviction Cliff Looming. While the picture may be rosy for those with the freedom and ability to afford a white-picket fence, that’s not the case for all. A dichotomy is growing in the housing market. Many low-income workers living in rental units are on the brink of eviction. Not only are renters increasingly cost burdened by rising rents and other costs of living, but the moratorium on evictions for federally assisted housing put into place by the Coronavirus Aid, Relief, and Economic Security (CARES) Act recently has expired (see here for more).

The share of income lost from the pandemic has been disproportionately huge for low-income workers. Displaced hospitality and food services workers have limited earning prospects in the near future. Also lapsed is the generous weekly federal $600 boost to state unemployment insurance afforded by the CARES Act. Some level of aid is likely to be reinstated, but it’s currently unclear how much. On Monday, as leaders on both sides of the aisle met to continue to negotiate the next virus-relief plan, President Trump said that he might act to stop evictions, reported Bloomberg. While Trump offered no details, the eviction crisis clearly has become a national concern.

The problem preceded the pandemic, but the pandemic has made it worse. “Of America’s nearly 43 million renters, about 20.8 million—almost half—were ‘cost-burdened,’ meaning more than 30 percent of their income went to housing costs, according to the Joint Center for Housing Studies of Harvard University. Of those, about 10.9 million renter households were ‘severely burdened,’ spending more than 50 percent of their income on rent,” reported Vox. The article added: “The Covid-19 Eviction Defense Project, a Colorado-based legal project, estimates that between 19 million and 23 million renters are at risk of eviction by the end of September.”

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Bond Vigilantes: Rest in Peace

August 04 (Tuesday)

Bonds I: Eulogy. Let me begin my eulogy for the Bond Vigilantes with apologies to William Shakespeare. The emotional eulogy for Julius Caesar that Shakespeare penned for the character Marc Antony in his play Julius Caesar inspired the words that I would like to share with you on this solemn occasion:

Friends, countrymen, citizens of the world, lend me your ears. I come to bury the Bond Vigilantes, not to praise them. The noble Fed killed its rival, the Bond Vigilantes, because they were too ambitious. If it were so, it was a grievous fault. The Bond Vigilantes sought to marshal market forces to counter the ever-growing power of the government. That cause is noble and good. But while the evil that men do lives after them, the good is oft interred with their bones—so let it be with the Bond Vigilantes. Their well intentioned efforts were doomed to failure. The Fed meant well too, as did Caesar’s assassins. Both comprise honorable men. But men have lost their reason. Bear with me; my heart is in the coffin there with the Bond Vigilantes, and I must pause ’til it come back to me.

Bonds II: Requiem. My friends, I still fondly recall the days when the Bond Vigilantes rode high and mighty. The July 27, 1983 issue of my weekly commentary was titled “Bond Investors Are the Economy’s Vigilantes.” I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”

To this day, every time bond yields rise significantly almost anywhere in the world, I get asked to appear on at least one of the financial news TV networks to discuss whether the Bond Vigilantes are back. Having popularized “hat-size bond yields” and “Bond Vigilantes,” I’ve learned to appreciate the power of coining pithy terms to brand my economic and financial forecasts. Coin a good phrase that accurately describes future developments, and it will appear in your obituary, if not on your tombstone.

The Bond Vigilantes Model tracks the rise and fall of the Wild Bunch. It simply compares the bond yield to the growth rate in nominal GDP on a year-over-year basis (Fig. 1). My model shows that since 1953, the yield has fluctuated around the growth rate of nominal GDP. However, both the bond yield and nominal GDP growth tend to be volatile. While they usually are in the same ballpark, they rarely coincide. When their trajectories diverge, the model forces me to explain why this is happening. On occasions, doing so has sharpened my ability to see and understand important inflection points in the relationship. Here is a brief nostalgic walk down Bond Street:

(1) Getting whipped by inflation. From the 1950s to the 1970s, the spread between the bond yield and nominal GDP growth was mostly negative (Fig. 2). Investors underestimated the growth rate of nominal GDP because they underestimated inflation. Bond yields rose during this period but remained consistently below nominal GDP growth. Those were dark days for bond investors.

(2) Keeping law and order. The Bond Vigilantes were increasingly in command during the 1980s and 1990s. They fought to bring back law and order in the fixed-income markets to the benefit of bond investors. There were several episodes when rising bond yields slowed the economy and put a lid on inflation.

The Bond Vigilantes’ heyday was the Clinton years, from 1993 through 2001. Placating them was front and center on the administration’s policy agenda. Indeed, Clinton political adviser James Carville famously said at the time, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

(3) Long siesta. After the mid-1990s, the Bond Vigilantes seemed less active, because they no longer had to be as vigilant. As inflation fell, the spread between the bond yield and nominal GDP growth narrowed and fluctuated around zero. While today the US government faces the problem of persistently big federal budget deficits, it’s interesting to recall that at the start of 2001, a major topic of discussion was how big the coming surplus in the federal budget might get.

During the early 2000s, after the 9/11 terrorist attacks, the Fed kept the federal funds rate too low, and a global savings glut kept a lid on bond yields and mortgage rates. They remained relatively flat even as the Fed started raising the federal funds rate “at a measured pace” of 25bps moves, from 1.00% to 1.25% on June 30, 2004 up to 5.25% through June 29, 2006 (Fig. 3).

(4) Long good buy. The Great Financial Crisis (GFC) of 2008 caused the Fed to implement ultra-easy unconventional monetary policies. The federal funds rate was pegged in a range of 0.00%-0.25% from December 16, 2008 through December 16, 2015. The Fed’s three QE (quantitative easing) programs caused the Fed’s holdings of bonds to balloon from $0.48 trillion during the final week of November 2008 to $4.19 trillion by the start of October 2014 (Fig. 4). Inflation remained remarkably subdued after the GFC. Starting January 2012, the Fed targeted core PCED (personal consumption expenditures deflator) inflation at 2%, but it has remained below that pace during all but 13 months since then (Fig. 5).

The Fed’s QE3 was terminated near the end of 2014, and the federal funds rate was raised for the first time since the GFC on December 16, 2015. Fed officials continued to ratchet rates higher up to 2.25%-2.50% on December 19, 2018. They were expecting to normalize monetary policy (Fig. 6).

Nevertheless, investors, reaching for yield, poured money into bonds. The 10-year US Treasury bond yield fell to 1.92% at the end of 2019 (Fig. 7). It was a long good buy from the peak in its yield of 15.84% back on September 30, 1981 (Fig. 8).

(5) Last rites. The bond yield fell below 1.00% for the first time on March 5, 2020, and has been consistently below since March 20. The World Health Organization declared a pandemic on March 11. The Fed responded to the Great Virus Crisis (GVC) by lowering the federal funds rate by 100bps to zero and implementing QE4 on March 15. On March 23, QE4 was turned into QE4Ever. The bond yield fell to a record low of 0.55% on Friday. The Bond Vigilantes have been buried by the Fed.

Bonds III: The Inflation Scenario. Many investors who profited from the long good buy are now saying “you are dead to me” to the bond market. They are rebalancing more of their portfolios into other assets, such as US stocks, SPACs (special-purpose acquisition companies), precious metals, and overseas assets including currencies, stocks, and bonds.

The end of the long-term bull market in bonds has been declared, erroneously, by market prognosticators for many years. It may not be over just yet. The yield on the 10-year Treasury could still fall to zero. It could even turn slightly negative, as have comparable yields in Germany and Japan (Fig. 9).

Then again, what if a vaccine and effective treatments are discovered to end the pandemic early next year? Never before has the drug industry received billions of dollars to develop such medicines at warp speed. In this scenario, the global economy could recover quickly next year. Inflation could finally jump above the Fed’s 2.0% target as demand for goods and services outstrips supply, especially if global supply chains have been significantly disrupted by the pandemic and by the worsening Cold War between the US and China.

Would rising inflation cause bond yields to soar? We don’t think so. Both monetary and fiscal officials know that rising interest rates could abort the post-GVC recovery. They also realize that a rebound in interest rates would significantly balloon federal deficits and the debt. Net interest paid by the federal government totaled $346.9 billion over the 12 months through June, down from a record high of $384.8 billion during March (Fig. 10).

We believe that the Fed publicly would welcome inflation in a range of 2.0% up to 4.0% as a long overdue offset to inflation running below 2.0% for so long in the past. In this scenario, the Fed might announce that the federal funds rate will be held at zero and that the bond yield will be pegged below 1.00%. In other words, any sign that the Bond Vigilantes might rise from their graves (along with inflation) would be met by the Fed with whatever it takes to keep them buried. This would be wildly bullish for all of the alternative assets to bonds mentioned above, especially growth stocks and precious metals.

Our view that the Fed’s attitude toward rising inflation is evolving into one of benign neglect was confirmed by an important August 2 article by Nick Timiraos, the WSJ’s ace Fed watcher, titled “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation.” Timiraos reports that the Fed “is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.”

The Fed first formally targeted inflation in a January 25, 2012 press release titled “Federal Reserve issues FOMC statement of longer-run goals and policy strategy.” It stated: “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.” The widespread interpretation was that once the target was achieved, it would be a ceiling.

Timiraos reports that some Fed officials wouldn’t mind if inflation were to run hot above 2% for a while since it has run cold for so long. They want to offset previous deviations on the downside with a stretch of inflation overshooting the 2% target for a while.

Might all of this eventually lead to hyperinflation? Debbie and I aren’t in the hyperinflation camp. But if that’s the ultimate endgame of Modern Monetary Theory, then all bets are off.

 Bonds IV: The Dollar Vigilantes. Of course, the death of the Bond Vigilantes could lead to the emergence of other vigilantes in the financial markets. As I wrote in yesterday’s Morning Briefing: “My amigos the Bond Vigilantes have been subdued by the central banks and their QE programs. The Dow Vigilantes got what they wanted in response to the freefall in stock prices from February 19 through March 23. They got QE4Ever plus the CARES Act. The result has been trillions of dollars printed and spent by Powell and Mnuchin. …

“The Gold Vigilantes are certainly expressing their fear and loathing of this unholy alliance between fiscal and monetary policies. But they don’t have the kind of power that the Bond Vigilantes once had to rein in policy excesses. The only market players left with any power are the Dollar Vigilantes. They have lots of fear and loathing of MMT and can do something about it.

“They can devalue the dollar relative to other currencies, thus putting upward pressure on import prices, which could revive inflation. Even the Wizards of MMT acknowledge that they should at least think about tapping on the brakes if inflation makes a comeback.”

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Money, Money, Money In the Rich Man’s World

August 03 (Monday)

The Fed I: Having a Ball. Ever since March 23, when the Fed embraced MMT—Modern Monetary Theory—we’ve been having a great party. The Fed has been fueling the merriment by keeping the punch bowl full and spiked with lots of inebriating liquidity. In the June 23 Morning Briefing, I wrote: “In his song ‘1999,’ recording artist Prince seemed to be predicting that the tech bubble of that year would burst since ‘life is just a party and parties weren’t meant to last.’ He might also have been anticipating Y2K. That’s remarkable since the song was released, in his album by the same name, on October 27, 1982.”

Prince recommended that we should “party like its 1999,” recognizing in 1982 that the turn of the millennium was bound to be one of the biggest party times ever. What a great call. His song seems just as relevant today given the recent remarkable meltup in stock prices. The current party isn’t over yet, according to another relevant song. Abba’s 1976 hit titled “Money, Money, Money” provides an easy solution for enjoying the good life:

“In my dreams I have a plan / If I got me a wealthy man / I wouldn’t have to work at all / I’d fool around and have a ball / Money, money, money / Must be funny / In the rich man’s world …”

Our nation’s wealthy man is Fed Chair Jerome Powell. He has all the money in the world and can print more of it to keep the party going. US Treasury Secretary Steve Mnuchin is another wealthy man who is providing lots of money to lots of people. He can finance trillions of dollars of government spending simply by issuing Treasury bonds, which Powell then buys with the digital money he prints. I’m not being judgmental, just factual. Consider the following:

(1) US Treasury’s deposit account at the Fed. The Treasury has been borrowing at a record pace in the Treasury market to fund the various government support programs aimed at reducing the economic damage and pain resulting from the Great Virus Crisis (GVC). The federal budget deficit has totaled a record-shattering $1.92 trillion from March through June. As a result, the US Treasury General Account at the Fed has jumped from $439 billion at the end of February to a record $1.82 trillion during the July 29 week (Fig. 1).

(2) The Fed’s US Treasury purchases. Over that same period, the Fed facilitated the Treasury’s massive borrowing with massive purchases of US Treasuries, totaling $1.81 trillion. The Fed now owns a record $4.3 trillion in US Treasuries (Fig. 2).

(3) Commercial bank deposits and cash. The Fed also facilitated the mad dash for cash that started during February as the viral pandemic triggered an enormous pandemic of fear. The Fed’s purchases of Treasuries and agency securities from the public boosted commercial bank deposits by $2.17 trillion from the end of February through the July 22 week as the public sold securities to raise cash (Fig. 3).

The big jump in this liability item on banks’ balance sheets was offset on the asset side by “cash” assets, which are basically the banks’ reserve balances at the Fed (Fig. 4). They really aren’t cash per se, since the banks can’t make loans with these deposits at the Fed. They can make more loans by lending out the increase in their deposits less reserve requirements, which were lowered to zero on March 15. When they do so, the banks also create more deposits. That’s the way a fractional-reserve banking system works. By the way, the answer to the oft-asked question of why the banks don’t lend out all that cash on their balance sheets is that they can’t, because it is a balancing item determined totally by the Fed’s balance sheet!

(4) Commercial bank loans. The Fed’s MMT maneuvers also facilitated the $490 billion jump in commercial bank loans from the end of February through the July 22 week (Fig. 5). Commercial and industrial loans soared $462 billion over this same period as businesses cashed in their lines of credit, fearing a cash crunch (Fig. 6). The surge in loan demand was easily funded by the increase in deposits. Indeed, the brief surge in borrowing by banks during the weeks of February 12 through March 25 has been more than reversed subsequently (Fig. 7).

(5) Losses are mounting. While Fed officials have bragged about how the health of the banking system has improved dramatically since the Great Financial Crisis thanks to their regulatory oversight and supervision, the GVC is already infecting the banks with mounting losses. The Fed’s weekly data report on the balance sheet of commercial banks includes an item labeled “allowance for loan & lease losses.” It jumped from $115.1 billion at the end of February to $184.1 billion during the July 22 week (Fig. 8). It peaked at a record $235.2 billion during the April 21 week of 2010. For this reason, we aren’t keen on owning shares of Financials, especially if they lend money. We are monitoring this weekly series closely and figure so are Fed officials.

The Fed II: The Rich Man. Fed Chair Powell’s important interview on 60 Minutes with Scott Pelley was aired on May 17. Pelley asked where Powell got the trillions of dollars that the Fed spent on purchasing bonds since March 23: “Did you just print it?”

Powell forthrightly responded: “We print it digitally. So as a central bank, we have the ability to create money digitally. And we do that by buying Treasury bills or bonds or other government guaranteed securities. And that actually increases the money supply. We also print actual currency, and we distribute that through the Federal Reserve banks.” Powell also acknowledged that there was no precedent for the scale of what Melissa and I call “QE4Ever”: “The asset purchases that we’re doing are a multiple of the programs that were done during the last crisis.”

Ever since March 23, Powell repeatedly has stated that the Fed intends to keep interest rates close to zero for a very long time. At his June 10 press conference, in response to a question about the subject, he famously said: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” He reiterated that policy in his July 29 press conference, saying: “We have held our policy interest rate near zero since mid-March and have stated that we will keep it there until we are confident that the economy has weathered recent events and is on track to achieve our maximum employment and price stability goals.” Here are a few more insights we gleaned from Powell’s latest presser:

(1) A three-month extension. Powell acknowledged that the Fed’s policy responses since March 23 have stabilized the financial markets, which was the number-one priority back then. Nevertheless, he indicated that the Fed would keep them in place to support the Fed’s macroeconomic objectives. Indeed, on July 28, the Fed announced an extension through December 31 of its lending facilities that were scheduled to expire on or around September 30.

(2) Slowing recovery. Powell stressed that the most important sentence in the FOMC statement released prior to his presser was the following one: “The path of the economy will depend significantly on the course of the virus.” Like many economists in the private sector, Powell and his colleagues at the Fed are watching high-frequency indicators of the economy such as credit-card data and hotel occupancy rates. He observed that the rebound in COVID-19 cases since June has slowed the recovery, although housing and auto sales have been strong.

(3) Unlimited power. Powell confirmed that there is no limit to his power to print money: “We are committed to using our full range of tools to support the US economy at this difficult time. And we will always remain committed in that sense. We feel like we have ways to further support the economy, certainly through our credit and liquidity facilities which are effectively unlimited. We can adjust those programs. We also can adjust our forward guidance. We can adjust our asset purchases. So there are things that we can do. We feel like we have the ability to do more.” Money, money, money in the rich man’s world!

(4) A good place. In his presser, Powell reassuringly said, “I think our policy is in a good place.” At the beginning of this year, Powell was using the phrase in “a good place” in reference to the US economy all too frequently, as we noted in our remarkably prescient February 19 Morning Briefing titled “In a Good Place?” We noted that he had just used that expression again to describe the economy during his February 11 and 12 semi-annual congressional testimony on monetary policy. We reviewed his previous mentions of this phrase in that Morning Briefing, concluding: “We wish he would stop using that expression. Our contrary instincts come out every time he says it.” The stock market peaked that day at a record high and proceeded to plunge 33.9% through March 23.

(5) Inflation vs disinflation. Powell observed that “there is a lot of discussion” about how the GVC might set the stage for higher inflation. However, he opined that it is fundamentally a disinflationary shock: “And I do think for quite some time we’re going to be struggling against disinflationary pressures rather than against inflationary pressures.” Our contrary instincts are on alert.

The Fed III: No Shortage of Money. The mad dash for cash during February and March abated after the Fed’s March 23 measures. However, the result was a flattening of the yield curve close to zero. The return on bonds wasn’t much better than on deposits. Bonds have been turned into the equivalent of money. The big difference is that if inflation makes a comeback, bond yields could rise, resulting in capital losses. Depositors and bond holders both would suffer a loss of purchasing power if inflation increased, but the latter also would have capital losses. So the mad dash for cash has resulted in a rebalancing out of bonds and into cash. That can be seen in the major measures of the monetary aggregates in the US, as well as many of them overseas:

(1) US. On a y/y basis through the July 20 week, MZM and M2 are up 38.0% and 23.2% in the US (Fig. 9). Even currency included in M1 is up 13.0% y/y (Fig. 10).

(2) Europe. On a y/y basis through June, M1, M2, and M3 are up 12.6%, 9.2%, and 9.2% in the Eurozone (Fig. 11). Here are the comparable growth rates for Germany (through June: 11.2%, 7.3%, 7.0%), France (through May: 20.6, 15.3, 12.4), Italy (through May: 9.9, 7.9, 6.4), as well as the UK (through June: 15.2, 11.5, 10.5). (See our Global Monetary Aggregates.)

(3) Others. Canada (through May: 19.5%, 13.1%, 13.9%) is also showing double-digit growth rates in the three monetary aggregates. Australia’s M1 was up an astonishing 38.7% y/y during June, while its M3 was up 8.4%. Japan’s M2 plus CDs was up 7.2% y/y in June, the highest pace on record going back to 2004. China’s M1 and M2 rose 6.5% and 11.1% through June. These are not unusually high growth rates for China.

The Fed IV: Gold Rules While Dollar Reels. Given all of the above, I’m not surprised that more and more of our accounts are bullish on gold and bearish on the dollar. Many of them have rebalanced out of bonds and into stocks since March 23. Now they are thinking of cashing in some of their gains in stocks and rebalancing into some gold. The recent weakness of the dollar has many wondering whether it might also be a good time to rebalance portions of their equity positions out of Stay Home and into Go Global. The widespread consensus I’m hearing along these lines is another flare that has alerted my contrary instincts.

However, there is certainly a solid case to be made for some rebalancing of portfolios out of stocks and into gold, foreign currencies, and foreign stocks and bonds. Consider the following:

(1) A world of trouble. Gold and silver are widely viewed as better stores of value than fiat money when governments are printing too much of it. Gold Bugs also thrive during periods of financial, political, geopolitical, and social instability. There’s no shortage of such instability, including: i) a pandemic; ii) violent civil unrest; iii) extreme political partisanship; iv) a rapidly escalating Cold War between the US and China; v) a game of chicken between the US and Iran in the Strait of Hormuz; vi) out-of-control MMT fiscal and monetary policies; and vii) a possible left-wing regime change on November 3, with much more MMT.

(2) Relative case counts. As I noted last week on Tuesday, “while the US came out of the Great Financial Crisis in much better shape than most of the rest of the world, the same cannot be said for the US’s handling of the GVC, so far. Several European and Asian countries seem to be doing a much better job of re-opening their economies while keeping the virus from spreading anew, so far.” Then again, countries like Australia that seemed to be making progress in reducing the case count are experiencing another wave of outbreaks during their winter. Epidemiologists are fretting that a similar scenario might occur as temperatures cool later this year in the Northern Hemisphere. There already are renewed outbreaks in the UK and Spain.

(3) The Dollar Vigilantes. My amigos the Bond Vigilantes have been subdued by the central banks and their QE programs. The Dow Vigilantes got what they wanted in response to the freefall in stock prices from February 19 through March 23. They got QE4Ever plus the CARES Act. The result has been trillions of dollars printed and spent by Powell and Mnuchin. Wearing face masks, they testified at a House Financial Services Committee on June 30. They elbow-bumped in celebration as they embraced MMT. They now are joined at the elbows.

The Gold Vigilantes are certainly expressing their fear and loathing of this unholy alliance between fiscal and monetary policies. But they don’t have the kind of power that the Bond Vigilantes once had to rein in policy excesses. The only market players left with any power are the Dollar Vigilantes. They have lots of fear and loathing of MMT and can do something about it.

They can devalue the dollar relative to other currencies, thus putting upward pressure on import prices, which could revive inflation. Even the Wizards of MMT acknowledge that they should at least think about tapping on the brakes if inflation makes a comeback.

(4) By the numbers. The price of gold is up 31.5% since March 23 to a record high of $1,964.90 per ounce on Friday (Fig. 12). The trade-weighted dollar is down 6.5% from its recent peak on March 23 through Friday to the lowest reading since March 9 (Fig. 13). Notwithstanding all of the above, our Stay Home vs Go Global ratio remains on the uptrend that started around 2009 (Fig. 14). After all, the US still has the FANGMANT (Facebook, Amazon, Netflix, Google’s parent Alphabet, Microsoft, Apple, NVIDIA, and Tesla) stocks, which the rest of the world does not.

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De-Urbanization in US, Plagues Made in China

July 30 (Thursday)

Autos: De-Urbanization Should Boost Car Sales. The housing market continues to be on fire as city dwellers look to the suburbs for more room in this era of COVID-19. The need for one or even two home offices and a backyard provides a strong incentive to make a move.

Home purchases have a strong ripple effect on the economy, because they result in so many other, related purchases. New homeowners may need furniture to fill up rooms or lawn equipment and patio furniture to make the backyard look good. We’re speculating that ex-urbanites migrating to more open spaces will also need to buy a car—or two—to get around their new suburban neighborhoods. That possibility certainly doesn’t appear to be factored into the S&P 500 Automobile Manufacturers stock price index, which has fallen 27.9% ytd through Tuesday’s close. Let’s take a look at both housing and autos:

(1) More good housing news. The strength in the housing market continued last month as pending home sales in June soared 16.6% m/m and 6.3% y/y, the National Association of Realtors (NAR) reported on Wednesday (Fig. 1). The y/y increase is the first positive reading since before the pandemic, Debbie observes below.

Sales undoubtedly were helped by the drop in the 30-year fixed mortgage rate to 3.28% by the end of June from 3.57% near the end of May. The 30-year mortgage rate is currently 3.16% (Fig. 2).

The jump in activity looks likely to continue. The four-week average of home mortgage applications is up 63.5% since bottoming during the April 24 week, at its lowest level since late October 2015 (Fig. 3). Recent housing activity has been so strong that the NAR raised its 2020 projection for existing home sales to a 3% decline from an 8% decline previously. The association forecasts a 3% rise in new home sales this year, up from its previous forecast of a 1% rise.

(2) Need a car too? Auto sales have bounced off their low, but nothing like the rebound in the housing industry. There were 13.2 million (saar) new light vehicles sold in June, up from the 8.7 million-units low in April. But auto sales remain well off the 17.1 million units (saar) at the start of this year (Fig. 4). The two industries’ stock price indexes reflect the differences. As we mentioned above, the S&P 500 Automobile Manufacturers stock price index has fallen 27.9% ytd through Tuesday’s close, while the S&P 500 Homebuilding stock price index is up 19.5% ytd (Fig. 5 and Fig. 6).

Might new home buyers provide a boost to the auto industry that few investors expect? If so, they’ll be buying cars off dealer lots that are still light on inventory. Auto production fell far more sharply than sales earlier this year due to COVID-19-related factory shutdowns (Fig. 7, Fig. 8, and Fig. 9).

GM’s Q2 earnings report, announced Wednesday, noted that its plants were working to replenish “thinly stocked dealership lots, a sign that its bottom line could rebound in coming quarters as the company tries to make up for weeks of lost production this spring from the pandemic,” a July 29 WSJ article reported. The company did report a $758 million Q2 loss, primarily due to the US market, where its factories were closed for almost half the quarter. But GM’s 50 cents per-share earnings loss beat analysts’ forecasts of a $1.77 loss.

China I (an Editorial): Is the CCP Plagued? The Chinese Communist Party (CCP) seems to be causing plagues of biblical proportions. In the Bible, there were 10 all told. So far, we can count four such calamities:

(1) Second borns. China’s first plague was the CCP’s one-child policy imposed on their people from 1979 through 2015. Previously, I’ve observed that China’s one-child policy has created a demographic nightmare for the country. This first plague was the subject of “One Child Nation,” an extremely disturbing 2019 documentary about China’s horrible policy aimed at population control. It resulted in the mass forced sterilization of women and involuntary late-term abortions. It led to the human trafficking of babies, who were placed with adoptive families in overseas homes under the false pretense that the babies hadn’t been bought and sold prior to placement.

The government campaign to control the population’s growth rate was deemed necessary to avoid nationwide starvation. It was a brutal Orwellian response to a questionable Malthusian problem. It included incessant propaganda, a widespread network of informants, and the conscription of medical professionals to execute the government’s dirty deeds. Among the people interviewed in the documentary, a few condoned it, but most did not and seemed to have been deeply traumatized by it. Everyone involved in some capacity said they had no choice. The legacy of that policy is that China is rapidly turning into the world’s largest nursing home as the population ages without enough young adults to support the elderly.

(2) Ethnic cleansing. An Alaska-sized chunk of western China known as “Xinjiang” is the homeland of approximately 11 million Uighurs, an ethnic Turkic and largely Muslim population. Chinese officials have been accused of launching a plague of ethnic cleansing against the population, involving “re-education camps” and other Orwellian measures. The resulting horrors have been reported by numerous media outlets around the world. The Chinese government denies the accusations.

(3) Virus. Everyone agrees that the COVID-19 pandemic originated in Wuhan, China. US officials claim that China failed to alert the world about the severity of COVID-19 so that it could accumulate necessary medical equipment. A May 1 report by the US Department of Homeland Security (DHS) states that Chinese leaders held off telling the World Health Organization (WHO) that COVID-19 was a contagion for much of January so that it could boost its medical supplies, a May 4 AP article reported. DHS noted that during that time, China’s imports of face masks and surgical gowns and gloves increased, and its exports of those items decreased. China counters that US officials are using the country as a scapegoat.

(4) Floods. The second-highest rainfall that has swamped China in more than a

half-century has fueled new questions about the Three Gorges Dam, the world’s biggest hydroelectric facility. It was designed to help to tame floodwaters. The state-owned operator of the dam has denied rumors that it is showing signs of structural stress.

What’s next? How about bad seeds? The July 28 Boston Herald reported: “State and federal authorities both put out news releases on Tuesday warning Bay Staters that it appears that ‘suspicious, unsolicited packages of seed’ from China are suddenly showing up on people’s doorsteps—and that people should call the plant police if one shows up. ‘While the exact types of seeds in the packages are unknown, the seeds are thought to be invasive plant species, and not believed to be harmful to humans or pets but could pose a significant risk to agriculture or the environment,’ the Massachusetts Department of Agricultural Resources said.” Similar warnings have been issued in several other states.

(The views expressed in this editorial are solely my own.)

China II: Spy Games Continue. The Cold War between the US and China grew frostier last week. The US forced China to close its Houston consulate amid accusations of Chinese theft of US intellectual property. China retaliated by forcing the US to close its Chengdu consulate.

These are just the latest developments in the US government’s efforts to prevent the Chinese government from stealing US intellectual property. We first pointed out the numerous cases that the Department of Justice (DOJ) was bringing against US and Chinese citizens who had been stealing information for the Chinese government in the Morning Briefings of February 7, 2019 and February 21, 2019. Now the problem is publicly discussed on a regular basis by the most senior members of the Trump administration.

In a July 16 speech, US Attorney General William Barr warned that China was using any means possible to achieve “Made in China 2025,” the country’s extensive plan to dominate key industries—including advanced technology, robotics, aircraft, new energy vehicles, electrical generation and transmission equipment, agricultural machinery, new materials, pharmaceuticals, and advanced medical devices. And Barr explained in a February 6 speech that the DOJ has brought trade-secret-theft cases in eight of the 10 sectors that China aims to dominate by 2025.

The DOJ’s effort dates back to 2018, when then-US Attorney General Jeff Sessions established the China Initiative to identify and prosecute those engaged in trade-secret theft, hacking, and economic espionage, according to a DOJ report listing many of the agency’s ongoing cases. Expect the list to grow longer. The FBI reportedly has 2,000 active cases related to Chinese counterintelligence operations in the US, a July 26 American Military News article reported.

Here’s Jackie’s look at some of the recent DOJ allegations, which read more like spy novels than press releases:

(1) Hacking away. Li Xiaoyu and Dong Jiazhi, Chinese nationals and residents, were indicted after allegedly hacking into the computer systems of hundreds of companies, governments, non-governmental organizations, individual dissidents, clergy, and democratic and human rights activists in the US and abroad.

Many of the industries they targeted are those China has focused on in its Made in China 2025 program. “Targeted industries included, among others, high tech manufacturing; medical device, civil, and industrial engineering; business, educational, and gaming software; solar energy; pharmaceuticals; defense,” according to the July 21 DOJ press release. More recently, the duo has targeted companies developing COVID-19 vaccines, tests, and treatments. The DOJ claims the hackers acted for their own financial gain and for the benefit of the Chinese government’s Ministry of State Security.

This follows the February indictment of four members of the Chinese People’s Liberation Army for hacking into the computer systems of Equifax and stealing Americans’ personal data and Equifax trade secrets. To avoid detection, the hackers routed traffic through about 34 servers in nearly 20 countries, the DOJ’s February 10 press release stated.

(2) Chinese stealing for the motherland. There have been many charges against Chinese citizens working as researchers in US universities who have failed to disclose their ties to the Chinese military. Some are also accused of taking knowledge gained in the US and giving it to China.

Yanqing Ye was charged with visa fraud, making false statements, acting as an agent of a foreign government, and conspiracy earlier this year. Yi identified herself as a student on her J-1 visa and lied about her ongoing military service at the National University of Defense Technology (NUDT), a military academy directed by the CCP. She is a lieutenant of the People’s Liberation Army and a member of the CCP. She studied at Boston University’s Department of Physics, Chemistry and Biomedical Engineering from October 2017 to April 2019.

“[A]t the direction of one NUDT professor, who was a PLA Colonel, Ye had accessed U.S. military websites, researched U.S. military projects and compiled information for the PLA on two U.S. scientists with expertise in robotics and computer science. Furthermore, a review of a WeChat conversation revealed that Ye and the other PLA official from NUDT were collaborating on a research paper about a risk assessment model designed to decipher data for military applications,” a January 28 DOJ press release stated.

The same press release claimed that Zaosong Zheng entered the US on a J-1 visa and conducted cancer cell research at Beth Israel Deaconess Medical Center in Boston from September 2018 to December 2019. “Zheng stole 21 vials of biological research and attempted to smuggle them out of the United States aboard a flight destined for China. Federal officers at Logan Airport discovered the vials hidden in a sock inside one of Zheng’s bags … [Zheng] stated that he intended to bring the vials to China to use them to conduct research in his own laboratory and publish the results under his own name.”

(3) Americans can be bought by China too. In March, Xuehua Peng, a US citizen, was sentenced to four years in prison and fined $30,000 for acting as an agent of the People’s Republic of China’s (PRC) Ministry of State Security. Peng, who pled guilty, said that in 2015 an official from the PRC introduced himself when Peng was in China on business. The official had an offer. Peng was hired to make dead drops to exchange money for items to deliver to the PRC. He would locate and reserve hotel rooms where he would leave money and then depart for several hours. During that time, a source would leave a small electronic storage device in the room. Peng would retrieve the device, fly to China, and deliver it to the PRC official. He completed six dead drops and received $30,000 from the PRC official before being arrested, the DOJ March 17 press release stated.

(4) Thousand Talents plan. Many DOJ cases involve US or Chinese researchers who have accepted US research funding and failed to disclose their receipt of funding from China. In the worst cases, there’s evidence that the scientists intended to give China the fruits of their US research.

The National Institutes of Health (NIH) has been investigating scientists who received undisclosed foreign funding since 2018. So far, 54 scientists have resigned or been fired due to the investigation. NIH is finding that most of the undisclosed funding comes from China—that’s the case for 93% of the 189 scientists, working in 87 institutions, who’ve been investigated so far, a June 22 Science article reported.

Perhaps the highest-profile scientist targeted by the DOJ is Dr. Charles Lieber, Chair of Harvard University’s Chemistry and Chemical Biology Department. He was indicted by a federal grand jury for making false statements to federal authorities. Lieber, who specialized in nanoscience, has received more than $15 million in grants from the NIH and Department of Defense, but allegedly failed to disclose his funding from Chinese organizations.

Beginning in 2011, Lieber allegedly became a “Strategic Scientist” at Wuhan University of Technology and was a contractual participant in China’s Thousand Talents Plan from at least 2012 to 2015. China’s Thousand Talents plan aims to attract, recruit, and cultivate high-level scientific talent, both at home and abroad, a June 9 Justice Department press release stated. As part of his Thousand Talents contract, Lieber was paid $50,000 a month, living expenses of almost $160,000, and more than $1.5 million to establish a research lab at Wuhan University of Technology. He was to work for the Chinese university for not less than nine months a year.

Song Guo Zheng was charged with fraud for not disclosing that he was a member of the Chinese Talent Plan while accepting about $4.1 million in grants from the NIH to develop expertise in rheumatology and immunology. He is also charged with making false statements about maintaining employment in China while employed by universities in the US, including the Ohio State University. He was arrested in May as he was about to board a flight from Alaska to China while carrying bags containing two laptops, three cellphones, several USB drives, and several silver bars.

“We allege that Zheng was preparing to flee the country after he learned that his employer had begun an administrative process into whether or not he was complying with rules governing taxpayer-funded grants,” said David M. DeVillers, US Attorney for the Southern District of Ohio in a July 9 DOJ press release.

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V-Shaped Indicators

July 29 (Wednesday)

US Economy I: Like a Natural Disaster. The latest available data confirm that the US economy started to recover during May and continued to do so through July from its freefall during March and April. It’s hard to call that a recession since it lasted only two months. On the other hand, millions of people remain unemployed and thousands of businesses are struggling. So far, the impact of the Great Virus Crisis (GVC) on the economy has been more like a natural disaster than a man-made recession. Then again, the virus is still out there, and the recovery could slow or even stall in coming months. For now, the latest batch of economic indicators are consistent with a V-shaped recovery. Consider the following:

(1) Purchasing managers. Markit’s flash estimate for the US M-PMI has rebounded from a low of 36.1 during April to 51.3 during July (Fig. 1). The comparable NM-PMI is up from an abysmal reading of 26.7 during April to 49.6 during July. The services-providing side of the economy was hit harder by the GVC than the goods-producing side. Nevertheless, both of their recoveries have been impressive so far. The Markit data augur well for July’s PMIs, which will be reported by the Institute for Supply Management (ISM) in early August.

(2) Regional business surveys. The average of the five regional composite business indicators (compiled by the Federal Reserve Banks of Dallas, Kansas City, New York, Philadelphia, and Richmond) rose from a low of -58.6 during April to 10.3 during July (Fig. 2). This too augurs well for the ISM’s July PMI reports too.

The average of the regional orders indexes is up from a low of -66.4 during April to 12.4 in July, the highest since November 2018 (Fig. 3). The comparable average employment index is up from -36.0 to 4.7 over the same period.

(3) Durable goods orders. Durable goods orders plunged 32.0% during the two months through April to the lowest reading since the end of 2009 (Fig. 4). Much of that weakness was in orders for motor vehicles and aircraft. Excluding transportation, durable orders fell 10.0% over this period to the lowest since October 2016. The total has rebounded 23.5% since the low through June, and 7.0% excluding transportation. Nondefense capital goods fell 7.8% during the two months ending April and are up 5.0% since then.

(4) Economic Surprise Index. The Citigroup Economic Surprise Index plunged from 73.8 on March 13 to a record low of -144.6 on April 30 (Fig. 5). Since then, it has rocketed to a record high of 270.8 on July 16. It edged down to 238.5 on Monday, which remains a surprisingly high reading.

US Economy II: Transports on Recovery Road. The S&P 500 stock price index fell 33.9% from February 19 through March 23. Over that same period, the S&P 500 Transportation stock price index plunged 37.3% (Fig. 6). Since March 23 through Monday’s close, the former is up 44.8%, while the latter is up 43.9%. This relationship is mirrored in the Dow Jones Industrials Average and the Dow Jones Transportation Average (Fig. 7). In other words, Dow Theory is currently bullish since both indexes have rebounded together.

Also rebounding are some economic indicators of transportation activity:

(1) Trucking. For example, the ATA Truck Tonnage Index fell 11.2% from a record high of 119.5 during March to 106.1 through May (Fig. 8). That was the lowest reading since July 2017. It rebounded to 115.3 during June. So the index represents another V-shaped economic indicator at this point; its recovery could stall, of course.

(2) Gasoline. Interestingly, the weekly gasoline usage series that Debbie and I track rebounded smartly from a low of 5.3mbd during the April 24 week to 8.6mbd during the April 10 week (Fig. 9). However, it stalled there during the April 17 week.

(3) Railroads. What about railcar loadings? We track the 26-week average of the data to smooth out the volatility in the series for railcar loadings (Fig. 10). The total has dropped 11.9% since the start of this year through the week of July 18. It might be starting to bottom now, maybe. It is the lowest since August 2009 but has been brought down that low by plunging railcar loadings of coal (Fig. 11). Excluding coal, railcar loadings are down 9.1% so far this year to the lowest since June 2012. Intermodal railcar loadings are down 8.5% so far this year and may also be bottoming.

 Strategy: Bottoming Forward Earnings. While there’s no sign yet of a V-shaped recovery in corporate earnings, there are plenty of signs that earnings have bottomed. Let’s review the latest data for the S&P 500 operating earnings per share:

(1) Quarterly. Analysts’ consensus expected earnings per share for Q2-Q4 plunged sharply after the World Health Organization (WHO) declared on March 11 that COVID-19 had turned into a pandemic (Fig. 12). However, the estimates for Q2 (recently blended with reported earnings) along with those for Q3 and Q4 started to level out in recent weeks.

(2) Annually. The consensus earnings-per-share estimates for 2020, 2021, and 2022 all have dropped sharply after the WHO’s declaration, but also have started to level out in recent weeks (Fig. 13). The latest readings, for the week of July 23, show $124.79 for this year, $163.61 for next year, and $186.12 for 2022. Our targets are still $120, $150, and $175.

(3) Forward. S&P 500 forward earnings per share, the time-weighted average of consensus estimates for this year and next year, rose to $147.01 during the July 24 week (Fig. 14). It bottomed at $141.00 during the May 15 week and has been up every week since then.

US Fiscal Policy: A Precedent for a Universal Basic Income? Congressional leaders are debating whether the $600 per week in Federal Pandemic Unemployment Compensation may be extended beyond its July 31 expiration date. It was included in the Coronavirus Aid, Relief, and Economic Security (CARES) Act with the aim of fully replacing lost income during the pandemic when combined with traditional state unemployment insurance (UI). The CARES Act also expanded unemployment benefits to certain individuals who would not typically receive state aid.

Democrats are fighting for the full amount of the fixed benefit to be extended. They argue that a new program suggested by Republicans is not enough aid and is too complicated to implement in a timely manner. Republicans have argued for a new program supplementing the benefits of those on pandemic aid such that they’d receive around 70% of their prior income for a period, capped at $500 per week. But the new supplemental payment would start at $200 until the more complex program could be implemented, which could take several months for some states. That’s all according to a July 27 Washington Post article on the subject.

Both sides of the aisle have valid concerns. Lots of workers have lost their jobs, businesses, and childcare options due to the pandemic. Unemployed workers have lost not only income but also health insurance and other benefits. Without the aid, not only would unemployed workers suffer but so would the broader economy, owing to lower consumer spending.

But there is a good chance that some workers either have turned down available work or refrained from looking for work because they stand to receive more from UI than they would in the workforce and in some cases even more than they had earned before the pandemic hit. Some recent research suggests that taking advantage of the benefit program in these ways isn’t widespread, though the opportunity to do so exists. Here is a quick summary of some recent research on the matter:

(1) Earning more than before. As intended, the average replacement rate under CARES is roughly 100%, according to a working paper from the National Bureau of Economic Researchers (NBER). However, the distribution of aid relative to lost income is uneven among the population receiving the benefits.

Unemployed workers are receiving an income expansion, replacing lost income by a median of 134% with the program benefits. Two-thirds of eligible workers can receive benefits exceeding lost earnings, and one-fifth can receive benefits at least double lost earnings. Low-income workers have received the brunt of the lost income, which is why the math for the $600 per week comes out to such a generous replacement rate.

The NBER researchers identified significant variation in the effects of the CARES Act across occupations, which may promote unfair distribution of income for “essential” and “nonessential” workers: While laid-off workers receiving UI benefits have been reimbursed for lost earnings and then some, essentially receiving a “bonus,” their still-working “essential” counterparts have been putting themselves and households at risk while receiving the same amount of income as before the pandemic.

(2) Disincentive is there. That unfairness aside, however, a recent Yale study found that the supplemental federal aid did not reduce return to employment. There was not much disparity in return to employment by early May between workers whose UI benefits were relatively generous relative to what they had earned in the labor market and those whose benefits were not. Those in the former category returned to work at a slightly faster pace than those in the latter.

Possible reasons for this: Under the CARES Act, people who quit their job for no other reason than concern about contracting COVID-19 are not eligible for UI. Further, once an individual receives a “‘suitable offer of employment,” they no longer qualify for UI even if they reject the offer. However, the researchers admit that it is plausible that “employers and workers could cooperate to lay off workers who would receive higher incomes from UI benefits than from earned wages.”

(3) Solution is a rate. But the incentive to remain unemployed could be removed while still supporting the legitimately unemployed. Even if the fixed payment were halved (i.e., to $300), 42% of unemployed workers would see benefits representing income-replacement rates above 100%, estimate the NBER researchers, and a quarter of them would receive benefits representing replacement rates below 60%, they say. To solve for the distributional disparity with a fixed amount of aid, the researchers suggest implementing a supplemental replacement rate to better target lost income.

(4) Universal Basic Income. As a result of the GVC, our nation may have just taken one small step toward providing a Universal Basic Income. In addition to the federal UI supplement, the CARES Act provided for stimulus checks. The next stimulus package may include another round of them. These developments are setting precedents for a Universal Basic Income. As Obama administration Chief of Staff Rahm Emanuel famously said in 2008 and reiterated in a March 25 Washington Post op-ed: “Washington needs to make sure this crisis doesn’t go to waste.”

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Welcome to Oz

July 28 (Tuesday)

MMT: Professor Kelton’s Dreamland. We live in surreal times. I’ve previously compared them to the TV series The Twilight Zone. However, a more apt comparison would be with the land that Dorothy and her dog Toto visited in the movie The Wizard of Oz. When a tornado ripped her house from its foundation, causing it to crash-land in Oz, she emerged safe and sound, looked around in wonder and famously marveled, “Toto, I’ve a feeling we’re not in Kansas anymore.” Oz had a colorful cast of characters, including assorted Munchkins, the Good Witch of the North, the Bad Witch of the West and her Winkie Guards, and a blustery wizard—not unlike Washington today. And the news these days showcases plenty of national and local leaders behaving like cowardly lions, heartless tin men, and brainless straw men.

The analogy with Oz was first provided by none other than the Wizard of MMT, Professor Stephanie Kelton. In her book The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, she wrote: “Like Dorothy and her companion in The Wizard of Oz, we need to see through the myths and remember once again that we’ve had the power all along.”

Kelton was referring to Dorothy’s power to go back home to Kansas simply by clicking the heels of her ruby-red slippers three times. Similarly, Kelton believes that the US government has always had the power to run huge budget deficits and should be doing so now to cure all our ills. As a result of the Great Virus Crisis (GVC), her theory has taken on a life of its own beyond her wildest dreams. Governments around the world are spending massively on stimulative fiscal policies to offset the recessionary forces unleashed by the GVC.

Most of those contractionary forces have been driven by the extreme government lockdown policies adopted to impose social distancing to slow the spread of the virus. So far, all the government stimulus has provided some support for the global economy. But the virus is still out there, and so are the recessionary forces. As a result, price inflation remains subdued even though much of the ballooning fiscal deficits are being financed by central banks’ purchases of government securities, which MMTers also support.

In Kelton’s dreamland, that’s a perfect outcome, because she and her merry band of arm-linked MMTers believe that the only limit on deficit-financed government spending is price inflation. Sure enough, the US government has responded precisely as she advocates, producing one stimulus program after another. Another one is imminent, sized to the tune of $1.0 trillion, which will most likely cause the Congressional Budget Office to raise its current fiscal 2020 budget deficit estimate from $3.7 trillion to $4.7 trillion…click, click, click (Fig. 1 and Fig. 2). No problem: The Fed will continue to buy more Treasuries…click, click, click (Fig. 3 and Fig. 4).

Melissa and I have written previously about MMT. Our latest analysis, titled “Modern Monetary Theory: In Theory & In Practice,” was in our July 8 Morning Briefing. We wrote:

“Kelton argues that the federal government can and should run large budget deficits as long as inflation remains subdued. MMT opponents’ main objection is that the theory provides a blank check for the government to get much bigger. It provides the government with too much power to allocate resources. Free-market capitalists believe that markets do a much better job of doing so than politicians and bureaucrats. Kelton clearly disagrees. … But whether one is for MMT or against it, Kelton’s book leaves no doubt about what MMT is all about: It’s an agenda for more big government and higher taxes.” In brief, it legitimizes a massive power grab by the government for our own good.

Kelton probably would welcome the opportunity to be Treasury secretary if the Democrats win the White House in November. Ironically, her views already are reflected in the current Republican administration’s fiscal policymaking! By the way, Kelton contributed to the 110-page Biden-Sanders Unity Task Force Recommendations. Other contributing luminaries included former US Secretary of State in the Obama administration and former Senator (D-MA) John Kerry, Representative Alexandria Ocasio-Cortez (D-NY), former US Attorney General under Obama Eric Holder, former White House Chief Economist under Obama Jared Bernstein, and American Federation of Teachers President Randi Weingarten. So Professor Kelton is either in good company or bad company depending on your political leanings.

We concluded our analysis: “But remember, the story was all a bad dream Dorothy had after getting hit on the head. Free market capitalists might exclaim: ‘Pay no attention to the professor behind the curtain!’” We like to think of “The Wizard of Oz” as a long episode of The Twilight Zone.

 Gold: In Oz, It’s ‘In Bullion We Trust.’ Gold and silver are leading a meltup in precious metals prices (Fig. 5). That makes sense in Oz, which is currently experiencing: i) a pandemic; ii) violent civil unrest; iii) extreme political partisanship; iv) a rapidly escalating Cold War between the US and China; v) a game of chicken between the US and Iran in the Strait of Hormuz; vi) out-of-control MMT fiscal and monetary policies; and vii) a possible left-wing regime change on November 3.

The price of an ounce of gold is up 24.7% since March 23, when the Fed embraced MMT with QE4Ever, through Friday’s close. QE4Ever set the stage for the Fed to finance the CARES Act, which was signed by President Trump on March 27. The price of an ounce of silver is up 76.0% over that same period. The S&P 500 and the Nasdaq registered meltups of 44.8% and 53.6% through yesterday’s close (Fig. 6).

Many investors have concluded that there is no alternative to stocks now that the 10-year Treasury bond yield has been below 1.00% consistently since March 20. Many investors have moved rapidly to rebalance their portfolios, lowering their bond weighting and increasing their stock weighting since March 23. However, some investors see precious metals as an alternative to bonds and maybe even to stocks, which have become overvalued based on historical measures of valuation. Consider the following related developments:

(1) Gold & industrial commodity prices. In the past, gold tended to signal the underlying trend in the CRB raw industrial spot price index (Fig. 7). The latter is more volatile than the former, but their trends have coincided. However, the two have been diverging for a while. The price of gold is up 49% since the end of 2018 through Friday, while the CRB index is down 10% over that same period.

The divergence may be resolved by a rebound in industrial commodity prices if the global pandemic is halted by a vaccine, leading to a big rebound in world growth. Or else, it may be a worrisome sign that we aren’t in Kansas anymore. We may be in Oz. If so, that strange land—as noted above (if I may repeat myself for emphasis) —is currently experiencing: i) a pandemic; ii) violent civil unrest; iii) extreme political partisanship; iv) a rapidly escalating Cold War between the US and China; v) a game of chicken between the US and Iran in the Strait of Hormuz; vi) out-of-control MMT fiscal and monetary policies; and vii) a possible left-wing regime change on November 3. In other words, it’s a breeding ground for Gold Bugs.

(2) Gold & TIPS. The 10-year TIPS yield continues to plummet below zero. It was down to a record-low -0.92% on Friday, and was little changed at -0.90 yesterday  (Fig. 8). We have long observed that it is highly inversely correlated with the price of gold. That relationship continues to work even in Oz. What’s different in Oz is that yesterday gold broke out to a new record high.

The inverse correlation between the price of gold and the TIPS yield is a widely recognized fact. In fact, the concept was generalized to other assets besides gold in a July 17 WSJ article titled “Beneath Bond Market’s Surface, Tumbling Real Yields Boost Other Assets.” It observed that while the 10-year nominal yield has been relatively stable around 0.60%, the comparable TIPS yield has been turning more negative, implying that the expected inflation rate embedded in the spread of the two jumped from a recent low of 0.50% on March 19 to 1.52% yesterday (Fig. 9 and Fig. 10).

The article put an interesting spin on these developments: “Taken together, the increase in inflation expectations and decline in real yields both echo and help explain the strong performance of stocks in recent months. A rising break-even rate is typically associated with an improved economic outlook. Falling real yields, meanwhile, can boost the economy by weakening the U.S. dollar and spurring investors to buy riskier assets because inflation is causing them to lose money on their bonds.”

That’s a very insightful interpretation of these variables. The TIPS yield is falling because investors expect inflation to rebound, which is why they are buying inflation-protected bonds and driving down those bonds’ yields. The nominal yield is flat because investors believe that the Fed is aiming to boost inflation and that it will do so by keeping short-term rates down near zero. That would tend to be bearish for the dollar; a downward-headed dollar would boost both inflation and trade-led growth by boosting exports and depressing imports.

(3) Gold & the dollar. From 1994 through 2015, the price of gold was broadly inversely correlated with the trade-weighted dollar (Fig. 11). Since then through 2019, the two have trended in the same direction. This year, the dollar peaked on March 23 and was down 6.3% through yesterday, while gold is now in record-high territory. In other words, the inverse relationship between the two may be making a comeback.

By the way, the foreign-exchange value of gold surpassed its previous record high of $1,797 on August 5, 2019 (Fig. 12). It rose to yet another record high of $2,383 on Friday.

US Dollar: Reservations About the Reserve Currency in Oz. Is gold signaling a collapse in the dollar? Yes, it is. But Melissa and I aren’t convinced that gold’s prediction will pan out, though there are some good arguments in favor of it. First and foremost might be that, while the US came out of the Great Financial Crisis in much better shape than most of the rest of the world, the same cannot be said for the US’s handling of the GVC, so far. Several European and Asian countries seem to be doing a much better job of re-opening their economies while keeping the virus from spreading anew, so far.

We can see this in July’s Markit purchasing managers flash estimates. They show that the M-PMIs were close during the month for the US (51.3) and the Eurozone (51.1). However, the NM-PMIs of the US (49.6) and the Eurozone (55.1) diverged (Fig. 13). Re-opening the services economy has been slower going in the US than in the Eurozone.

In addition, the recent agreement by the members of the Eurozone to issue “corona bonds” is widely deemed as a vote of confidence in the monetary union, which already seems to be benefiting the euro (Fig. 14). Now consider the following counterarguments:

(1) Reserve currency. Data compiled by the International Monetary Fund (IMF) show that non-gold international reserves totaled $12.3 trillion during May (Fig. 15). The IMF’s quarterly data show total foreign exchange reserves of $11.7 trillion during Q1-2020, with allocated reserves at $11.0 trillion. The dollar remains a key currency, accounting for 62% of allocated reserves (Fig. 16).

(2) Capital flows. Melissa and I have devised a proxy for world ex-US capital flows by subtracting the 12-month sum of the merchandise trade surplus with the US (i.e., the US trade deficit multiplied by -1.0) from the 12-month change in non-gold international reserves (Fig. 17 and Fig. 18).

Our proxy shows capital outflows from the rest of the world into the US of $592 billion over the past 12 months through May. Notwithstanding the problems we have in the US, foreign investors continue to find plenty of opportunities here. The trade-weighted dollar tends to be inversely correlated with our proxy. When the latter is negative (because capital is flowing into the US from the rest of the world), the yearly percent change in the dollar tends to be positive.

(3) Oil price. Finally, for today, one of the closest correlations we’ve observed is the one between the price of a barrel of Brent crude oil and the inverse of the trade-weighted dollar (Fig. 19). I simply am not convinced that there is much further upside for the price of oil given the weakness of the global economy. I may change my mind if a vaccine is developed soon that gets us all out of Oz and back to Kansas.

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Maxim Gorky & The Fed’s Punch Bowl

July 27 (Monday)

Strategy I: The Fed’s Party. Maxim Gorky wrote his depressing play The Lower Depths during the winter of 1901 and spring of 1902. It depicts a group of impoverished Russians living in a shelter near the Volga River. The harsh truth of their harsh condition is contrasted to their delusional denial of their bleak existence.

After the S&P 500 plunged 33.9% to the lower depths from February 19 through March 23, the index soared 43.7% through Friday’s close (Fig. 1). The stock market continues “to accentuate the positive, eliminate the negative, latch on to the affirmative,” as the song goes.

Are stock investors delusional? Not yet, but that could be an apt characterization if stock prices continue to rise faster than forward earnings. This has been a P/E-led meltup. The S&P 500 forward P/E has jumped from 12.9 back then to 22.0 on Friday (Fig. 2). The S&P 500 forward price-to-sales ratio rose to a record 2.32 during the July 16 week, well above the previous two cyclical peaks (Fig. 3). It’s a great weekly indicator of the quarterly Buffett Ratio.

Stock prices have soared even as analysts’ consensus expected earnings estimates have plunged (Fig. 4). These estimates have started to show signs of bottoming in the past few weeks. However, any recovery could be dampened or even aborted if the COVID-19 case count continues to mount and state governors slow or reverse the lifting of lockdown restrictions (Fig. 5). If many school districts don’t allow their students to attend in person this fall, it could be a serious problem for parents’ ability to return to work if they can’t get or afford childcare. If colleges opt for another semester of online classes, that could be more bad news for lots of businesses in college towns around the country. There’s certainly mounting evidence that the V-shaped economic recovery during May and June is slowing or even stalling in July. That could lead to more delinquencies and defaults on loans and bonds.

All these considerations are all the more reason for investors to come to their senses and let stock prices consolidate their gains while waiting for more evidence of a sustainable recovery. Sure, there’s been lots of good news (hype?) about vaccines, but it has been discounted several times in recent weeks. Nevertheless, the Fed continues to keep the wild party going by keeping the punch bowl full of liquidity. That has allowed investors to party while ignoring the harsh reality of the health crisis and the depths of despair among millions of unemployed workers and thousands of struggling small business owners.

Strategy II: Are Growth Stocks Punch-Drunk? Investors in Growth stocks have been punch-drunk, while Value investors have been getting a bit tipsy since the Fed filled the punch bowl to the rim on March 23 and kept it full ever since. The former might have passed out on Thursday and Friday, as the Magnificent Six FAANGM (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft) stocks were hard hit by profit-taking. They certainly have been profitable in the face of the Great Virus Crisis. That’s because they benefit as more of us use the Internet to work and to shop from home, to get our education online, and to be entertained with streaming services and interactive games.

Since the end of last year through Friday’s close, the Magnificent Six are up as follows: Amazon (62.8%), Netflix (48.5), Microsoft (27.6), Apple (26.2), Google’s parent Alphabet (12.6), and Facebook (12.4). Over this same period, their aggregate market cap is up 28.8%, while the S&P 500 is down 0.5%, but the index’s decline worsens to 7.5% excluding these stocks (Fig. 6). They were down 3.9% Thursday on profit-taking after Microsoft reported earnings. They fell 0.2% on Friday on news that the US-China Cold War continues to heat up, as I discussed last Monday and update below.

The pandemic continues to help more than hurt Microsoft’s business. Revenue of $38 billion in the quarter ending June was up 13% y/y and $1.48 billion ahead of analysts’ estimates. The company’s cloud business grew revenue by 17%. The segment that includes Windows, Surface, and X-Box saw 14% revenue growth. Earnings per share came in at $1.46, up 7% y/y on an adjusted basis and 9 cents better than analysts were expecting. Microsoft did incur a $450 million charge related to the permanent closure of its physical retail stores. Also down on Thursday was Apple’s stock, following a warning by a Goldman Sachs analyst that earnings, which will be reported on July 30, are likely to be well below expectations.

As Joe and I previously noted, the Magnificent Six are dominating the three major investment styles: i) LargeCaps versus SMidCaps; ii) Growth versus Value; and iii) Stay Home versus Go Global. Consider the following:

(1) LargeCaps vs SMidCaps. The Magnificent Six currently account for 24.6% of the S&P 500’s market capitalization as well as large shares of the market cap of the following S&P 500 sectors: Information Technology (44.2%), Communication Services (65.6), and Consumer Discretionary (50.6). All six are included in the S&P 500 Growth index and give these three sectors a growthy bent.

The Magnificent Five (the five biggest S&P 500 companies) account for 23.8% of the market-cap share of the S&P 500, down from a record high of 25.2% during the July 10 week (Fig. 7). Here are the cyclical peaks in the previous Magnificent Five’s market-cap shares of the S&P 500 during the weeks of August 8, 1997 (12.4%), March 24, 2000 (18.5), November 21, 2008 (16.0), September 28, 2012 (13.9), and August 31, 2018 (17.5).

The Magnificent Five even dominate the S&P 100’s mega-cap index. The market-cap share of the former in the latter is currently 35.1%. In turn, the market-cap share of the S&P 100 relative to the S&P 500 is at a near-record-high 66.1% (Fig. 8).

(2) Growth vs Value. The Magnificent Six account for 29.9% of the S&P 500 Growth index. I asked Joe to calculate the latest Growth versus Value weights for the 11 sectors in the S&P 500. Here are the latest readings: Communication Services (16.1% Growth, 7.6% Value), Consumer Discretionary (13.8, 7.1), Consumer Staples (6.7, 12.9), Energy (0.7, 4.1), Financials (5.4, 16.3), Health Care (12.1, 20.5), Industrials (8.0, 10.9), Information Technology (31.6, 9.4), Materials (2.2, 3.1), Real Estate (2.6, 3.1), and Utilities (1.0, 5.0).

The S&P 500’s Energy and Financials sectors have lots of Value stocks. Weakening oil prices have weighed on the Energy sector’s stock prices, which have underperformed the S&P 500 since 2008 (Fig. 9). That’s one reason why Value has underperformed the S&P 500 since then.

In addition, the Financials have underperformed the S&P 500 since 2007 (Fig. 10). The Great Financial Crisis crushed them and led to a tougher regulatory environment; more recently, the downward trend in interest rates along with the flattening of the yield curve have weighed on them. So the S&P 500 Value index relative to the broad index has been falling along with the bond yield and the TIPS yield (Fig. 11 and Fig. 12).

(3) Stay Home vs Go Global. The ratio of the S&P 500 Growth stock price index to the S&P 500 is highly correlated with the ratio of the US MSCI stock price index to the All Country World ex-US MSCI stock price index (in dollars) since 1997 (Fig. 13). Since the Magnificent Six account for so much of the Growth index, they clearly have accounted for much of the recent outperformance of the US to the rest of the world.

Not surprisingly, the forward P/E of the US MSCI recently has been highly correlated with that of the S&P 500 Growth index, so the forward P/E of the Magnificent Six has soared and boosted both (Fig. 14). Furthermore, the All Country World ex-US MSCI has been trading—and continues to trade—at a forward P/E relatively near that of the S&P 500 Value index (Fig. 15).

In our July 20 Morning Briefing, we concluded: “Attention global stock investors: The US MSCI has more ‘growthier’ companies than do other MSCI stock market indexes around the world. Therefore, the former trades like a typical Growth stock, while the latter trades more like a typical Value stock! It’s that simple.” Nevertheless, the FAANGM-led selloff in the S&P 500 at the end of last week suggests that investors are cashing in some of their profits in these high-flyers.

Strategy III: What Could Possibly Go Wrong? No one in the world is living under the delusion that the world is a perfect place given that we’re all still fighting the ongoing pandemic. The stock market, however, is priced for perfection, or at least for a near-term peak in cases, a continued economic recovery, a vaccine sooner rather than later, and no radical left political regime change on Election Day. Now that the stock market has recovered sharply from the lower depths of March 23, there’s much less chatter about a move back down there anytime soon than there was in late March and April.

However, there is lots of chatter about the narrow breadth of the stock market rally since March 23. Everyone knows that the Magnificent Five and Six have led the way, as discussed above, in our latest contribution to the chatter. We know what could go wrong on the health and economic fronts. But what could possibly go wrong for the Magnificent Five (FAANG), Six (FAANGM) or Eight (FANGMANT, including NVIDIA and Tesla)? Here are a couple of possibilities:

(1) Cold War heating up. Last Monday, I reviewed how the US-China Cold War is escalating very quickly. It continued to do so over the rest of the week. On Wednesday, the US State Department ordered the Chinese to shut their consulate in Houston. On Thursday, Secretary of State Mike Pompeo delivered a blistering attack in a speech titled “Communist China and the Free World’s Future.” Here, in his words, is the key theme of his speech: “The truth is that our policies—and those of other free nations—resurrected China’s failing economy, only to see Beijing bite the international hands that were feeding it. ... Securing our freedoms from the Chinese Communist Party is the mission of our time, and America is perfectly positioned to lead it because our founding principles give us that opportunity.” His main conclusion was unambiguously hostile toward the Chinese government: “The free world must triumph over this new tyranny.”

On Friday, Beijing responded by ordering the closure of the American consulate in Chengdu. So far, the Chinese haven’t retaliated for the US moves to block Huawei from doing business around the world. What if the Chinese do so against any of the FANGMANT companies or any other major American companies doing business in China or dependent on Chinese supply chains? What if China bans the export of rare earth metals or solar panels?

Meanwhile, China has plenty of homegrown problems. The country is at risk of a Chernobyl-like disaster, as I discussed a week ago. China has been suffering through record rains the past few weeks, leading to the worst flooding in the country in decades. A few days ago, officials admitted that certain “peripheral” structures of the massive Three Gorges Dam deformed due to the building water pressure. More rain is forecast for the coming week.

(2) Radical left wins. Last week, Melissa and I considered the consequences of a Democratic sweep in the upcoming presidential and congressional elections. The party has been moving toward the left and most likely would move the country in that direction if it takes control of the White House, the House of Representatives, and the Senate. In this scenario, the corporate tax rate would be raised and regulations on business would proliferate. The Magnificent Eight companies might be forced to spin off some of their businesses if they were deemed to be too powerful and monopolistic.

That’s about all that we can imagine going wrong right now. We are working on becoming more imaginative.

Movie. “Miss Sloane” (+) (link) is a 2016 thriller starring Jessica Chastain, who plays a take-no-prisoners lobbyist in Washington, DC. It’s another movie about how the game is played in the “swamp.” Lobbyists have got to be engaged in the world’s second most unethical profession, after politicians. I’ve often observed that the difference between entrepreneurial capitalism and crony capitalism is that the latter system is corrupted by lobbyists. Big Business hires them to deal with Big Government. The deal-making is a win-win for both of them but a lose-lose for the rest of us.

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Biden’s Brave New World: Utopia or Dystopia?

July 23 (Thursday)

Strategy: Three-Front War. On Monday, I wrote about the escalating Cold War between the US and China. I also wrote about the latest plague to hit China, i.e., the worst flooding in decades, coming right after the COVID-19 plague. Yesterday’s WSJ reported: “Two months of unusually powerful rains in central and southern China have swelled the Yangtze River, triggering the worst flooding in decades and raising concerns about the Three Gorges Dam, the world’s largest hydroelectric facility.”

Also yesterday, we learned that the US State Department abruptly ordered China to shut down its consulate in Houston “in order to protect American intellectual property and Americans’ private information.” In addition, the Justice Department announced criminal charges against hackers, working with the Chinese government, who targeted firms developing vaccines for the coronavirus and stole hundreds of millions of dollars’ worth of intellectual property and trade secrets from companies across the world.

The stock market mostly ignored these negative developments along with the latest round of bad news about the pandemic. We may be having significant setbacks in the war against the virus on the health front, but the dispatches coming from the economic front continue to be mostly favorable (for now). Meanwhile, we seem to be winning on the financial front (thanks to the Fed’s B-52 campaign to carpet-bomb the economy with cash). Here is some of the recent news from the three fronts:

(1) Health front. According to the COVID-19 Tracking Project, the 10-day moving average of new positive test results rose to a record 64,000 through July 21. On this basis, current hospitalizations rose to 54,000, up from a recent low of 29,037 on June 23. New deaths remained relatively low at 786 (Fig. 1).

Those numbers come at a time when more is being learned about the virus and how the US collects data on cases. A new study by the Centers for Disease Control and Prevention concluded that coronavirus antibody tests vastly undercounted the true number of COVID-19 infections in the US from March to May. The study showed that COVID-19 rates were more than 10 times higher than what was reported. That might actually be good news since it indicates that the death rate is much lower than widely reported.

(2) Economic front. Yesterday’s report on existing home sales showed that they rebounded 20.7% m/m during June (Fig. 2). Sales of single-family dwellings jumped 19.9%. Demand has been boosted by the historically low 30-year fixed mortgage rate, which has been hovering around 3.00%, the lowest since 1971. As Debbie and I noted yesterday, people seeking homes away from densely populated cities are swelling the demand for single-family homes. On the other hand, the supply of such dwellings has tightened up as homeowners in the sought-after suburban and rural locations are staying put.

The bad news is that the four-week average of gasoline usage stalled during the July 17 week at 8.6mbd, following a V-shaped recovery from 5.3mbd during the April 24 week (Fig. 3). This coincides with the surge in cases, particularly in the Sunbelt states in recent weeks, forcing their governors to slow the pace of reopening their economies.

(3) Financial front. On Tuesday, the S&P 500 turned slightly positive for the year, having soared 45.6% from the March 23 bottom. Instead of retesting that low, as was widely predicted, the index is on track to revisit and perhaps exceed its February 19 record high of 3386.15 (Fig. 4). The rebound in the S&P 500 has been led by an extraordinary meltup in its forward P/E from 12.9 on March 23 to 22.4 currently (Fig. 5).

Our year-end target of 2900 for the S&P 500 was exceeded back on April 29. The index clearly could reach our 2021 year-end target of 3500 well ahead of schedule too. As you know, Joe and I are increasingly of the opinion that we are in a meltup situation that could set the stage for a meltdown. It’s hard to call this market. Ask us again when and if the S&P 500 gets to 3500. We’ve been rooting for a consolidation around 3000 (plus/minus 100) in the market’s gains, but the market isn’t listening to us. The bottom line is that we remain bullish but are worrying that a meltup could be followed by a meltdown.

The stock market is clearly accentuating the positives and ignoring the negatives, for now. A very important set of positive developments is that industry analysts have been cutting their revenues and earnings estimates for this year and next year at slower paces in recent weeks (Fig. 6 and Fig. 7). As a result, S&P 500 forward revenues bottomed during the May 28 week, and has been up each of the past seven weeks through the July 16 week by 2.0% (Fig. 8). Similarly, forward earnings bottomed during the May 15 week, and has been up every week since then.

 US Politics I: Progressive Task Force. On Tuesday, Melissa and I reviewed some of the key policy proposals outlined on Joe Biden’s webpage titled “Joe’s Vision for America.” We also reviewed an analysis by the Tax Policy Institute of Biden’s tax proposals. If enacted, they would amount to the biggest tax increase in American history.

It is unclear how many of the policies now listed on Biden’s website would make it into the administration’s official agenda, but many overlap with recommendations detailed in the “Biden-Sanders Unity Task Force Recommendations“ released on July 8. After Biden won as the Democratic presidential nominee on a centrist platform over Bernie Sanders (I-VT), a self-proclaimed “democratic socialist,” the duo combined forces to create their Unity Task Force, and this document sets out its policy recommendations for a Biden presidential administration.

The recommendations suggest that Biden is aiming to appeal to a more progressive left audience than he did during the Democratic primaries. The task force document is a blatant push for bigger government and more public spending than seen in decades. Sanders told MSNBC that the task force document’s policies, “if implemented, will make Biden the most progressive president since FDR.” But he hasn’t moved as far left as some task-force members would like to see him. Here’s more:

(1) To the left. Several of the task-force contributors stand far to the left. Some have a history of promoting socialist ideals. Six smaller groups compose the larger task force that devised the policy recommendations.

Co-chairing the committees on climate change, a cornerstone of the Biden campaign, are Representative Alexandria Ocasio-Cortez (D-NY)—a.k.a. AOC—and former Secretary of State John Kerry (D). Former Obama administration Attorney General Eric Holder holds a seat on the criminal justice committee. On the “stronger, fairer” economic committee are Jared Bernstein, former Obama administration Chief Economist and official at the liberal Economic Policy Institute, and Stephanie Kelton, Modern Monetary Theory advocate. The American Federation of Teachers union’s president, Randi Weingarten, is an education contributor. Contributing on “universal healthcare” policy is Abdul El-Sayed, a former medical doctor and second-place candidate in Michigan’s 2018 Democratic gubernatorial primary election, endorsed by Sanders and AOC.

(2) Not so far, yet. While the task-force policies don’t include some of the more progressive policies previously proposed by some contributors, the recommended steps suggest a clear left direction. Notably absent are the federal job guarantee that Kelton wants to see (see our July 8 Morning Briefing for more), the Green New Deal (AOC), and Medicare for All (Sanders). But there is a massive push for public job creation and fair labor standards, an extensive climate change agenda, and a healthcare plan that is closer to Sander’s than Biden supported during the Democratic primaries, as a July 12 Washington Post article discussed. While the group wouldn’t defund the police, it does advocate for federally funding an unarmed first-responder civilian corps.

US Politics II: Task-Force Crib Sheet. The task force’s stated mission is to “use federal resources and authorities across all agencies to accelerate development of a clean energy economy and deploy proven clean energy solutions; create millions of family-supporting and union jobs; upgrade and make resilient our energy, water, wastewater, and transportation infrastructure; and develop and manufacture next generation technologies to address the climate crisis right here in the United States.” Scattered amid impassioned rhetoric within the 110-page document are the key policy proposals. Please see our three-page summary of the progressive proposals.

Disruptive Technology: Killer Turbines? The Biden-Sanders program promises a clean-energy future. For example: “To reach net-zero emissions as rapidly as possible, Democrats commit to eliminating carbon pollution from power plants by 2035 through technology-neutral standards for clean energy and energy efficiency. We will dramatically expand solar and wind energy deployment through community-based and utility-scale systems. Within five years, we will install 500 million solar panels, including eight million solar roofs and community solar energy systems, and 60,000 made-in-America wind turbines.”

That’s great. However, we should beware of unintended consequences, which always seem to pop up when the government fixes our economy. I asked Jackie to investigate whether anyone is looking into the unintended consequences of building so many wind turbines. Here is her report:

Wind energy is the fastest-growing source of renewable energy in the US, with 300.1 billion kilowatt hours (kwh) generated last year, up from 5.6 billion in 2000. As a result, wind turbines produced more energy than any other renewable source, including hydroelectric (273.7 billion kwh), solar (72.2 billion kwh), and biomass (58.4 billion kwh), according to the US Energy Information Association.

Less discussed than the amount of energy wind turbines are producing these days is the impact they are having on the environment as they do so, particularly on birds, bats, and bugs. Wind turbines are certainly cleaner than traditional power plants require, but they do kill winged creatures that cross paths with their giant blades, which can reach more than 300 feet into the sky. Let’s take a look at the dark side of green energy:

(1) Flying into trouble. A big impediment to understanding how problematic wind turbines are is the lack of definitive data on the numbers of birds, bats, and bugs affected. The US Fish & Wildlife Service website, which was updated in 2018, estimates that bird/turbine collisions killed between 140,000 and 500,000 birds per year. As the number of turbines increases, the agency predicts that the mean number of bird deaths by turbines could reach 1.4 million annually. The American Wind Energy Association estimates that there are 328,000 birds killed by turbines annually, a small fraction of the 2.5 billion birds killed annually, according to its website (bigger threats are cats, which kill roughly 2.4 billion birds a year, followed by building windows, automobiles, and power lines).

While wind turbines don’t endanger most bird populations, there is concern about their impact on the populations of hawks, falcons, and eagles. Those birds are slow to mature and reproduce, and some populations were in decline before wind turbines proliferated. Steps can be taken to mitigate the impact of wind turbines, according to the US Fish & Wildlife Service, including building them away from birds’ migratory routes or building them smaller so they don’t interfere with birds’ flight zones—but that would reduce the amount of energy they generate.

(2) Bats crashing too. While the thought of bats flying into turbine blades doesn’t elicit the same emotional response as that of birds meeting with the same fate, bats are important members of the ecosystem because they consume insects and act as pollinators. The bat population was already under stress before wind turbines popped up, owing to disease, pesticides, and habitat destruction. Wind turbines exacerbate the population’s situation, threatening migrating bats in particular, such as the hoary bat, eastern red bat, and silver-haired bat, a 2019 report by the National Wildlife Federation stated.

An oft-cited 2013 study published in the Wildlife Society Bulletin by K. Shawn Smallwood estimated that there are 880,000 turbine-related bat deaths annually. Bats may be attracted to wind turbines because insects that the bats eat gather around turbines, but some simply fly into turbines during their annual migration.

The notion of bats crashing into wind turbines may be counterintuitive, as bats are known to be exceptional navigators owing to their echolocation abilities. They “see” by sending audio signals into the air and react when the signals bounce off objects. But that process may not leave time enough to avert a turbine’s fast-moving blades. And even if a bat doesn’t physically hit a blade, the air pressure generated by the moving blade can collapse the bat’s ear canals and lungs, causing instant death, explained a 2015 paper by University of Massachusetts students dubbed “Wind Turbines or Giant Bird Blenders?”

A study by Sweden’s University of Lund suggested that bat deaths in Sweden could be reduced if wind turbines stopped operating for at least 10 nights between June 15 and September 15, according to a May 10, 2017 article in Engadget. Because the wind blows more slowly during those months, only 1% of total output would be cut. The National Wildlife Federation suggests changing wind turbine speed to mitigate the problem, particularly during times of migration. Acoustic deterrents and ultraviolet illumination of turbines are also being studied.

(3) A pesky problem. The declining population of insects in general—and honeybees in particular—has captured scientific and general news headlines. Bees are of utmost importance due to their role in crop pollination. Most scientists attribute the population decline of insects to the increase of urbanization, farmland, pesticides, and disease. Wind turbines could be having an impact too.

Roughly 1.2 trillion insects per year may be killed by German wind farms, a number large enough that it could affect insect population stability, concluded a 2018 German study cited in a June 26, 2019 Forbes article. The study based its conclusions on literature about insects and calculations about the number of insects that would pass through wind turbine blades. Because insects migrate, bugs that travel through Germany from other countries in Europe and Africa could be affected.

Conversely, a researcher in Poland reported last year that bees near a wind farm were not affected. One group of honeybees was placed near a wind farm, and another group was placed 11 kilometers away from the farm. After watching them for two years, the researcher didn’t notice any negative effects in the group near the windfarm; in fact, they produced more honey.

Another Polish study done in 2014 found the area surrounding wind turbines “supported equal species richness, diversity and abundance of pollinating insects” as exists in grasslands and better richness, diversity, and abundance than in farm land. The researchers attributed the disparity to a greater diversity of weeds near the windmills than the farms, creating “biodiversity hot spots.”

(4) Bigger picture. Beyond the deaths of birds, bats, and bugs, humans may want to consider the overall impact wind turbines are having on the broader environment. A study recently found that most birds avoided flying into a wind farm in India. But because the birds no longer flew around the wind farm, the lizards the birds used to eat no longer had a predator. Without a predator, the lizard population increased. The lizards, however, were skinnier and less colorful than the same lizards living elsewhere. That’s because the larger lizard population near the wind farm had to compete harder to secure food. There were more lizards, but not more food.

“[W]ind farms can create a cascade of unintended effects within an ecosystem by essentially acting like top predators,” a November 14, 2018 Scientific American article concluded.

Clearly, more study is called for to better understand the myriad impacts of wind turbines on nature; it’s somewhat concerning that wind farms are sprouting up before scientific conclusions are reached. Rightly or wrongly, scientists seem to be concluding that a wind farm is less destructive to the environment than the coal- or gas-fired power plant that might have otherwise been built.

In one case we know of, however, the cart isn’t being put before the horse. A study of bugs, birds, and bats is being done prior to the construction of a proposed wind farm by scientists at the University of Wyoming. They now have baseline data and can return to study the area after the wind farm is built … if their project is funded.

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A Billion Here, A Trillion There

July 22 (Wednesday)

Strategy I: No Shortage of Liquidity. Asset prices around the world are melting up. It isn’t just stock prices that are soaring. It’s also the prices of inflation-protected bonds. Precious metals prices are moving higher too. Home values are appreciating as well. Some of these bullish trends may be driven by expectations that the billions of dollars being spent on a vaccine will pay off. Undoubtedly, the main reason for the widespread bull markets in assets is the fact that governments around the world are spending and printing trillions of dollars, euros, yen, and yuan to offset the economic shock from the Great Virus Crisis (GVC). Consider the following:

(1) Vaccines. Typically, it takes roughly a decade for a new vaccine to go through the various stages of development and testing. However, the urgency of the pandemic, which has killed more than 600,000 people worldwide, has resulted in a mobilization of global medical resources rarely seen before in human history. Billions of dollars, provided by both the public and the private sectors, are funding the global campaign to develop tests, vaccines, and cures for the virus.

For example, the Trump administration has launched “Operation Warp Speed” with the goal of delivering 300 million doses of a safe, effective vaccine for COVID-19 by January 2021, as part of a broader strategy to accelerate the development, manufacturing, and distribution of COVID-19 vaccines, therapeutics, and diagnostics. Congress has directed almost $10 billion to this effort through supplemental funding, including the CARES Act.

More than 100 clinical trials of dozens of potential coronavirus treatments are already underway around the world. Yesterday, we learned that the early trial results for two vaccine candidates—one developed by the University of Oxford and AstraZeneca and the other by the Chinese company CanSino Biologics—showed that both were safe and could induce immune responses in participants. But the next phase will be critical to demonstrate that the potential vaccines can protect against infections.

For the Oxford-AstraZeneca and CanSino vaccine candidates, the next step in testing is known as “Phase Three” of human clinical trials. It’s in this stage that scientists will be able to see whether a potential vaccine truly works to prevent coronavirus infections. The newly released clinical trial results showed that the Oxford-AstraZeneca vaccine candidate triggered the production of both antibodies and T cells, which can recognize and attack virus cells.

(2) EU ups the ante. On April 9, Eurozone finance ministers agreed on a new coronavirus stimulus package worth €540 billion, but couldn’t agree on a crucial decision: whether to issue joint debt instruments, called “corona bonds,” that would combine debt securities from the 19 Eurozone countries. Germany and the Netherlands, traditionally more fiscally conservative than Italy and Spain, were holdouts.

Yesterday, a new agreement was reached authorizing the European Commission (EC), the executive arm of the European Union (EU), to create a €750 billion recovery fund, which will be distributed among the countries and sectors most impacted by the coronavirus pandemic, and will take the form of grants and loans.

The new deal means that the EU will become a major borrower in global financial markets for the first time. It plans to repay the money by 2058. Nevertheless, the EC intends to propose new taxes on financial transactions and fines on greenhouse gases released by companies. Tech companies can also expect a “digital levy.”

(3) ECB is on the case. Undoubtedly, some of the new bonds will be purchased by the European Central Bank (ECB), which is currently buying government bonds as part of its Pandemic Emergency Purchase Program (PEPP), which totals €1.35 trillion. The PEPP started on March 18 with a commitment to make €750 billion in open-ended asset purchases. It was expanded on June 4 by €600 billion.

The ECB’s balance sheet has soared by €1.62 trillion since the week of March 13 through the July 17 week (Fig. 1). Securities held for monetary purposes rose €552 billion during that period.

(4) Japan writes a blank check to fight the virus. In Japan, Prime Minister Shinzo Abe’s government has rolled out combined stimulus spending worth ¥234 trillion ($2.2 trillion); that boosts its annual budget spending to ¥160 trillion, with new debt issuance totaling ¥90 trillion. To cushion the economic fallout from the virus, the new stimulus programs include handouts to 126 million residents of ¥100,000 (just under $1,000) each.

Yesterday, Finance Minister Taro Aso said that the Japanese government’s budget won’t set a spending cap on requests aimed at fighting the COVID-19 pandemic for the fiscal year that begins in April 2021. The budget ceiling is usually set around mid-year by the Finance Ministry to keep tabs on spending requests from ministries for next year’s budget, to be compiled in December.

The government would ask ministries to keep requests for other spending in line with the current fiscal year’s initial budget totaling a record ¥102.7 trillion, Aso said at a Cabinet meeting. The government then would set aside an unspecified amount of budget requests to respond to “urgently needed expenses” to battle the fallout from the coronavirus.

(5) BOJ is on the case. The Minutes of the June 15-16 Monetary Policy Meeting of the Bank of Japan (BOJ) was released on Monday. After easing monetary policy in March and April, the BOJ kept policy settings unchanged and maintained its view that the economy will gradually recover from the damage caused by the pandemic. The BOJ’s balance sheet has soared by ¥64 trillion ($600 billion) since February, through June (Fig. 2).

(6) Another CARES package in the US. The CARES Act was passed on March 27. It provided $2.2 trillion in various short-term support payments as state governors issued stay-in-place executive orders to slow the spread of the virus. It was widely expected that they would gradually lift these restrictions in a few weeks, reopening the economy. The first round of support payments is running out for many households and businesses, while the reopening of the economy has been slowed by rapidly rising cases.

On Monday, congressional lawmakers returned from their recess and started working on a second relief package. They are under pressure to come up with something this week. Though the CARES Act allows the $600-per-week federal boost to state unemployment insurance to be paid through July 31, most states’ weekly benefits are based on a cycle that ends on a Saturday or Sunday, making this week the last one that recipients will get that extra money unless lawmakers intervene fast.

(7) The Fed is on the case. The US federal budget deficit totaled a record $3.0 trillion during the 12 months through June (Fig. 3). After the CARES Act was passed, the Congressional Budget Office (CBO) estimated that it would total $3.7 trillion this year. The CBO may have to add another $1 trillion to $2 trillion to its estimate if the economic recovery stalls and if Congress passes CARES Act II.

No problem: We are all MMTers now! We all believe in the magic of Modern Monetary Theory, which Melissa and I described as a big power grab by Big Government in the July 8 Morning Briefing. In response to the GVC, the Fed embraced the theory and its practice on March 23 with its programs of QE4Ever and No Asset Left Behind (NALB). The Fed already has financed more than half of the currently projected FY2020 federal budget deficit by purchasing $2.1 trillion in Treasury securities over the past year through the July 15 week (Fig. 4).

Among the biggest proponents of MMT are former Fed Chairs Ben Bernanke and Janet Yellen. Last month, they signed a public letter from more than 150 economists that called on Congress to pass another big spending bill to extend and broaden the CARES Act. In a joint July 17 blog post, they commended the Fed’s response to the pandemic: “Broadly speaking, though, the Fed’s response has been forceful, forward-looking, and comprehensive.” In other words, Fed Chair Jerome Powell did what they would have done. We guess that they’ve provided Powell lots of advice in recent months, which he acted upon.

What about the federal deficit? Bernanke and Yellen are all in on MMT: “Following our advice would further increase the already record-level federal budget deficit. With interest rates extremely low and likely to remain so for some time, we do not believe that concerns about the deficit and debt should prevent the Congress from responding robustly to this emergency. … [A]t some point, we will have to think through how to ensure the long-run sustainability of federal finances. The top priorities now, however, should be protecting our citizens from the pandemic and pursuing a strong and equitable economic recovery.”

Read that excerpt again and think about it. Contrarians should be alarmed. What could possibly go wrong with this who-cares-about-deficits approach? ? Well, let’s see: i) inflation might make a surprising comeback; ii) bond yields might rise; and iii) if the Fed imposes yield-curve control to put a cap on the bond yield, the dollar might take a dive, which could boost inflation.

(8) The PBOC is on the case. The People’s Bank of China (PBOC) continues to flood the Chinese economy with more and more credit during the GVC, as it has ever since the Great Financial Crisis (GFC). Over the past 12 months through June, social financing totaled a record $4.5 trillion, led by a record $2.7 trillion in bank loans (Fig. 5 and Fig. 6). Bank loans are up a whopping $18.9 trillion to a record $23.3 trillion from $4.4 trillion at year-end 2008, when the government started to respond to the GFC with massive credit expansion (Fig. 7).

(9) Bottom line is a bottomless pit. As we noted at the start of this commentary, a billion here, a trillion here and there add up to serious money. With the help of MMT, government deficits are a bottomless pit. If they can be financed so easily with easy money without boosting inflation, why do we bother collecting taxes? I would be a big advocate of MMT if my taxes were cut to zero. Let’s give it a try! Why not? Anything is possible in the Twilight Zone.

While MMT hasn’t boosted inflation as measured by consumer prices, so far, it certainly is boosting asset inflation, potentially fueling the Mother of All Meltups (MAMU), which potentially could set the stage for the Mother of All Meltdowns (MAMD).

Strategy II: Liquidity Has Consequences. The total assets of the Fed, the ECB, and BOJ are up $4.9 trillion since the March 13 week through the July 10 week (Fig. 8). They are up $5.8 trillion y/y. The bullish impact on all sorts of assets has been dramatic:

(1) Stocks. By lowering the yield curve to zero at the short end and below 1.00% at the long end, the Fed has forced investors to rebalance out of bonds and into stocks. No wonder that the forward P/E of the S&P 500 soared from a recent low of 12.9 on March 23 to 22.0 at the end of last week (Fig. 9). This series is very highly correlated with the size of the Fed’s balance sheet!

Leading the charge has been the forward P/E of the FAANGM (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft) stocks. It jumped from 26.1 during the week of March 20 to 41.0 during the July 17 week, as their market share rose from 22.4% to 24.9%. (See our FAANGM chart books, which is automatically updated.)

Other stock markets around the world have had similar P/E-led rebounds since March 23, though their valuation multiples remain below that of the US MSCI stock price index, mostly because of the high valuation and market-cap share of the FAANGMs, as we discussed in the “Stay Home or Go Global?” story in the July 20 Morning Briefing.

(2) Bonds & gold. The 10-year TIPS yield dropped to -0.84% on Monday (Fig. 10). That’s down from 0.25% a year ago and the lowest since December 11, 2012. This yield is inversely correlated with the price of gold, which rose 54% from a low of $1,178.40 per ounce during August 2018 to $1,815.65 on Monday.

(3) Home prices. Record-low mortgage rates and “deurbanization,” attributable to people seeking homes away from densely populated cities, have combined to boost the demand for single-family homes. The supply of such dwellings has tightened up as homeowners in the sought-after suburban and rural locations are staying put. Debbie and I like to track the yearly percentage changes in median and average existing single-family home prices (Fig. 11). The former is up 6.0%, while the latter is up 4.4% through May. We expect that both series soon will show higher home price appreciation rates.

(4) Commodities & foreign currencies. The Goldman Sachs Commodity Index (GSCI) is up 29% since March 23 through July 20 (Fig. 12). The index is heavily weighted with oil and petroleum products. The CRB raw industrials spot price index is up 2% since March 23 through July 20, led by a 37% increase in the price of copper.

The GSCI is highly inversely correlated with the trade-weighted dollar, which is down 5.7% since March 23. The enormous fiscal and monetary policy stimulus provided by governments around the world could revive global economic growth if progress is made in combating the virus. Better global economic growth would be reflected in further gains in commodity prices and weakness in the dollar, i.e., strength in foreign currencies.

In this scenario, the dollar could really get whacked if the Fed stops US bond yields from rising by implementing yield-curve control.

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Meet the New, Improved Joe Biden

July 21 (Tuesday)

US Economy: ‘V’ Is for ‘Victory’—But Also ‘Virus.’ As the US economy recovered during May and June from the prior two months’ lockdown recession, some key economic indicators traced out V-shaped recoveries. That’s the good news. The bad news is that so-called “Covidiots” have interpreted the lifting of lockdown restrictions as license to gather rather than distance.

In the March 25 Morning Briefing, I first promoted containing the spread of the virus by mandating the wearing of face masks in public as an alternative to lockdowns. I expected that after being forced to stay in place for a few weeks, we would all see mask-wearing as a small price to pay for mobility and an open economy. But I was wrong. Too many of us are breathing in each other’s faces and spreading the virus in public places such as bars and beaches. Many are teens and young adults, who figure that COVID-19 wouldn’t likely kill them anyway. They seem unconcerned about the high risk of asymptomatic spread to more vulnerable older people or the fact that more and more younger people are getting sick enough to require hospitalization.

Unfortunately, President Donald Trump has chosen to ignore my advice. I reached out to my friends in the White House a couple of times in recent weeks explaining why the President should issue an executive order requiring wearing masks in public. Last Tuesday, Dr. Robert Redfield, director of the Centers for Disease Control and Prevention, said the US could get the coronavirus pandemic under control in one to two months if every American wore masks in public. That makes sense to me. It would allow the reopening of the US economy to continue and would be very bullish for stocks. It would buy us more time, without another round of lockdowns, to develop vaccines. The President’s chances of winning a second term in office would be greatly increased if the economy continued to recover, confirmed by rising stock prices. If the economic recovery falters because the virus continues to spread uncontrollably around the country, Trump will surely be a one-term president.

Indeed, Trump seems to be doing his best to associate his handling of the pandemic with defeat rather than victory in the war against the virus. Not only has he refused to take a stance on masks but he also has changed hospital data-reporting procedures, impairing the dissemination of hospital-capacity data, and he is seeking to block funds for coronavirus testing and contact-tracing.

BREAKING NEWS: At 3:43 pm yesterday, just as we were finishing writing this commentary and just before the stock market closed, Trump offered his strongest endorsement yet for wearing face masks in public, tweeting that it is a “patriotic” action to take during the coronavirus pandemic. That’s progress, but an executive order requiring face masks in public would be a stronger message.

Nevertheless, it’s time to consider the possibility that not only will Joe Biden be the next president, but also that the Democrats will have majorities in both houses of Congress. Before we go there, let’s review the V-shaped recovery so far, which could give way to a W-shaped one if we don’t stop the exponential spread of the virus in many parts of the country:

(1) Retail sales. Remarkably, retail sales jumped 27.0% during May and June after falling 21.7% during March and April (Fig. 1). Retail sales is only 1.0% below its record high during January and is at a record high excluding gasoline service station sales. This certainly helps to justify the stock market meltup since March 23 (Fig. 2). Actually, the strength isn’t so remarkable in light of the extraordinary amount of government stimulus provided to offset the economic damage caused by the lockdowns.

(2) Earned income, government benefits, and saving. While wages and salaries in personal income fell sharply by $1.1 trillion (saar) in March and April, government social benefits in personal income soared by $3.1 trillion (Fig. 3 and Fig. 4). Because so many stores and restaurants were closed, most of the stimulus boosted personal saving from $1.4 trillion during February to a record-breaking $6.0 trillion during April, followed by $4.1 trillion during May (Fig. 5).

When lockdown restrictions were eased in May and June, wages and salaries rose along with the 7.5 million increase in payroll employment during those two months, which should be confirmed when June income data are released on July 31. That combined with the pile of savings fueled the V-shaped recovery in retail sales.

(3) So, what’s next? While the weekly gasoline usage data series that Debbie and I follow has continued to recover nicely since the week of April 24 through the July 10 week, retail sales could run out of gas if the employment rebound stalls, as a result of another round of virus-related lockdowns, just as the $600-per-week in federal jobless benefits expires at the end of July. There are already signs of a slowdown in the recovery that was stimulated by government support payments. For example, weekly data on consumer credit- and debit-card spending have been stalling in July so far (Fig. 6).

The government’s policymakers timed the stimulus benefits to end when they expected that the easing of lockdown restrictions would be reviving employment. Instead, the worsening of the pandemic in the US is likely to cause Washington to provide yet another round of stimulus. Now let’s move on to recent political developments that could potentially be very unhealthy for the economy and unsettling for the stock market.

 US Politics I: Left Full Rudder. Democratic presidential candidate Joe Biden is widely believed to be a centrist in the Democratic party. That doesn’t mean much since his party continues to move to the left, dragging centrists including Biden along. How far Biden has moved to the left should become clearer over the next few weeks, after he names his running mate and presents his acceptance speech at the Democratic National Convention on August 17. Until then, we can look to Biden’s official campaign website and the report recently released by his policy task force—which we will discuss at length on Thursday—for his agenda.

Melissa and I doubt that Biden would turn the nation’s rudder hard to the left as soon as he took the helm; he’d more likely start with a less extreme left full rudder. But that would be a radical change from the course pursued by the current administration. A radical policy change early next year could put the economy on a rocky path, perhaps causing a double-dip W-shaped scenario.

Wherever the specifics of Biden’s policy agenda settle, it’s clear that his approach favors big government, i.e., making direct investments in infrastructure and jobs as opposed to incentivizing the private sector to promote growth, as the Trump administration has done. Biden’s team also emphasizes climate change.

Biden envisions a clean energy future where corporate polluters would be jailed, workers would unionize, and city dwellers would ride bikes and other zero-emissions modes of transportation. Investments in infrastructure and workers would be made to benefit low-income communities.

On the other hand, Biden would likely carry Trump’s torch when it comes to preventing China from overtaking the US as global technology leader, albeit using different tactics. Here’s more on Biden’s top three policy priorities per his campaign website:

(1) Climate first. Biden’s website promotes “environmental justice” and greater economic equality. Corporate executives who exacerbate environmental injustice would be held personally accountable and subject to jail time.

To achieve better water and air quality in underprivileged communities, Biden would take an “all-of-government” approach, creating new and combining existing White House departments. Departments that would be prioritized include the US Department of Justice, Environmental Protection Agency, Department of Health and Human Services, Occupational Safety and Health Administration, and the Centers for Disease Control and Prevention.

COVID-19 and other infectious diseases would be deemed “climate disasters.” Poor conditions in low-income communities created at the hands of corporate polluters have exacerbated COVID-19, the plan claims.

(2) “Build back better” (BBB). Biden aims to achieve “net-zero emissions, economy-wide, by no later than 2050” with a “$2 trillion accelerated investment” in infrastructure. New “sustainable jobs” would be created to build roads and bridges, green spaces, water systems, electricity grids, universal broadband, and zero-emissions public transit systems.

Fair labor standards would be emphasized for those put to work on this plan. Companies receiving procurement contracts would have to commit to “pay at least $15 per hour, provide paid leave, maintain fair overtime and scheduling practices, and guarantee a choice to join a union and bargain collectively.”

Specific components of the BBB plan include: i) 1 million new jobs for the US auto industry to create clean-vehicles zero-emissions public transportation options for major US cities; ii) a carbon-pollution-free power sector, powered by solar and wind energy by 2035; iii) energy-efficiency upgrades for 4 million buildings and 2 million homes, construction of 1.5 million sustainable homes and housing units; and iv) reduction of costs for critical clean energy technologies to be made in America.

Enhanced public transport options would spark “the second great railroad revolution.” All new American-built buses would have zero-emissions by 2030. Infrastructure would be built for pedestrians, cyclists, and micro-mobility vehicles like e-scooters.

(3) Made in America. Biden’s administration would promote buying, making, innovating, and investing in America. Aggressive trade enforcement actions would be taken “against China or any other country seeking to undercut American manufacturing through unfair practices.”

Biden’s main Made-in-America goal is to prevent China (by way of the “Made in China 2025” plan) from overtaking the US on R&D (by way of direct federal R&D investments). China’s efforts to steal American intellectual property would be confronted by an international allied response. The plan would also bring back critical supply chains that produce critical goods from China and other countries, leveraging the Defense Production Act and starting with a 100-day supply chain review.

Each Made-in-America initiative is tied to specific investments and incentives, including: Buy America ($400 billion procurement investment in clean vehicles, materials, medical supplies, and technologies with at least 23% of federal contracts awarded to American small business), Make It in America (incentives and low-cost credit for manufacturers), and Innovate in America ($300 billion investment in R&D for breakthrough technologies from electric vehicles to lightweight materials to 5G and artificial intelligence). Biden would eliminate tax incentives for pharmaceutical and other companies to move production overseas.

 US Politics II: The Taxman Cometh. The Tax Policy Center (TPC) analyzed the revenue and distributional effects of Biden’s 2020 campaign tax proposals in a March 5 document based on information released by the Biden campaign and conversations with its staff as of the end of February.

TPC notes: “Biden would increase income and payroll taxes on high-income individuals and increase income taxes on corporations. He would increase federal revenues by $4.0 trillion over the next decade. Under his plan, the highest-income households would see substantially larger tax increases than households in other income groups, both in dollar amounts and as a share of their incomes.”

Here are the report’s highlights:

(1) Individual income and payroll taxes. “High-income taxpayers would face increased income and payroll taxes. Biden’s plan would roll back income tax reductions from the Tax Cuts and Jobs Act of 2017 (TCJA) for taxpayers with incomes above $400,000. It would also limit the value of itemized deductions for taxpayers in income tax brackets above 28 percent. His plan would tax capital gains and dividends at the same rate as ordinary income for taxpayers with incomes above $1 million and tax unrealized capital gains at death. Biden also would subject earnings over $400,000 to the Social Security payroll tax.”

(2) Business taxes. “Biden’s plan would increase the top corporate income tax rate from 21 percent to 28 percent and impose a 15 percent minimum tax on companies’ book income. The plan also would double the existing minimum tax on profits earned by foreign subsidiaries of US firms, raising it from 10.5 to 21 percent.”

(3) Tax expenditures. “Biden’s plan would reduce tax expenditures for investments in fossil-fuel production and commercial real estate. It would also provide additional tax credits for investments in electric vehicles, renewable energy, and energy-efficient technologies as well as tax benefits for family caregiving, student loans, and childless workers age 65 and older. His plan would make tax incentives for retirement saving more progressive by replacing the deduction for traditional individual retirement account (IRA) and defined-contribution pension plan contributions with a refundable tax credit as well as by automatically enrolling most workers without pensions in IRAs.”

(4) Distributional effects. “Biden’s spending proposals would have important distributional and economic effects. Those proposals include changes to Social Security benefits, federal financial aid for postsecondary students, and housing assistance as well as creating a public insurance option for Affordable Care Act Marketplaces.”

 US Politics III: The Task Force. Biden’s move to the left of the political spectrum certainly was confirmed by the recently released 110-page Biden-Sanders Unity Task Force Recommendations. Immediately after it was released on July 8, Senator Bernie Sanders (D-VT) predicted that Biden could become the “most progressive president” since Franklin D. Roosevelt.

The task force’s stated mission is to “use federal resources and authorities across all agencies to accelerate development of a clean energy economy and deploy proven clean energy solutions; create millions of family-supporting and union jobs; upgrade and make resilient our energy, water, wastewater, and transportation infrastructure; and develop and manufacture next generation technologies to address the climate crisis right here in the United States.” Scattered amid impassioned rhetoric within the document are the key policy proposals. We will review them on Thursday.

Strategy: Blue Wave Winners & Losers. Biden has emerged as a polling favorite over Trump for the 2020 presidential race despite running a relatively low-profile campaign that hinges on Trump’s self-destructing. With the continued spread of COVID-19, its resulting economic burden, and unfavorable public perceptions of Trump’s management of the fallout, his campaign has some serious PR work to do. But even if Biden wins, his policies might not make it very far unless the Democrats win a majority in the Senate while keeping their majority in the House.

That’s possible, according an article in the 7/14 Washington Post: “Democrats need to net four seats total in November’s election, or they need to net three and for Democrats to win back the White House, which would allow the vice president to cast tie-breaking votes.” It added: “But Democrats will probably also have to win in at least one state that has traditionally been difficult for them at the Senate level, such as Georgia or Iowa.”

 If a Democratic sweep occurs, increased corporate taxes and regulations are likely to follow. Corporate costs could significantly increase from higher labor standards, including a higher minimum wage. Corporations benefited greatly from President Trump’s tax cuts, but that likely would change under a Biden administration. Investors and wealthy Americans could see higher taxes under a Biden administration too.

To make the best of what might not be a good outlook for the stock market in this scenario, investors might start looking at building a “Biden Blue portfolio” that focuses on areas where public investment would be great. Here’s more on the likely winners and losers in the event of a blue Election Day sweep:

(1) Pockets of winners. Winners in a blue wave likely would be domestic energy-efficient technologies (e.g., wind and solar), railroads, homebuilders, building contractors, and engineers, manufacturers and material suppliers, broadband network providers, utilities, autos, medical suppliers, and innovative technologies (e.g., artificial intelligence). Pot stocks, too, would benefit from the federal decriminalization of marijuana.

(2) Industry losers. Industries that could suffer in a blue sweep include airlines and aerospace, pharmaceuticals, and healthcare. The airline industry would be particularly challenged by the Biden emphasis on emissions standards. Air pollution is mentioned plenty of times in the task force document, as are energy-efficient railroads and buses; but airlines would not benefit from public spending and probably would suffer from higher regulations. US-based multinational pharmaceutical companies might see costs increase if they are forced to move supply chains to the US and would likely be pressured to reduce drug costs to consumers. Private healthcare companies would take a profits hit if the Biden administration expanded upon a public healthcare option. Frackers could lose out severely to green energy technologies.

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US-China Cold War Heating Up

July 20 (Monday)

Geopolitics I: Declarations of War. China’s mercantilist trade war against the US effectively started when China joined the World Trade Organization (WTO) on December 11, 2001. The US supported China’s admission to the WTO, expecting that China would abide by the organization’s rules, which mostly promoted free trade among its 144 member nations back then. (There are 164 members currently.) Instead, the Chinese abused their membership by pursuing mercantilist trade policies. They persistently and systematically violated the organization’s trade rules by using their WTO status to unfair advantage.

However, US officials didn’t publicly acknowledge that the US had been duped until Donald Trump became president. During the presidential election campaign, Trump often promised to take effective measures to correct America’s huge bilateral trade deficit with China. He called China one of the “greatest currency manipulators ever.” He declared that he would instruct the Treasury Department to so label China when he became president.

On April 13, 2018, the Treasury Department, in its biannual currency exchange report, scolded China for its lack of progress in reducing the trade deficit with the US but did not find that it was improperly devaluing its currency, the renminbi. Actually, it was the third time since Trump assumed the presidency that the Treasury Department opted not to accuse China of improper meddling. Instead, the administration opted for tariffs as an alternative means to pressure the Chinese to fix the trade problem.

By the way, previous administrations recognized the problem, but chose a less public and lower-key diplomatic approach to get China to change its ways. For example, to kick-start negotiations to resolve the problem, the Clinton administration slapped the “currency manipulator” label on China in 1994. That was well before China was admitted to the WTO.

In other words, the problem has been festering for a very long time indeed. The US merchandise trade deficit with China was $29.5 billion in 1994 (Fig. 1). Even back then, it was almost 20% of the total US trade deficit (Fig. 2). By 2018, it was up to $419.0 billion, accounting for 48% of the total trade gap.

Let’s briefly review the escalating tensions in the Cold War between the US and China, before we get to the latest declaration of a cold war by US Attorney General William P. Barr:

(1) Peter Navarro is still Trump’s China hawk. Unlike most of President Donald Trump’s early-term advisers, Peter Navarro is still in the White House. Melissa and I profiled him in our March 8, 2018 Morning Briefing, fittingly titled “Meet Peter Navarro.” We wrote that “the White House director of the National Trade Council seems to be gaining influence and may even be up for a promotion.” Sure enough, he since has been promoted to assistant to the President, Director of Trade and Manufacturing Policy, and the national Defense Production Act policy coordinator.

Navarro long has been a critic of China’s mercantile trade practices. In fact, he literally wrote the book on this subject in 2011, fittingly titled Death by China: Confronting the Dragon—A Global Call to Action. Here is an excerpt from the book’s Amazon description: “The world’s most populous nation and soon-to-be largest economy is rapidly turning into the planet’s most efficient assassin. Unscrupulous Chinese entrepreneurs are flooding world markets with lethal products. China’s perverse form of capitalism combines illegal mercantilist and protectionist weapons to pick off American industries, job by job. China’s emboldened military is racing towards head-on confrontation with the U.S. Meanwhile, America’s executives, politicians, and even academics remain silent about the looming threat.” Most importantly, above and beyond China’s unfair trade practices, Navarro strongly suggested that China posed an existential threat to America’s national security.

(2) The President’s 2018 UN speech. In his September 25, 2018 speech before the United Nations General Assembly, Trump said the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(3) The Vice President’s 2018 speech. In an October 4, 2018 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s case against China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

The rest of the speech was a no-holds-barred blistering attack on the Chinese government. He accused the Chinese Communist Party (CCP) of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment.” He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence.” He accused China of economic and military aggression abroad. Pence also documented instances of China using so-called “debt diplomacy” to expand its influence. Pence accused the Chinese government of oppressing its own people at home. He stated that the US was taking steps “to protect our national security from Beijing’s predatory actions.”

The S&P 500 plunged 19.8% from September 20 through December 24, 2018. In our October 15, 2018 Morning Briefing titled “Panic Attack #62,” we listed six reasons for the selloff. We included the Veep’s speech: “Also setting the stage for last week’s selloff was a 10/4 speech by Vice President Mike Pence detailing the Trump administration’s long list of complaints against China. It wasn’t just about trade. …. Pence’s speech made it clear that the problem is that China aspires to be a superpower at the expense of the US. While Trump seems to be winning his trade wars with most of America’s major trading partners, the conflict with China is likely to worsen because it isn’t just about trade. It is about national security.”

(4) The President’s 2019 UN speech. In a September 24, 2019 speech at the UN, Trump again called out China, berating Beijing as follows: “In 2001, China was admitted to the WTO. Our leaders then argued that this decision would compel China to liberalize its economy and strengthen protections … for private property and for the rule of law. Two decades later, this theory has been tested and proven completely wrong. Not only has China declined to adopt promised reforms, it has embraced an economic model dependent on massive market barriers, heavy state subsidies, currency manipulation, product dumping, forced technology transfers, and the theft of intellectual property and also trade secrets on a grand scale.”

(5) No Phase 2 to follow Phase 1. After an escalating trade war between the US and China during 2018 and 2019, with both sides raising their tariffs on the other, both parties signed a “Phase 1” trade agreement at the start of this year. It deescalated the trade tensions but left some of the toughest issues for a future Phase 2 deal. While Phase 1 focused mainly on Chinese purchases of US goods, improved US access to China’s financial services market, and some intellectual property issues, Phase 2 was meant to tackle far more difficult issues associated with China’s technology transfer policies, industrial espionage, and government subsidies to state-owned enterprises.

On Tuesday, July 14, Trump shut the door on the next round of trade negotiations with China, saying he does not want to talk to Beijing about trade because of the coronavirus pandemic. “We made a great trade deal,” Trump said, of the Phase 1 agreement signed in January. “But as soon as the deal was done, the ink wasn’t even dry, and they hit us with the plague,” he said, referring to the novel coronavirus, which emerged from the Chinese city of Wuhan.

At the White House, Trump also announced that he signed legislation and an executive order to hold China accountable for the “oppressive” national security law it imposed on Hong Kong. The measure approved by Congress gives Trump’s administration the authority to penalize banks doing business with Chinese officials who implement Beijing’s new national security law on Hong Kong. Trump said he has no plans to talk with Chinese President Xi Jinping.

(6) Pompeo weighs in. In a statement on Monday, July 13, US Secretary of State Mike Pompeo said he was aligning the US position on China’s maritime claims in the South China Sea with the 2016 ruling of an international arbitral tribunal in The Hague. This places the US squarely behind the interests of Vietnam, Malaysia, Indonesia, Brunei, and the Philippines, all of which have serious disputes with Beijing.

 On Thursday, July 16, Pompeo repeated the administration’s charge that the Chinese government “was aware of human-to-human transmission” of the coronavirus “before they shared this with the world.” The day before, he said, “I’m very confident that the world will look at China differently and engage with them on fundamentally different terms than they did before this catastrophic disaster.”

(7) Raising other barriers. The Senate passed legislation on May 15 that could ban many Chinese companies from listing shares on US exchanges or raising money from American investors without adhering to Washington’s regulatory and audit standards. That same day, the Trump administration issued a new rule that will bar Huawei and its suppliers from using American technology and software, a significant escalation in the White House’s battle with the Chinese telecom giant and one that is likely to inflame tensions with Beijing. The rule change, which is slated to go into effect in September, will block companies around the world from using American-made machinery and software to design or produce chips for Huawei or its entities.

On August 15, companies that bid on US federal contracts must certify that they do not use banned products or services from telecom giants Huawei and ZTE, camera makers Hangzhou Hikvision Digital Technology and Zhejiang Dahua Technology, or radio manufacturer Hytera Communications. Washington cites the risk of sensitive information leaking to Beijing.

Taiwan Semiconductor Manufacturing Co. Ltd stopped taking new orders from Huawei in May and does not plan to ship wafers after September 15. On July 14, Britain announced that it would ban equipment from Huawei from the country’s high-speed wireless network, a victory for the Trump administration that escalates the battle between Western powers and China over critical technology.

Last week, reports surfaced that the White House is considering putting TikTok on a blacklist that effectively would prevent Americans from using the popular video app, as one option to prevent China from obtaining personal data via the social media platform.

(8) Japan paying companies to leave China. On July 18, Bloomberg reported that the Japanese government will pay at least $536 million for companies to leave China: “Japan’s government will start paying its companies to move factories out of China and back home or to Southeast Asia, part of a new program to secure supply chains and reduce dependence on manufacturing in China.”

(9) The Attorney General’s speech. On Thursday, July 16, Attorney General William Barr warned that the CCP has launched an “economic blitzkrieg” to topple the US from its perch as the world’s superpower, laying out the threat as the most important issue of this century and calling for the Free World to join together in a “whole of society approach” against it.

“How the United States responds to this challenge will have historic implications and will determine whether the United States and its liberal democratic allies will continue to shape their own destiny or whether the CCP and its autocratic tributaries will control the future,” Barr said during a July 17 speech in Michigan.

In some ways, Barr’s speech was even more blistering than Pence’s speech in 2018. He got personal: “The General Secretary of the Chinese Communist Party, Xi Jinping, who has centralized power to a degree not seen since the dictatorship of Mao Zedong, now speaks openly of China moving ‘closer to center stage,’ ‘building a socialism that is superior to capitalism,’ and replacing the American Dream with the ‘Chinese solution.’”

As Pence had done in his speech, Barr blasted the CCP’s “Made in China 2025” initiative to dominate high-tech industries like robotics and information technology and electric vehicles, which “poses a real threat to US technological leadership.” The 2025 plan is a “state-led, mercantilist economic model. For American companies in the global marketplace, free and fair competition with China has long been a fantasy.” Barr warned that the “ultimate ambition of China’s rulers isn’t to trade with the United States. It is to raid the United States.”

Barr attacked China’s “ruthless crackdown of Hong Kong.” He said that China is as authoritarian now as it was in 1989 when tanks confronted pro-democracy protesters in Tiananmen Square. He criticized American companies that “have come under Beijing’s influence—even at the expense of freedom and openness in the United States.”

Peter Navarro certainly has won the debate over China within the administration, hands down.

Geopolitics II: Good Earth, Bad Dam? At the start of the Great Virus Crisis (GVC), we suggested that the COVID-19 pandemic, which started in China, might turn out to be China’s Chernobyl. We asked the following question: “Could the coronavirus outbreak do to China anything like the Chernobyl nuclear catastrophe did to the Soviet Union—arguably setting the stage for its rapid collapse by manifesting the consequences of incompetency and corruption in a national government?” Our answer: “China’s economy is in much better shape today than was the Soviet Union’s economy before it disintegrated. However, the coronavirus outbreak has the potential to cause a social explosion that could set the stage for the meltdown of the Communist regime.”

We were right about China’s economy; it has bounced back impressively. Real GDP rose 3.2% y/y during Q2, after falling 6.8% during Q1, also on a y/y basis (Fig. 3). On a q/q basis and annualized, real GDP soared 49.7% after plunging 43.0% during Q1. June’s industrial production rose 4.8% y/y after falling as much as 13.5% during both January and February (Fig. 4). Similarly, inflation-adjusted retail sales on a y/y basis rebounded from a low of -20.1% during March to -4.3% during June (Fig. 5). However, exports were flat y/y during Q2, raising an interesting question: Is China ramping up production of export-related goods that end up stored on docks as they await a new overseas home?

In any event, China’s economic rebound and the authoritarian regime’s very effective efforts to contain the COVID-19 virus and stop its spread have averted any social unrest stemming from the pandemic.

Then again, could the Three Gorges Dam on the Yangtze River be China’s Chernobyl? The July 17 Fox News reported: “The second-highest rainfall that's swamped China in more than a half-century has fueled new questions about the world's biggest hydroelectric facility, billed as helping to tame floodwaters. Since last month, at least 141 people have died and around 28,000 homes have been damaged in the Yangtze River region, affecting virtually all of mainland China.” The July 13 Nikkei Asian Review reported that 38 million people have been evacuated on fears that the dam might overflow.

The Three Gorges Dam was completed officially in 2006. Its power operation went online in 2012, and it is one of China’s most expensive and questionable developmental projects. On Twitter #threegorgesdam, there’s lots of chatter about millions of people getting evacuated as a precaution against a possible collapse of the dam, which has been controversial since it was first proposed.

Don’t worry: The July 9 South China Morning Post reported: “The state-owned operator of China’s Three Gorges Dam has moved to quash rumours that the world’s largest hydropower project is in trouble, after images from Google Maps circulated which appeared to show the structure had warped. In a statement on its WeChat social media account, the company said the mammoth Three Gorges Dam on the Yangtze River was in normal working order, with all metrics up to standard, and it was running ‘safely and reliably.’”

The May/June issue of Foreign Affairs included an article by Minxin Pei, Professor of Government at Claremont McKenna College, titled “China’s Coming Upheaval

Competition, the Coronavirus, and the Weakness of Xi Jinping.” He argues that the chances of China’s upheaval have been increased by several of President Xi’s recent actions: i) his decision in 2018 to abolish presidential term limits; ii) his heavy-handed purges of prominent party officials; iii) his suppression of Hong Kong; iv) his implementation of the tightest media censorship since Mao; v) his incarceration of more than a million Muslim minorities; and vi) the over-centralization of economic and political decision-making under his rule.

“The centralization of power under Xi has created new fragilities and has exposed the party to greater risks,” writes Pei. “If the upside of [the] strongman rule is the ability to make difficult decisions quickly, the downside is that it greatly raises the odds of making costly blunders.”

 Strategy: So Stay Home or Go Global? Apparently, China’s stock investors aren’t worrying about the Three Gorges Dam or an upheaval in China. The China MSCI stock price index is up 34.3% since March 23 through Friday’s close (Fig. 6). However, it dropped 4.6% last week after the government adopted measures to slow the pace of gains in what had suddenly become the world’s hottest equity market.

Bloomberg reported that on July 16, Kweichow Moutai Co. stock price fell 7.9%, the most in nearly two years, after the People’s Daily took aim at the high price of the liquor the company makes, saying the alcohol was often used in corruption cases. The company is China’s biggest domestically listed company. “The plunge reverberated across China’s almost $10 trillion stock market, with the SSE 50 Index of the nation’s largest companies sinking 4.6%, its worst decline since early February,” according to Bloomberg.

In any case, China’s MSCI is up 34.3% since March 23, while the US MSCI is up 46.0% since then. Nevertheless, might it be time to Go Global rather than to Stay Home (i.e., underweight rather than overweight the US in a global stock portfolio)? After all, China and a few other Asian economies have done a better job of opening their economies with limited renewed outbreaks of the virus than has the US. The same can be said of Europe. Consider the following:

(1) Outstanding outperformance and outstandingly expensive. From the March 23 low through Friday’s close, the US stock market has significantly outperformed most of those in the rest of the world. Here is the performance derby over this period for the major MSCI stock price indexes in local currencies: US (46.0%), EM (35.8), EMU (34.0), All Country World (ACW) ex-US (31.0), EAFE (28.1), UK (24.4), and Japan (22.9).

As a result, based on forward P/Es, the US MSCI is currently much more expensive (22.4) than the ACW ex-US (16.6) (Fig. 7). The former’s forward P/E typically exceeds the latter’s; its relative P/E averaged 1.17 from 2002 through 2019. But currently, that relative P/E is 1.35, near its record high of 1.47 on April 30 (Fig. 8).

Here are the latest forward P/Es for the major MSCI stock indexes around the world: US (22.4), EMU (17.7), EAFA (17.5), Japan (17.3), Canada (17.1), ACW ex-US (16.6), UK (15.0), and EM (14.8).

(2) It’s those fast-growing FAANGMs again! The reason why the forward P/E spread between the US MSCI and the ACW ex-US has widened is simply that the former has been boosted by the forward P/E of the S&P 500 Growth index, currently at 27.7 (Fig. 9). The FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft) currently have a collective forward P/E of 41.0 and a collective market-cap share of 42% of the S&P 500 Growth index, up from 23.3 and 23%, respectively, since the start of 2017.

Furthermore, the ACW ex-US has been trading, and continues to trade, at a forward P/E relatively near that of the S&P 500 Value index (Fig. 10).

Attention global stock investors: The US MSCI has more “growthier” companies than do other MSCI stock market indexes around the world. Therefore, the former trades like a typical Growth stock, while the latter trades more like a typical Value stock! It’s that simple.

 (3) Bottom line. Joe and I are thinking about recommending Go Global, but for now we still prefer Stay Home. The ratios of the US MSCI to the ACW ex-US MSCI in both local currencies and in dollars remain on solid uptrends that started in late 2010 (Fig. 11). Those uptrends have been fundamentally based on the uptrend in the ratio of the forward earnings of the US MSCI to the ACW ex-US MSCI since late 2008 (Fig. 12). This ratio rose to a record high of 6.39 during the July 10 week, up from 3.28 during the week of November 28, 2008. (See our Style Guide: Stay Home vs Go Global, an automatically updated chart publication.)

Movie. “Washington” (+ + +) (link) is a three-part mini-series about America’s revolutionary military leader who led American forces to win the country’s independence from Great Britain. The entire venture could have easily collapsed but for Washington’s willingness to come out of retirement after the war to serve as the nation’s first president. He was truly the founding father of the American nation. The docudrama extols his achievements while recognizing that he had his flaws. He didn’t always tell the truth, contrary to what kids are taught in school. He had a temper. His checkered relationship to slavery is also fairly presented. King George III described Washington as “the greatest man in the world.” He certainly was back then and remains among the greatest military and political leaders in history.

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Banks Are Winning & Losing

July 16 (Thursday)

Good News: More of It. More Americans may be getting chills and fevers, but more of us are chillin’ on the open road again too. While the COVID-19 case count is making record highs, so is gasoline usage in the US. The four-week average bottomed at 5.3mbd during the April 24 week, and is up 62% since then through the July 10 week (Fig. 1). It’s been up every week since the bottom and still looks more like a V than a U, W, or Nike swoosh.

Gasoline usage is our favorite high-frequency economic indicator. We acknowledge that it may be getting boosts from more Americans driving to work rather than taking public transportation and more taking driving vacations in the USA rather than traveling abroad. Given that recent COVID-19 outbreaks are causing some states to reverse course on reopening their economies, we expect some weakness in this indicator in coming weeks.

Another surprisingly happy high-frequency economic indicator is the daily Citigroup Economic Surprise Index (Fig. 2). It has set record highs every day but two since June 15. It is up from a record low of -144.6 on April 30 to 243.4 on Tuesday.

Our favorite weekly fundamental stock market indicators are also starting to look up after taking dives from mid-March through the end of May. S&P 500 forward revenues, forward earnings, and the implied forward profit margin all have been edging higher in recent weeks (Fig. 3). All three are great coincident indicators of their comparable actual quarterly series. So they suggest that the worst was over during Q2 for S&P 500 revenues, earnings, and margins.

Banks: The Gift of Time. The Federal Reserve and the federal government have given the banks the gift of time—time to squirrel away enough reserves to face the tsunami of loan losses and delinquencies that look poised to hit over the next six to 12 months.

By paying extra unemployment benefits, by providing companies with forgivable loans that prevent layoffs, and by allowing consumers to postpone payments on loans, rent, and taxes, the fiscal policymakers have pushed off the days of reckoning. The monetary authorities flooded the financial markets with liquidity, averting a severe credit crunch. Collectively, their actions have led to higher incomes and saving, while the flight out of cities has boosted home prices. Let’s take a look at the bunkers JPMorgan and Goldman are building during this highly unusual lockdown recession:

(1) Playing defense. The stimulus checks and the extra $600 a week in unemployment benefits have boosted household incomes, which jumped to $20.7 trillion in April from $18.7 trillion in March, easing to $19.9 trillion in May (Fig. 4). Likewise, existing home prices have risen recently despite the surge in unemployment; they rose 6.0% y/y in May, continuing an eight-year uptrend (Fig. 5).

But bankers recognize that today’s government-supported economy has darkening clouds in the distance. Credit card and auto loan delinquencies were trending up before COVID-19 hit, and they’ll certainly continue to do so as unemployment remains elevated (Fig. 6). In March, S&P Global Ratings forecast that the default rate for junk bonds would head to 10% over the next 12 months, up from 3% at the end of last year, a March 20 CNBC article reported.

The good news is that during this stimulus-induced break from reality, the banks have made hay. JPMorgan boosted loan-loss reserves by $8.9 billion in Q2 and $6.8 billion in Q1, bringing its total reserves up to $34 billion, more than double the level at the end of 2019. JPMorgan’s reserve positions are more conservative than its base-case scenario for the US economy: unemployment of 10.9% in Q4-2020 and 7.7% in Q4-2021. Likewise, US Bancorp boosted its provision for credit losses by $1.7 billion in Q2 and $993 million in Q1, major jumps from last year’s quarterly credit-loss provisions, which ran between $365 million and $395 million. And Goldman’s provision for credit losses soared to $1.6 billion last quarter compared to $214 million in Q2-2019.

JPMorgan CFO Jennifer Piepszak explained on the bank’s Q2 conference call that the brunt of its reserve-building may be over: “Given the increased uncertainty of the macroeconomic outlook … we’ve put more meaningful weight on the downside scenario this quarter. And so therefore, we’re prepared and have reserved for something worse than the base case. And given CECL covers life of loan, if our assumptions are realized, we wouldn’t expect meaningful additional reserve builds going forward.”

If a base-case scenario materializes, the bank would be left with excess capital and be positioned to restart its share repurchases. “We don’t expect that this year, but I wouldn’t completely rule it out in the fourth quarter,” said CEO Jamie Dimon.

(2) Capital markets to the rescue. In addition to keeping the consumer afloat, the government’s stimulus programs have contributed to the roaring stock and bond markets. The Fed’s willingness to buy corporate bonds and keep interest rates around zero has kept the capital markets open for business and the stock market flying. The S&P 500 is only 5.5% off its all-time high, and companies have pounced on the low-interest-rate environment to sell debt and prefund expenses (Fig. 7). Global debt issuance is up 20.1% ytd compared to last year, and global equity underwriting is up almost 50% ytd, according to the WSJ’s Dealogic rankings.

The trading and capital market operations of Goldman Sachs and JPMorgan both have benefitted from this environment. Goldman’s global markets business rose 93% y/y in Q2, and its investment banking business line jumped 36%. At JPMorgan, trading revenue was up 79% in the quarter. These gains certainly helped the pair’s bottom lines, but such boons often aren’t reoccurring.

(3) Investors remain wary. It’s certainly impressive that Goldman and JPMorgan managed to be solidly profitable last quarter given the economic backdrop. But the firms’ stocks are 13.1% and 29.5% off their respective January highs as of Tuesday’s close. Investors presumably remain concerned about potential loan losses.

For a broader perspective, the S&P 500 Diversified Banks stock price index is down 36.2% ytd through Tuesday’s close and up 24.3% from its March 23 low (Fig. 8). The index’s other constituents have fared worse ytd than JPMorgan’s stock. Here’s how much some have fallen so far this year: Wells Fargo (-54.9%), US Bancorp (-38.8), Citigroup (-37.2), and Bank of America (-31.5). Analysts expect the industry’s collective revenue and earnings will drop 6.8% and 57.7%, respectively, this year only to rebound by 1.4% and 80.7% in 2021 (Fig. 9 and Fig. 10).

Disruptive Technology I: Developing New Vaccines. Historically, vaccines have been made by injecting a live virus into a fertilized chicken egg and letting it replicate. Scientists then extricate the virus-filled egg white from the egg and kill, thus deactivating, the part of the virus that infects people. It takes months to ensure that all of the virus in the egg white is dead. Making the flu vaccine each year, for example, takes six months or more.

So companies have been working to devise faster and less costly methods of making vaccines. This week brought good news from two companies using two different methods of vaccine production. Moderna, which uses messenger RNA, revealed more positive results from an earlier trial and announced that it’s beginning its final vaccine trial on July 27. Separately, a company partially owned by Philip Morris announced that its plant-based vaccine would begin Phase 1 clinical trials. Leading the pack may be a vaccine developed at Oxford University. Here are some of the details:

(1) Chimps lend a hand. Oxford’s COVID-19 vaccine candidate is considered the front-runner. Instead of using a live COVID-19 virus, Oxford scientists use a chimpanzee virus for the common cold that’s weakened and genetically changed so that it can’t replicate in humans. Inserted into this virus is genetic material that makes the proteins from the COVID-19 virus. It’s hoped that when this contrived virus is injected into humans it will elicit a response that will give humans immunity to the COVID-19 protein.

A May 22 Oxford press release explained why that protein is so important: “The SARS-CoV-2 coronavirus uses its spike protein to bind to ACE2 receptors on human cells to gain entry to the cells and cause an infection. By vaccinating with ChAdOx1 nCoV-19, we are hoping to make the body recognise and develop an immune response to the Spike protein that will help stop the SARS-CoV-2 virus from entering human cells and therefore prevent infection.”

The viral vector method was developed so that a vaccine could be developed quickly for any disease. The Oxford scientists previously used it to develop a vaccine for MERS, which in a 2018 small trial of 24 people proved safe. Oxford’s COVID-19 vaccine has begun Phase 3 trials with 10,000 humans in Brazil, South Africa, the UK, and the US. If successful, the vaccine will be produced by AstraZeneca. Results from Phase 1 trials are expected by the end of July, and if Phase 3 trials are successful, a vaccine could be available late this year.

(2) Moderna’s vaccine inches closer to the finish line. Investors learned more good news about Moderna’s COVID-19 vaccine this week. The vaccine triggered an immune response in all 45 people who received the shot in the trial, and it was deemed safe and well tolerated.

Researchers found that antibody production increased after the second dose and resulted in “neutralizing activity similar to that seen in the top half of blood specimens taken from 41 people who had recovered from COVID-19 and who weren’t in the vaccine study,” a July 14 WSJ article reported. Antibodies were still detected two months after the vaccine was given. Yet unknown are how long the antibodies will last and how many antibodies are needed to fend off the disease.

Moderna also reported that it would launch Phase 3 trials with 30,000 high-risk adults on July 27. About half of the trial participants will receive the COVID-19 vaccine in two doses, four weeks apart, while the other half gets a placebo. Recall that Moderna used the genetic code of the COVID-19 virus to create messenger RNA. The messenger RNA in the vaccine enters the body’s cells and makes proteins that prompt an immune response, which the body then can use to fight the virus.

(3) Harnessing plants to create a vaccine. A number of institutions are using plants to generate vaccines, including Canadian-based Medicago, in which Philip Morris International is an investor, and Kentucky BioProcessing, a subsidiary of British American Tobacco. It’s hoped that using plants to produce vaccines will be a safer, lower-cost alternative that won’t require the refrigeration needed for vaccines made using eggs. The process also would be faster, taking weeks instead of months to create a vaccine.

An April 4 WSJ article explained the process well: “Plant-based vaccines are generally made by infecting a plant—sometimes by dipping leaves in a liquid—with a bacteria that contains the genetic sequence of the desired protein. The bacteria hijack the plant cells to make large quantities of the protein in the space of about a week, which is then harvested from the plant and purified into a raw material for the vaccine.”

Medicago announced on Tuesday that it has begun Phase 1 trials of its plant-based COVID-19 vaccine and soon will dose 180 volunteers. The volunteers will be given booster shots made by GalaxoSmithKline and Dynavax Technologies. Medicago believes it can make about 100 million doses of the vaccine by the end of 2021 and is building a facility in Quebec that could make a billion units a year by 2021, a July 14 Reuters article reported.

 Disruptive Technology II: Rooting for Falling Tesla Prices. Earlier this week, Tesla announced a $3,000 price cut on its Model Y sports utility vehicle, and the doubters came racing out of the woodwork. Critics warned that the price cuts are being done to juice demand in a market that has been sapped of buyers due to COVID-19.

While Tesla’s worldwide sales have fallen slightly over the past six months, they’ve held up far better than those of other manufacturers, a July 2 CNBC article reported. In Q2, Tesla said it delivered 90,650 vehicles, beating Wall Street analysts’ average estimate of 72,000 vehicles according to FactSet and 83,000 according to a Bloomberg count. The company’s Q2 deliveries were down only 4.8% y/y, while traditional manufacturers such as General Motors and Ford sustained Q2 sales drops of more than 30%.

Tesla’s share of the electric vehicle market has jumped to 21% in China, up from 6% last year, and its global market share jumped about 3ppts y/y to 26% in H1-2020, according to ARK Investment Management analyst Sam Korus.

We’d suggest that the price cuts may have less to do with the auto market’s slump and more to do with the fact that Tesla is more tech company than auto manufacturer. Tesla cars are computers with a battery and four wheels attached. As the company’s technology improves and its production volumes increase, we would expect Tesla’s costs to continue to decline, allowing the company to cut prices further.

This week’s price cut wasn’t the company’s first. It also cut prices in May of this year and in March 2019, before anyone had ever heard of COVID-19. In last year’s cuts, prices fell on the Model S vehicles by anywhere from $10,000 to $18,000 and the Model X vehicles’ prices dropped by $8,000 to $18,000. In this week’s news, the Model Y’s price fell by $1,000 to $3,000, depending on the car’s mileage and other bells and whistles.

ARK’s Korus is betting that Wright’s Law—which forecasts price declines resulting from production increases—will apply to Tesla. So far it has. For every cumulative doubling of its production, the Model 3’s costs have fallen by roughly 15%, Korus explained in a September 4, 2019 report. It’s a theory that we discussed in the July 3, 2019 Morning Briefing to explain why manufacturers might be more inclined going forward to adopt robots on their factory floors.

The ability to lower costs as manufacturing ramps up and technology improves gives Tesla the ability to cut prices, improve margins, or invest more in research and development. Just how much of that sanguine scenario is priced into the stock already, with a forward P/E of 227 on July 10, is another question entirely.

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Getting Technical

July 15 (Wednesday)

Strategy I: Powell, Malthus & COVID-19. Before Joe and I review some of the recent technical developments in the stock market, let’s start with some fundamentals behind the meltup since March 23. First and foremost, of course, is the Fed’s shock-and-awe monetary policy response to the Great Virus Crisis (GVC). It was shockingly awesome! Potentially even more important, are developments in finding vaccines and/or cures for this curse. Consider the following:

(1) The Fed is our friend. Technicians like to say “Let the trend be your friend.” Joe and I agree; but from a fundamental perspective, our mantra has long been “Don’t fight the Fed.” Indeed, that’s the main theme of my recently published book, Fed Watching for Fun & Profit.

One of the five-star reviews by our good friend Vineer Bhansali (who frequently writes for Forbes) observed: “If Sherlock Holmes was deciphering the mysteries of what the Fed is doing and what it is going to do, he would probably consult Ed Yardeni. As advertised, this is a book for investors who want to objectively analyze what the Fed is likely to do, and as such different than all the other books on what the Fed has done wrong and what it should do; and as such sticks out as a unique and valuable addition to my top shelf of references. Case in point: Ed and his crystal ball (which he shares in this book) predicted in December 2018 that the next move from the Fed was going to be the great pivot to an ease, even as the dot plot and markets were braced for more tightening.”

My book concludes with the events of 2019. I’m working on a follow-up tentatively titled The Fed Fights the Virus. Enough has happened since the start of this year to write a second volume rather than an update to the first book. For now, let’s cut to the chase: By pushing the yield curve close to zero in response to the GVC, the Fed left investors no choice but to either earn close to nothing on their fixed-income securities or rebalance into stocks, which is what many have done since March 23.

Ever since then, Fed officials repeatedly have stated that they intend to keep interest rates close to zero for a very long time. As Fed Chair Jerome Powell famously said at his June 10 press conference: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” In a Freudian slip, Powell said that monetary policy is in “a good place,” as “we’re continuing asset prices in coming months … at a relatively high level.” A footnote in the transcript stated: “Chair Powell intended to say ‘asset purchases’ rather than ‘asset prices.’”

When asked whether he is concerned about high asset prices, he made it clear that the Fed’s main concern is getting through the GVC by “pursuing maximum employment and stable prices.” He added: “we’re not focused on moving asset prices in a particular direction at all. It’s just we want markets to be working, and I think, partly as a result of what we’ve done, they—they are working. And, you know, we hope that continues.” He clearly rejected “the concept that we would hold back because we think asset prices are too high.”

In new projections released after the June 10 meeting of the FOMC, all 17 participants said they expect to hold rates near zero next year, and 15 of them projected that rates would stay there through 2022. As Powell concluded, “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”

Officials made one policy change at the meeting by announcing they would maintain their recent pace of purchases of Treasury and mortgage securities, effectively ending gradual, weekly reductions. They will buy at least $80 billion in Treasuries and $40 billion in mortgage securities, net of maturing bonds, a month (Fig. 1 and Fig. 2). Over the past year through the week of July 8, the Fed has purchased $2.1 trillion in Treasuries, financing 66% of the federal budget deficit (Fig. 3 and Fig. 4).

The Fed isn’t even thinking about the possibility that asset prices are too high. Yes, indeed, the Fed is truly our friend for the foreseeable future.

(2) The virus is our enemy. The stock market has been accentuating the positive, as recommended in the 1944 song “Ac-Cent-Tchu-Ate The Positive.” It has been doing so ever since the S&P 500 bottomed on March 23. Some of the biggest up days occurred on news of a possible vaccine. That helps to explain why the market hasn’t accentuated the negatives on the health front since March 23. There certainly have been plenty of negatives in recent weeks, but the market has been singing “eliminate the negative, latch onto the affirmative.” As Melissa and I discussed yesterday, the case count in the US is soaring. Overseas, troubling flare-ups are occurring in countries that had seemed to have defeated the virus. Yet, the stock market continues to soar.

We have developed a strong in-house team to keep track of the pandemic. Melissa is our epidemiologist, and Jackie is our virologist. Melissa reviewed the latest US case data yesterday. Tomorrow, Jackie will update us on developments on the vaccine front. Today, I would like to remind you about Thomas Malthus, who was the original “dismal scientist” and perma-bear.

Between 1798 and 1826, Malthus published six editions of his widely read treatise An Essay on the Principle of Population. He rejected the notions about mankind’s future advancements that were popular at the time, believing instead that poverty cannot be eradicated but is a permanent fixture in the economic firmament. He explained this supposed principle by arguing that population growth generally expanded too fast in times and regions of plenty, until the size of the population relative to the primary resources, particularly food, caused distress. Famines and diseases were nature’s way of keeping population growth from outpacing the food supply.

Malthus was the original Malthusian, and his pessimistic outlook was probably the most spectacularly wrong economic forecast of all times and a classic for contrarian thinkers. Grain production soared during the 1800s thanks to new technologies, more acreage, and rising yields. During the first half of the century, chemical fertilizers revived the fertility of European soil, and the milling process was automated using steam engines. During the second half of the century, vast new farmlands were opened in the US under the Homestead Act of 1862, and agriculture’s productivity soared with the proliferation of mechanical sowers, reapers, and threshers. Tremendous progress in agriculture continued during the 20th century, particularly during the Green Revolution of the 1950s and 1960s.

What does this have to do with COVID-19? Technology solves problems. It solved the Malthusian problem of food shortages. One of the greatest success stories in the history of technological innovation has been in agriculture. Malthus never saw it coming. Similarly, today’s doomsters could be confounded by biotechnological innovations that deliver not only a vaccine for COVID-19 but for all coronaviruses. In the March 5 Morning Briefing, we discussed technology using messenger RNA (mRNA) to instruct our cells to make proteins that produce antibodies that provide immunity to viruses.

Here is an excerpt from a July 14 Verdict article on a possible revolution in rapidly testing for viruses: “CRISPR is a well-known biotechnological tool for gene editing due to its programmable ability to detect specific sequences of DNA within a gene of interest and subsequently ‘snipping’ it, using an enzyme effectively functioning as molecular scissors. By removing the latter enzyme, however, CRISPR can operate as a diagnostic tool for detecting specific sequences of DNA such as those that uniquely exist in the SARS-CoV-2 virus. Two startup companies have capitalised on this capability by developing their own CRISPR-based POC tests, specifically for rapid Covid-19 diagnosis.”

The public and private sectors are spending billions of dollars to develop a vaccine. That’s happening around the world. Companies with potential solutions are raising lots of money to accelerate their research and development on a vaccine. Introduced in April, Operation Warp Speed is a public–private partnership, initiated by the Trump administration, to facilitate and accelerate the development, manufacturing, and distribution of COVID-19 vaccines, therapeutics, and diagnostics. It is an interagency program that includes components of the Department of Health and Human Services, including the Centers for Disease Control and Prevention (CDC), Food and Drug Administration (FDA), the National Institutes of Health, and the Biomedical Advanced Research and Development Authority (BARDA); the Department of Defense; private firms; and other federal agencies, including the Department of Agriculture, the Department of Energy, and the Department of Veterans Affairs. The project has a budget of at least $10 billion.

Strategy II: Bad Breadth. Joe has been doing lots of great work on the breadth of the stock market rally since March 23. It is widely believed that broadly based stock market rallies are more sustainable than narrowly based ones. We agree with that assessment. The narrowness of the rally since March 23 is worrisome.

There are numerous ways to gauge the breadth of bull markets. These days, one of the most popular ones is to follow the market-cap share of the five biggest corporations in the S&P 500. There are other measures. Consider the following:

(1) Magnificent Five suggests correction likelier than bear market. Joe compiled a weekly series, starting in 1994, that tracks the market-cap share of the five biggest corporations in the S&P 500, i.e., the Magnificent Five (Fig. 5). Sure enough, this series tends to peak at the start of corrections and bear markets (Fig. 6).

Here are the cyclical peaks in the Magnificent Five’s market-cap shares during the weeks of August 8, 1997 (12.4%), March 24, 2000 (18.5), November 21, 2008 (16.0), September 28, 2012 (13.9), and August 31, 2018 (17.5). During the July 10 week, this series rose to a record 25.2%. That strongly suggests that either a correction or a bear market is a high risk currently. A correction is more likely than a bear market, in our opinion. That’s because bear markets tend to be triggered by credit crunches that cause recessions.

A credit crunch was certainly underway during late February through March 23. But on that fateful day, the Fed tossed away its bazookas, kept its helicopters grounded, and instead started to carpet-bomb the financial markets with B-52 bombers loaded with trillions of dollars of cash. That was the day the Fed announced QE4ever purchases of Treasuries and mortgage-backed securities and expanded its liquidity facilities to backstop numerous other areas of the capital markets in a No-Assets-Left-Behind campaign to stop the credit crunch.

The S&P 500 VIX spikes during credit crunches and recessions (Fig. 7). It did so again recently, jumping to a record 82.7 on March 17. But the Fed’s massive liquidity programs since March 23 brought it back down sharply to 32.2 on Monday.

(2) FANGMANT, with and without the “T.” We recently expanded the Magnificent Five (a.k.a. the FAANG stocks) to what we call the Magnificent Eight. These FANGMANT stocks are Facebook, Amazon, Netflix, Google, Microsoft, Apple, NVIDIA, and Tesla, which could soon be added to the S&P 500. Yesterday, we showed that the market-cap share of the broader group rose to a record 28.2% of the S&P 500’s market-cap share during the July 10 week (Fig. 8). That’s up from 17.2% at the end of 2018 and 9.4% at the end of 2013. Take out Tesla, which isn’t actually in the S&P 500 (yet), and the market-cap share of Magnificent Seven is currently a record 27.1%.

(3) Market-cap ratios. There are other measures of breadth. The one that tracks the ratio of the S&P 500 market-cap-weighted stock price index and the comparable equal-weighted index is heavily influenced by the FANGMANT (Fig. 9). So is the ratio of the S&P 100 to the 500 (Fig. 10). Interestingly, while both have been moving higher since late 2018, they are still well below their peaks of 1999-2000, when a few large-cap technology stocks also had a great deal of market-cap share.

(4) Mixed message. On the other hand, the narrowness of the breadth of the current rally in the S&P 500 is confirmed by the percentage of its companies trading above their 200-day moving averages. Only 39.0% of them did so during the July 10 week (Fig. 11). Furthermore, only 38.4% of them are up on a y/y basis (Fig. 12). We’re not sure those are actually bearish readings, since it is readings well above 50% that tend to have the most downside potential for both measures.

Strategy III: Golden Cross. There’s a big difference between shamrocks and four-leaf clovers. The former are young sprigs of clover with three leaves. They have been a symbol of Ireland for centuries. The latter are four-leaf clovers and are widely associated with good luck because they are so hard to find. And while four-leaf clovers are in your box of Lucky Charms cereal, they’re not at the heart of Irish culture.

Among the luckiest patterns discerned by technical analysts in their charts is the so-called golden cross. They’re seeing one in the S&P 500 as its 50-day moving average crossed above its 200-dma on Friday (Fig. 13 and Fig. 14). Just by coincidence, we found an article by Proinsias O’Mahony in yesterday’s The Irish Times titled “Stocktake: A golden cross for stocks.” Mr. O’Mahony observed that “the golden cross has a strong record in recent decades, with intermediate-term returns tending to be better than normal.”

On the other hand, he reports: “Sceptics might note data doesn’t support fears regarding the death cross, this indicator’s bearish equivalent. Indeed, the S&P 500 soared after March 30th’s death cross, so it’s clear these are imperfect signals.” In other words, bet on golden crosses and ignore death crosses.

The market is showing both bad breadth and a golden cross. In addition, on Monday, the Nasdaq had a bearish “outside day reversal,” a leading indicator for a potential downward trend change or at least a near-term top. In any case, both the S&P 500 and Nasdaq had a good day yesterday. These certainly are confusing times on a fundamental basis; no wonder the technical indicators are also confusing.

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Counting Chinese Yuan & US COVID-19 Cases

July 14 (Tuesday)

Strategy: Twilight Zone Scenario. The Twilight Zone television series, broadcast from 1959 to 1964, always started with Rod Serling’s voice-over: “There is a fifth dimension, beyond that which is known to man. It is a dimension as vast as space and as timeless as infinity. It is the middle ground between light and shadow, between science and superstition, and it lies between the pit of man’s fears and the summit of his knowledge. This is the dimension of imagination. It is an area which we call the ‘Twilight Zone.’” I’ve previously observed: “That is a remarkably good description of the predicament that we humans are confronting during the current Great Virus Crisis (GVC).”

In this “dimension of the imagination,” Joe and I can imagine lots of surreal scenarios. Submitted for your approval is one where the economy remains plagued by the virus, but the S&P 500 continues to melt up, and soon does so in record-high territory, on expectations that the Fed will continue to pump liquidity into the financial markets and a vaccine is on the way.

Leading the charge are the FANGMANT stocks (Facebook, Amazon, Netflix, Google, Microsoft, Apple, NVIDIA, and Tesla, which could soon be added to the S&P 500) that we discussed in yesterday’s Morning Briefing, which are widely viewed as winners both during and after the GVC. They rise from 28.2% of the S&P 500 market’s cap currently to 40% by the end of the summer (Fig. 1 and Fig. 2). The collective forward P/E of this Magnificent Eight soars from 44.2 currently to over 60, which drives the S&P 500’s forward P/E to 30 (Fig. 3 and Fig. 4). (Of course, in the Twilight Zone, there is always the possibility that the FANGMANT stocks are a figment of our imagination.)

Then just in time for the September/October season, which has a history of occasional nasty meltdowns, the Mother of All Meltdowns (MAMD) occurs. The virus has a second wave that forces another round of business and school closings, aborting the economic recovery. Hopes for an imminent vaccine are frustrated. Joe Biden is expected to defeat Donald Trump during the upcoming presidential campaign, and does so though the election results are fiercely, albeit briefly, contested. In his acceptance speech, Biden confirms that he intends to move further to the left, as outlined in the recently released 110-page Biden-Sanders Unity Task Force Recommendations. By the way, immediately after it was released on July 8, Senator Bernie Sanders (D-VT) predicted that Biden could become the “most progressive president” since Franklin D. Roosevelt.

A week after the November 3 election, the S&P 500 plunges 30% as the Democrats sweep the White House, the House, and the Senate. But don’t despair just yet. After all, the Fed is still in the Twilight Zone with us. Following an emergency meeting of the FOMC, Fed Chair Jerome Powell announces that the Fed will start buying equities. The Fed also lowers the federal funds rate slightly below zero. Stock prices soar again.

Or maybe this alternative scenario will happen: Like Dorothy in The Wizard of Oz, we all wake up from this bad dream. The election results in another two years of political gridlock, as the Republicans hold on to the Senate. A vaccine is discovered that helps to get us out of both the Twilight Zone and Oz. Until then, it would help a great deal if everyone wore masks.

 China: Still on Monetary Steroids. China’s experience with the GVC confirms that there is a way out of the Twilight Zone without a vaccine: strictly following widespread social distancing protocols, especially wearing masks, taking temperatures, and testing. The same can be said about the experiences of South Korea and Taiwan.

Meanwhile, the Chinese government continues to flood the Chinese economy with more and more credit during the GVC, as it has ever since the Great Financial Crisis (GFC). That’s proven to be an effective treatment, so far, to overcome economic and financial ills. Consider the following:

(1) Social financing. Over the past 12 months through June, social financing totaled a record $4.5 trillion, led by a record $2.7 trillion in bank loans (Fig. 5 and Fig. 6). Bank loans are up a whopping $18.9 trillion to a record $23.3 trillion from $4.4 trillion since the end of 2008, when the government started to respond to the GFC with massive credit expansion (Fig. 7).

(2) Copper and stock prices. The latest round of credit expansion is boosting China’s economy, as evidenced by the dramatic 36% meltup in the price of copper since March 20 through Friday (Fig. 8). It also seems to have triggered a meltup in Chinese stock prices. The Chinese MSCI stock price index is up 41.2% since March 19 through July 10, while the Shanghai-Shenzhen 300 is up 32.4% over this same period.

 Epidemiology I: Update on COVID-19 Data Challenges. In our July 1 Morning Briefing, we discussed the problems with the available COVID-19 data and our preference for data from The Atlantic’s COVID Tracking Project (CTP). The problems persist, as hospitalizations and deaths continue to be undercounted, but some progress in improving the accuracy of the data has been made over the past two weeks. Here’s an update:

(1) Hospitalizations. When we last wrote about COVID-19 data challenges, there was no series for the current number of COVID-19 patients hospitalized nationwide. Now there is a one that is nearly nationwide; it will cover 98% of the nation when Florida’s current hospitalization become available soon, as a July 4, CTP blog post discussed.

However, the CTP wrote a follow-up July 8 blog post focused on data problems in Florida and indicated that the current hospitalizations series remained unavailable. For that reason, the hospitalization data discussed below are not comprehensive nationwide totals but remain the best data we have to see current hospitalization trends among the states reporting the data at this point. Florida’s data are important not only because it is a populous state but also because it is one of the current epicenters of surging outbreaks.

(2) Deaths. Counting deaths has also been a challenge in Florida. The CTP noted: “When testing capacity is overwhelmed and it becomes harder to get lab confirmation for suspected cases of COVID-19, lab tests can no longer capture the full impact of an outbreak. In these circumstances, data on probable cases and deaths becomes crucial to understanding the full extent of the outbreak. Florida does not report probable cases or deaths.”

More generally, deaths data may severely lag, not only because of how the virus works but also because there may be significant lags in reporting, as Bloomberg recently discussed. (Also see the “Approximate timeline for Covid-19 related deaths” at the top of the first CTP blog link.) The coding of cause of death on death certificates also happens to be quite subjective, according to our evaluation of the Centers for Disease Control’s (CDC) website discussion on the completeness and accuracy of death certificates.

(See the CTP’s separate blog post for more nationwide details on probable versus confirmed deaths.)

(3) Alternative sources. The White House chose the COVID Tracking Project as the best source to cite for daily US test numbers in its “Opening Up America Again” testing strategy. Johns Hopkins University & Medicine’s (JH) Coronavirus Resource Center is frequently quoted in the media, especially for worldwide confirmed cases and deaths. But JH’s website does not include hospitalizations, and it only recently began displaying the number of tests performed in the US. The CDC’s COVID Data Tracker has improved since the pandemic began, but it doesn’t seem to apply as consistent a methodology for data collection across series as the CTP does, and there are questions about its completeness and accuracy.

 Epidemiology II: Update on COVID-19 National Trends. As we all know, the latest available national US COVID-19 trends are not heading in the right direction. Case counts have surged, and hospitalizations risen, albeit more slowly than cases. The question is whether these uptrends will show up in rising deaths in coming weeks. For now, let’s have a look at what the available series are showing:

(1) Cases. The 10-day moving-average (ma) of new positive test results reached a record high of 53,179 as of the latest data, on July 10, which was well above the previous nationwide peak of 30,293 on April 17 (Fig. 9).

(2) New tests. Testing has also increased significantly. New tests rose to a record 653,103 on a 10-day ma basis through July 10. The positivity rate, which equals new positive tests as a percent of new tests, rose to 8.2% on July 10, the highest since May 14 (Fig. 10).

A June 25 CTP blog post reported that, at 500,000 tests per day, the US isn’t testing anywhere near the 900,000 tests per day that the Harvard Global Health Institute estimated on May 9 it must do to get ahead of the virus; recommendations by other groups are even higher.

The July 9 WSJ reported that surging cases and growing demand for tests “are straining the ability of pharmacies and labs to deliver timely results to consumers, causing delays that hamper efforts to contain the spread of the virus.”

(3) Hospitalizations. On the same 10-day ma basis, current hospitalizations climbed to 40,027 on July 10, after having steadily declined from the previous peak of 58,151 on April 24 to a recent low of 29,036 on June 23. The July 10 number is the highest since May 27, but it still doesn’t include data from Florida, Hawaii, and Kansas. New hospitalizations also have increased since mid-June on a five-day ma basis (Fig. 11).

(4) Deaths. Deaths have trended down on a 10-day ma basis. However, the five-day ma has started to tick up again. Deaths are the ultimate lagging indicator, as we discussed above.

 Epidemiology III: State of Hospitalizations. Since our previous update, the CDC’s COVID Data Tracker has incorporated hospital impact data from its National Healthcare Safety Network (NHSN). The data come with lots of caveats (see note below) but represent a good step toward a comprehensive look at the impact of COVID-19 on hospitals. In addition to community spread, hospital capacity may be a critical decision factor for potential future community closures. (A hat tip to Goldman Sachs research cited in a July 11 Bloomberg article for pointing us to these newly available data.)

The CDC’s NHSN enables hospitals to directly send data to the central repository including data on current inpatient and ICU bed occupancy, healthcare-worker staffing, and personal protective equipment supply status and availability. The CDC qualifies the data on its website with this caveat: “As more facilities submit data to NHSN, the data in the dashboard may change. Differences in how each facility implements this COVID-19 data collection, including variation in which staff collect the data on any given day, and changes in state and local reporting mandates, may affect the number and characteristics of healthcare facilities participating in NHSN’s COVID-19 surveillance.”

Not all hospitals participate yet. For example, in Texas, less than 50% of healthcare facilities are reporting, according to the website.

The CDC adds: “Estimates of hospital capacity measures are representative at the national and state levels. The estimates are based on data submitted by acute care hospitals to the NHSN COVID-19 Module. The statistical methods used to make these estimates include weighting (to account for non-response) and multiple imputation (to account for missing data). The estimates (number and percentage) are shown along with 95% confidence intervals that reflect random error.”

In any event, here’s what the data show at this point:

(1) Nationwide hospitalizations. On April 1, about 10% of patients in an inpatient care location had suspected or confirmed COVID-19. That figure moved lower through June, but then crept back up slightly to 7% as of July 7 (Fig. 12).

(2) State hospitalizations. The picture is much different on a state level. For example: New York’s percentage of COVID patients in hospitals peaked at around 45% and has steadily declined since, reaching just 4% on July 7. Arizona’s increased from around 7% during mid-May to nearly 24% during early July. The percentages for both Florida and Texas rose from about 6% at the end of May to about 15% in early July.

(3) Capacity. Hospital capacity (or the percentage of inpatient beds occupied) for Arizona, Florida, and Texas are currently 79.1%, 74.8%, and 70.1% versus 69.2% for New York. Nationwide, hospitals are estimated to be 67.0% full.

Epidemiology IV: Jumping the Gun? Melissa and I are hoping that new treatments for the virus will reduce deaths over time even if cases continue to rise. Gilead Sciences’ remdesivir is one of the drugs currently being used to treat COVID-19 on a widespread basis. However, it may have raised unrealistically optimistic expectations.

As MarketWatch explained on July 11, Gilead’s encouraging news that remdesivir may reduce mortality risk by 62% caused Gilead’s share price to pop on July 10. But curbing of investor enthusiasm might be in order. “The source for the analysis … is unorthodox,” said the article. “It’s not from a randomized, placebo-controlled clinical trial, which has long been considered the gold standard for medical research in the U.S. … [I]t compares clinical trial data to non-clinical trial data.” Company management said that the findings need to be confirmed in a prospective clinical trial but didn’t say whether it will be conducting one.

If confirmation isn’t forthcoming, regulators may not continue to grant emergency-use access to the drug for COVID-19 patients. The Motley Fool explained that regulators are likely to have other treatment options. For example, Regeneron “recently began phase 3 studies of REGN-COV2, a pair of antibodies that glom on to the surface of SARS-CoV-2 to prevent it from entering host cells.” (Read more about Regeneron’s progress in this July 9 New York Times article.) For now, supply of remdesivir is becoming an issue for hotspot regions, as CNN reported on Sunday.

In a wild trading session, the S&P 500 sold off late yesterday to close down 0.9%. It had been up as much as 1.6% on news that two experimental coronavirus vaccines jointly developed by German biotech firm BioNTech and Pfizer have received “fast track” designation from the Food and Drug Administration (FDA). The FDA grants fast-track status to speed up the review of new drugs and vaccines that show the potential to address unmet medical needs.

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Bad Earnings & Good Yearnings

July 13 (Monday)

Strategy I: Earnings Season Starting. Here we go again, as we do on a quarterly basis: It’s the start of another earnings reporting season. This one is going to be exceptional—that is, exceptionally bad. We all know that. Yet the S&P 500 is up 42.4% since March 23 (Fig. 1). It is down only 1.4% ytd and up 5.7% y/y. It needs to rise by only 6.3% to match its February 19 record high.

It is also widely recognized that the meltup since March 23 has been led by the Magnificent Six FAANGMs stocks, as Joe and I discussed last Monday. Their aggregate market capitalization is up 61.0% since March 23, while the market cap of the S&P 500 with them is up 42.0% and without them is up 36.3% (Fig. 2). Their market-cap share of the S&P 500 has soared from 15.0% at the start of 2018 to 26.1% on Friday (Fig. 3).

Nevertheless, the rally off the March 23 bottom has been broad based. Here’s the performance derby since then through Friday’s close for the S&P 500 sectors: Consumer Discretionary (57.7%), Information Technology (53.4), Materials (51.0), Energy (49.3), Communication Services (39.7), Industrials (39.5), Real Estate (37.0), Health Care (34.8), Financials (32.8), Utilities (28.9), and Consumer Staples (23.6) (Fig. 4). The S&P 500 Transportation stock price index is up 36.7% over this same period.

As bad as the Q2 earnings reporting season is likely to be, investors are clearly yearning for better times and already discounting them in current stock prices. Let’s review what we know about the awful earnings season ahead and whether investors’ yearnings for better earnings are realistic:

(1) Really bad quarter. The good news is that industry analysts have been cutting their quarterly earnings estimates for the rest of this year at a much slower pace in recent weeks after slashing them in the weeks after the World Health Organization declared a global pandemic on March 11 (Fig. 5 and Fig. 6). Nevertheless, as of the July 2 week, they estimated that S&P 500 operating earnings per share during Q2, Q3, and Q4 will be down on a y/y basis by 43.9%, 25.6%, and 13.8% as a result of the Great Virus Crisis (GVC). During the Great Financial Crisis (GFC), the worst y/y decline was -65.6% in Q4-2008.

Here is the latest performance derby for analysts’ consensus y/y earnings expectations for the 11 sectors of the S&P 500 during Q2: Utilities (-2.5%), Information Technology (-8.0), Health Care (-15.0), Real Estate (-15.0), Consumer Staples (-15.7), Materials (-38.0), S&P 500 (-43.9), Financials (-48.3), Industrials (-89.0), Consumer Discretionary (-114.2), and Energy (-153.4).

(2) Perennial optimism. On an annual basis, analysts’ consensus earnings expectations are currently $124.81 this year (down 23.4% y/y), $163.32 next year (up 30.9%), and $186.34 (up 14.1%) in 2022 (Fig. 7). S&P 500 forward earnings, the time-weighted average of consensus expected earnings in the current year and coming year, seems to have bottomed eight weeks ago; it edged up to $144.81 during the July 2 week. Like the analysts, we expect that earnings will start recovering during the second half of the year. However, we think that they may still be too optimistic since our annual earnings-per-share estimates are lower than theirs currently: 2020 ($120), 2021 ($150), and 2022 ($175).

Strategy II: Banks on First. The earnings season will begin next week with lots of reports from banks, which typically kick off the earnings seasons. They are likely to report some bad news and some good news. Consider the following:

(1) Dividends. On June 25, the Fed published the results of stress tests on 33 banks. As a result, Wells Fargo & Co. said it would cut its dividend, while most others said they would maintain theirs. But unlike in years past, when stress test participants typically disclosed full-year allotments for shareholder payouts, banks mostly confined themselves to guidance on dividends for Q3, sometimes with caveats that things might change.

Almost all the banks reported common equity Tier 1 (CET1) ratios in Q1 that exceed new requirements due to go into effect in Q4. However, a July 8 S&P Global report observed: “The Fed's auxiliary ‘coronavirus event’ analysis, which did not disclose individual firm results, is perhaps more telling about the provisional nature of the June results. Under a ‘W-shaped’ double-dip recession scenario, the simulation found that losses would push a quarter of the 33 stress test banks to a CET1 ratio of 4.8% or less. The minimum is 4.5%.” The report identifies some of the banks that might be forced to cut their dividends in that scenario.

(2) Provisioning for more losses. While it is unlikely that there will be any significant announcements about dividend cuts by the banks during their conference calls this week, they are likely to boost their provisions for loan losses as a result of the ongoing GVC. Jackie and I are closely monitoring a weekly series compiled by the Fed on “allowance for loan & lease losses” at all commercial banks. It jumped from $112.9 billion at the start of this year to $168.7 billion during the July 1 week (Fig. 8). We think it is headed higher. The previous record high in this series was $235.2 billion during the week of April 21, 2010.

The good news (sort of) is that commercial and industrial loans jumped $745 billion from mid-February though early May (Fig. 9). The bad news is that the recent spike reflected a mad dash to cash lines of credit by businesses that faced a cash crunch resulting from GVC lockdowns. As the economy gradually reopens, these loans are likely to be repaid. In fact, they are down $228 billion since early May through the July 1 week.

Also in the negative column is credit-card debt outstanding, which is down $109 billion over the three months through May, which will reduce the fees earned by banks from these loans (Fig. 10). The delinquency rate on credit-card loans overdue by 90 days or more jumped to 9.1% during Q1, the highest since Q4-2013, which will increase the losses incurred by banks for these loans (Fig. 11). The comparable rate on auto loans rose to 5.1% during Q1, the highest since Q1-2011. It undoubtedly continued to rise during Q2, though government emergency benefit payments might have moderated the jump.

(3) Commercial real estate. On June 10, American Banker reported: “Commercial developers could be the banking industry’s next big credit risk. Many retailers, crippled by lower foot traffic tied to the coronavirus outbreak, didn’t pay their loans in May, with some banks reporting delinquency rates as high as 40%. If a similar percentage of stores are falling behind on their rent, it could create cash flow issues for landlords. That might mean more bankruptcies, increased defaults on commercial real estate loans and greater stacks of soured loans for bankers to work through.”

Corporate bankruptcies rose by 48% in May from a month earlier, with 724 businesses filing for Chapter 11 protection, according to data compiled by the legal-services firm Epiq Global. Bankruptcies had already risen by 30% during April. Three prominent retailers—J. Crew, Neiman Marcus, and JCPenney—were among the companies that filed for bankruptcy protection. They’ve been followed by Brooks Brothers, GNC Holdings, and Sur La Table. The following are closing retail locations: Bed, Bath & Beyond (200), AT&T (250), Microsoft (all of them).

US retailers are on track to close between 20,000 and 25,000 stores this year, about 60% of them in malls, according to a June report from Coresight Research, a retail research firm. That’s up from the firm’s previous estimate in mid-March of 15,000 closings, and it would surpass the record 9,000 store closures last year.

(4) Some positives. Of course, the flat yield curve means that net interest margins shrank during Q2. On the other hand, the banks earned some fees making loans under the government’s Paycheck Protection Program. In addition, the Fed’s QE4Ever program, launched on March 23, poured liquidity into financial markets, stimulating a tidal wave of bond and stock issuance.

The July 9 WSJ reported: “Thanks to a flood of new-stock issuance and a resilient IPO market, companies raised nearly $190 billion from the end of March through the end of June, the most ever in a single quarter for the U.S. equity-capital markets, according to Dealogic, whose data go back to 1995.

“The wave started in the convertible-bond market as the Federal Reserve gobbled up more bonds to help stimulate the economy. Then it spread to large stock sales by publicly traded companies looking to bolster their coffers as the virus threatened business. Those successes emboldened other companies looking to raise money opportunistically by selling stock. Then, in late May, initial public offerings jolted back to life.”

Over the past 12 months through May, the 12-month sum of new US corporate bonds and stocks rose to $2,413 billion, the highest since December 2007 (Fig. 12). New bond issuance totaled $2,213 billion, while new equity issuance totaled $200 billion. Most of these were issued in recent months.

Dealogic estimates that equity-capital-markets transactions brought in roughly $5.7 billion in fees in the first half of the year. In June, $17.2 billion was raised in IPOs, which tend to generate the highest-margin fees for banks in equity capital markets. There’s bound to be lots of M&A activity over the rest of this year as many weak businesses are acquired by stronger ones.

(5) Bottoming forward earnings. The forward earnings of the S&P 500 Financials sector got clobbered during the spring, plunging 32.0% from its cyclical high during the March 5 week to its recent low during the April 30 week, led by a 48.4% freefall in the forward earnings of Diversified Banks (Fig. 13). But both have been edging higher in recent weeks.

Strategy III: Winners & Losers. During most recessions, there are many more losers than winners. In fact, it’s hard to come up with many companies or businesses that benefit from economic downturns. The current GVC recession, on the other hand, clearly has some very visible winners. That’s evidenced by the clear outperformance of the FAANGM (Facebook, Amazon, Apple, Netflix, Google’s parent Alphabet, and Microsoft) stocks. As Joe and I observed in our July 6 Morning Briefing focused on them: “All six of the FAANGMs are among the biggest beneficiaries of the economic upheaval caused by the GVC and are likely to continue to benefit from its aftershocks well after the crisis is over. That’s because their businesses are Internet-based, so the more that people’s work, education, and entertainment are home-based, the more these businesses thrive.” Consider the following:

(1) Information Technology. Contrary to popular belief, only two of the FAANGMs are included in the S&P 500 Information Technology sector. They are Apple and Microsoft, and account for a whopping 45.1% of the sector’s market cap. They’ve clearly contributed greatly to the sector’s outperformance in recent years—especially during the recent meltup, with gains of 71.0% and 57.1%, respectively, since March 23. They’ve also helped to boost the forward earnings of S&P 500 Technology Hardware, Storage & Peripherals, and S&P 500 Systems Software (Fig. 14).

Another notable outperforming tech stock is Nvidia. It is up 97.1% since March 23. It has a market cap of $258 billion, accounting for 48.7% of the Information Technology sector in combination with Apple and Microsoft. It undoubtedly muted the recent downturn and is now adding to the upturn in the forward earnings of the S&P 500 Semiconductor industry (Fig. 15).

Joe and I are considering adding Nvidia to the Magnificent Six. Our acronym for the resulting Magnificent Seven would be “FANGMAN,” which rhymes forebodingly with “hangman.” Many institutional investors in actively managed equity portfolios are telling us that they can’t match the overweight of these stocks in the S&P 500 without violating their mandate to rebalance when any stock exceeds a certain maximum percentage of their portfolio, such as 4% in a portfolio with 25 stocks. Some are opting for benchmarking to the S&P 500 equal-weighted index rather than the market-cap weighted index, if they can.

(2) Consumer Discretionary. The Consumer Discretionary sector accounts for 11.3% of the S&P 500’s market cap, and Amazon accounts for an extraordinary 53.7% of the sector’s market cap.

Online sales accounted for a record 50.7% of GAFO (general merchandise, apparel and accessories, furniture, and other sales) sales, which includes sales of gift stores and retailers that specialize in department-store types of merchandise such as furniture & home furnishings, electronics & appliances, clothing & accessories, sporting goods, hobby-related goods, books, music, general merchandise, office supplies, and stationery (Fig. 16). That’s up from 36.0% during February. That means that brick-and-mortar stores that compete with online vendors saw their share plummet from 64.0% during February to 49.3% during April. There will clearly be winners and losers among retailers during the Q2 earnings season.

If Standard & Poor’s adds Tesla to the S&P 500 Consumer Discretionary sector, as recent buzz suggests, then we can have the Magnificent Eight, or FANGMANT, which sounds like “figment,” as in “figment of the imagination”! With a market capitalization of about $286 billion, Tesla would be among the most valuable companies ever added to the S&P 500, larger than 95% of the index’s existing components. Its addition would have a major impact on investment funds that track the index. Since March 23, Tesla’s stock price is up 255.7%.

(3) A long road for Transports. It will be interesting to hear the forward guidance provided by the railroad and trucking industries. Their fundamentals were awful during Q2. The 26-week moving average of railcar loadings fell to 451,000 during the July 4 week, little changed from 447,000 during the June 20 week, which was the lowest reading since mid-August 2009 and around the previous recession’s trough (Fig. 17). However, excluding coal loadings, it was still 27% above the previous recession’s low point. Intermodal railcar loadings are also down sharply, but still 32% above the previous recession’s bottom in this series.

The ATA Truck Tonnage Index plunged 11.2% from its record high during March through May to the slowest pace since July 2017 (Fig. 18). As we discussed on Thursday, that decline coincides with the 43% drop in gasoline usage from the March 13 week through the April 24 week, when it bottomed at 5.3mbd. Since then through the July 3 week, gasoline usage is up 60% to 8.5mbd, from which point it would need to rise another 14% to get back to a normal 9.7mbd pace of fuel consumption. This suggests that both retail and commercial traffic are increasing. So we expect to see a rebound in the ATA index for June and July. Let’s see what railroad and trucking company managements have to say.

Movie. “Greyhound” (+ +) (link) is a film written by and starring Tom Hanks. It pays homage to the brave Allied sailors who manned the naval convoys that crossed the North Atlantic during WW II with American supplies for the war effort in Europe. They were relentlessly attacked by Nazi U-boats, and were particularly vulnerable in the “Black Pit,” where the convoys couldn’t be protected with aerial support. The Battle of the Atlantic was the longest continuous military campaign in the war, running from September 1939 to the defeat of Germany in May 1945. For a few months in 1941, British codebreakers at Bletchley Park led by Alan Turing were able to rout convoys around the U-boats.

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TGI Thursday: Accentuating Some Positives

July 09 (Thursday)

US Economy: Sun Shining Through the Clouds. Here is an update on one of our favorite upbeat economic indicators, the four-week average of gasoline usage in the US. As a result of the lockdowns, it plunged 43% from the March 13 week through the April 24 week, when it bottomed at 5.3mbd. Since then through the July 3 week, it is up 60% to 8.5mbd (Fig. 1). It needs to rise another 14% to get back to a normal 9.7mbd pace of fuel consumption. It currently seems to be on the road to doing just that in coming weeks, though a slowing of state re-openings could place some roadblocks in the way of this indicator’s road to recovery.

Admittedly, gasoline usage may be overstating the extent of the economic recovery if more people are choosing to return to work by car rather than by taking public transportation. Then again, lots of people who have the option continue to work from home. In addition, very few Americans are likely to be vacationing overseas this summer. That means that more of them are likely to be taking driving vacations within the US, but that would be a positive for the US economy.

Here is another happy-go-lucky indicator: The Citigroup Economic Surprise Index soared to a record 221.3 on Tuesday, July 7 (Fig. 2). It is up from a record low of -144.6 on April 30.

Here’s more good news: S&P 500 forward revenues, forward earnings, and the forward profit margin continued to edge higher during the July 2 week, as they have been doing for the past seven weeks (Fig. 3). This strongly suggests that actual S&P 500 revenues, earnings, and the profit margin all bottomed during Q2 and should be moving higher during Q3. Seems like the stock market has been anticipating this development since it bottomed on March 23. TGIT!

Strategy: Worst Behind Semis? Semiconductor sales are proving themselves to be relatively resilient in this services-led recession. Worldwide sales of semiconductors for May, based on a three-month moving average, rose 5.8% y/y and 1.5% m/m, according to a July 3 press release from the Semiconductor Industry Association. That’s an improvement from April, when worldwide semi sales rose 6.1% y/y but fell 1.2% m/m. Here’s a look at some of the report’s details and the latest industry dynamics:

(1) Improvement spreading geographically. In April, China was the only geographic area that saw a m/m increase in semiconductor sales. By May, sales gains were showing up in Japan and the Americas in addition to China. Here are the m/m sales results by region in May and in April: China (5.8% in May, 2.1% in April), Japan (2.8, -0.9), Americas (1.9, -1.1), Asia Pacific/All Other (-1.7, -3.1), and Europe (-6.5, -7.6) (Fig. 4).

The same press release reported that the World Semiconductor Trade Statistics organization forecasts worldwide semiconductor sales growth of 3.3% y/y in 2020 and 6.2% in 2021. Their 2020 tally includes a 12.8% increase in the Americas, a 2.6% increase in Asia Pacific, a 4.1% decrease in Europe, and a 4.4% decline in Japan.

(2) Market moved ahead of the results. As is often the case, the stock market sniffed out the industry’s improvement ahead of the report. The S&P 500 Semiconductors stock price index is up 10.0% ytd through Tuesday’s close, and the S&P 500 Semiconductor Equipment stock price index is up 7.9% over the same period. Both indexes are about 2% below their highs earlier this year (Fig. 5 and Fig. 6).

Much of the ytd gain in the S&P 500 Semiconductors index is attributable to two of its largest stocks: Nvidia, up 67.8% ytd, and AMD, up 15.4%. Most of the industry’s other members are up or down in the low single digits. Nvidia’s and AMD’s chips are found in gaming consoles and data center servers that power the Cloud. Both areas have been helped by the many hours that people have spent working and playing at home due to COVID-19. The rally in Nvidia’s shares has inflated the company’s market capitalization to just a smidge below industry veteran Intel’s market cap.

(3) Analysts’ expectations. After declining for much of the past year, analysts’ 2020 revenue and earnings expectations for the S&P 500 Semiconductors industry started increasing again in early May. Revenue is expected to inch up 2.1% this year and jump 9.6% in 2021 (Fig. 7). Meanwhile, earnings are expected to tumble 7.1% this year and to rebound by 18.2% in 2021 (Fig. 8).

Individual chip companies have had positive earnings news of late. Most recently, Samsung Electronics forecast Q2 operating profit will rise 22.7% y/y to 8.1 trillion South Korean won and revenue will fall 7% y/y to 52 trillion won. The company’s forecasts—which include an unspecified one-time gain from the sale of its display business—beat analysts’ forecasts for 6.3 trillion won in operating profit and 50.3 trillion in revenue, a July 6 WSJ article reported. The strength in the company’s chip business is expected to have more than offset weakness in smart phone sales.

Last month, Xilinx raised its guidance for FY-Q1 ending June 27. The company now forecasts quarterly revenue of $720-$734 million, above the previous range of $660-$720 million. “While we have seen some Covid-19 related impacts during the June quarter, our business has generally performed well overall, with stronger than expected revenues in our Wired and Wireless Group and Data Center Group more than offsetting weaker than expected revenues in our consumer-oriented end markets, including automotive, broadcast, and consumer. A portion of the revenue strength in the quarter was due to customers accelerating orders following recent changes to the U.S. government restrictions on sales of certain of our products to international customers,” said CEO Victor Peng in a June 29 press release.

The industry’s forward profit margin has fallen from an all-time peak of 32.1% in August 2018 to a recent 27.9% (Fig. 9). Its forward P/E has climbed to 18.5, which is relatively elevated compared to the last decade but could weaken as earnings recover to cyclical highs (Fig. 10).

(4) More US semi manufacturing. As we discussed in the June 4 Morning Briefing, the Trump administration has focused on increasing semiconductor manufacturing in the US. And it looks like manufacturers are nibbling, with some considering building more US capacity, especially if the US offers financial assistance.

Last month, GlobalFoundries, the world’s third-largest semiconductor contract manufacturer, said that it could expand production at an existing US plant and, in a later phase, could build a new plant next to its first plant, a June 24 Reuters article reported. CEO Tom Caufield said expansion would depend on customer demand and the Senate’s pending $22.8 billion aid package to help semiconductor manufacturers expand their presence in the US. “A partnership with the U.S. can accelerate that capability. ... What may take us five years, we can accelerate to two years,” he told Reuters.

(5) Tapping a hot market. China’s Semiconductor Manufacturing International Corp. (SMIC) is planning a $6.6 billion of stock offering that could be upsized to roughly $7.5 billion, a July 6 WSJ article reported. The company said it will use the funds for a chip production and research site, research and development, and working capital.

Just like the US, China is looking to bolster its chip-manufacturing abilities, especially after the Trump administration banned Huawei from buying US parts last year. Investors apparently see benefit: SMIC shares have tripled this year versus a 2.6% ytd decline for the S&P 500. However, a July 6 WSJ article warned that the company’s technology is about five years behind the competition, and the company depends on US manufacturing equipment that it may not be able to purchase in the future.

Disruptive Technology: Trucking Along Autonomously. The breathless headlines about autonomous trucking—and autonomous driving in general—have been catching their breath over the past year. So news that TuSimple, an autonomous trucking company, was expanding its trucking routes caught our eye. Its progress stands in sharp contrast to news of layoffs and closings at other autonomous trucking operations. Let’s take a quick look at the industry, which appears to be entering its teenage years:

(1) Making progress. TuSimple still has humans sitting behind the wheel of its autonomous trucks, but it’s making progress toward driverless operations. A July 1 press release stated that the company—which already operates on routes between Phoenix, Tucson, El Paso, and Dallas—will expand this year to the Dallas Triangle: Dallas, Houston, and San Antonio.

By 2022, the company hopes to offer routes throughout the South, from Los Angeles to Jacksonville, Florida. And by 2023-24, it aims to offer driverless operations nationwide. The company typically runs its trucks between depots outside of city centers, avoiding congestion and leaving the trickier driving in local traffic to humans. It’s also starting in the Southwest, where flat roads (no mountains) and good weather make for easier driving.

TuSimple’s partnerships and investor base are impressive. It has been working with U.S. Xpress, a trucking company that’s expanding the routes on which it uses TuSimple’s trucks. The company also works with UPS and McLane Food Service, which makes deliveries to convenience stores, mass merchants, drug stores, and chain restaurants. TuSimple’s equity investors include UPS and Nvidia.

TuSimple claims that its autonomous trucks can lower the cost of shipping goods by 30% and solve the problem of driver shortages, one of the industry’s largest problems in recent years. TuSimple should make trucking safer because its trucks can “see” up to 1,000 meters away and react 15 times faster than humans. Because they can see so far ahead, the company’s trucks can cut fuel costs by up to 15% a year by better regulating speed and lane positions.

(2) Not everyone faring well. Starsky Robotics, an autonomous truck company started in 2016, shut down in March. The company’s autonomous truck was the first to do unmanned runs on a closed road (in 2018) and on a live highway (2019). Even so, it was unable to raise new funding.

In a March 19 post mortem on Medium.com, CEO Stefan Seltz-Axmacher wrote: “There are too many problems with the [autonomous vehicle] industry to detail here: the professorial pace at which most teams work, the lack of tangible deployment milestones, the open secret that there isn’t a robotaxi business model, etc. The biggest, however, is that supervised machine learning doesn’t live up to the hype. It isn’t actual artificial intelligence akin to C-3PO, it’s a sophisticated pattern-matching tool.”

Seltz-Axmacher went on to say that the initial success at creating autonomous vehicles has been followed by much slower progress and exponential increases in costs. Instead of seeing exponential improvements in artificial intelligence (AI) tracking the Moore’s Law curve, AI advances in this industry have plateaued, looking more like an S-curve. As a result, the current consensus is that self-driving cars are at least 10 years away, and not many startups can survive a decade before producing a product.

Before dismissing Seltz-Axmacher’s take as sour grapes, consider that other autonomous trucking companies have also hit speed bumps. This spring, Kodiak Robotics laid off about 20% of its employees, blaming COVID-19’s economic impact. It followed Zoox’s suit: The developer of self-driving taxis recently laid off about 10% of its 1,000 employees.

Around the same time, Sweden’s Einride announced that in addition to its autonomous electric truck effort, the company would begin developing electric trucks with human drivers, an April 22 article in VentureBeat reported. The company is working with grocer Lidl in the Stockholm region, where the electric trucks will transport goods from a central warehouse to stores in the area.

And before COVID hit, Daimler AG took a step back by shelving its autonomous taxi efforts to focus instead on autonomous long-haul trucks. A November 18, 2019 Bloomberg editorial attributed the move to the company’s need to cut costs and inability to commit to a “large, capital-intensive project without a clear idea of what kind of first-mover advantage it might confer.” In addition, no one has figured out how to make autonomous cars work, particularly in city traffic, and doing so will “take more than a couple of years.”

So while there are still many companies trying to build autonomous cars and trucks, the field has gotten less crowded, and that should be a good thing for investors in the surviving companies.

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Modern Monetary Theory: In Theory & In Practice

July 08 (Wednesday)

(I) MMT Description: Meet Professor Kelton. Stephanie Kelton is the most vocal proponent of Modern Monetary Theory (MMT) today. She is a former chief economist on the US Senate Budget Committee and professor of economics and public policy at Stony Brook University. Her June 2020 book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, reads like the MMT movement’s manifesto. Melissa and I have written about MMT before (see here and here). Kelton’s new book provides us with more to write about both her theory and her policy prescriptions.

Kelton argues that the federal government can and should run large budget deficits as long as inflation remains subdued. MMT opponents’ main objection is that the theory provides a blank check for the government to get much bigger. It provides the government with too much power to allocate resources. Free-market capitalists believe that markets do a much better job of doing so than politicians and bureaucrats. Kelton clearly disagrees; but before we go there, let’s dive into her theoretical description of MMT:

(1) Printing press. The central premise of MMT is that the US federal government, as the exclusive issuer of its sovereign currency (i.e., the US dollar), can “print” money without limit. It can do so as necessary to service or to pay down the public debt. It follows, therefore, that there is no well-defined limit on deficit-financed government spending unless and until inflation heats up.

Kelton notes: “Both the US Treasury and its fiscal agent, the Federal Reserve, have the authority to issue the US dollar. This might involve minting the coins in your pocket, printing up the bills in your wallet, or creating digital dollars known as reserves that exist only as electronic entries on bank balance sheets” (p. 17).

The power of the monetary printing press is not limited to the US. Any country that issues and borrows in its own currency also has the power of MMT.

(2) Inflation. Importantly, Kelton acknowledges that government budget deficits only matter if they cause inflation. That happens when real resources in the economy are strained by “overspending,” which causes inflation. The clear implication is that federal government deficits can balloon until they cause inflation to heat up. In Kelton’s world, the federal government budget deficit clearly is too small if there is any unemployment, a sign of underutilized resources.

MMT maintains that the federal government can achieve both full employment and stable inflation with an appropriate amount of deficit-financed spending. But what happens when the economy hits the wall of full utilization of resources, causing inflation to heat up? Any additional government spending beyond full resource utilization is inflationary. But never fear: MMT theorizes that inflation can easily be taxed away (as discussed in the section below)!

(3) Fiscal policy matters more. The old-school Keynesian concept of running budget deficits during recessions and surpluses during expansions is so yesterday. Even modern-school Keynesians have long abandoned any notion of fiscal discipline during good times. New-school MMTers reject the Keynesian belief—held by central bankers around the world—that a certain amount of unemployment is necessary to keep inflation stable. That concept is often referred to as the “natural rate of unemployment” (NAIRU). MMT advocates dismiss NAIRU given their stance that it’s possible to balance full employment (i.e., literally zero unemployment) with stable inflation. If done right, the theory goes, MMT can take the resources that are underutilized in the private sector and put them to work in the public sector.

From an MMT point of view, “we should rely on adjustments in taxes and spending (fiscal policy) rather than interest rates (monetary policy)” to balance our economy (p. 63). Kelton argues, as Keynesians do, that fiscal policy is better equipped for this task than monetary policy, mainly because the Federal Reserve cannot force borrowing to boost spending; it can only reduce the cost of borrowing. Fiscal spending directly targets areas of the private sector that need a boost.

(4) Accounting for MMT. MMT is based on an accounting identity, as every surplus (deficit) in one sector of the economy is offset by a deficit (surplus) in another sector of the economy. There are three “buckets” in the economy: the public sector, the private sector, and the foreign sector. The financial balance for any of these sectors at a given time all must total to zero. As Kelton observes: “Fiscal surpluses suck money out of the [private] economy. Fiscal deficits do the opposite” (p. 96).

Fiscal deficits also serve to keep the US private sector from falling into a deficit when the foreign sector runs at a surplus, Kelton maintains. More specifically, “the government must run budget deficits that exceed the US trade deficit” (p. 134). The US consistently runs a trade deficit with the foreign sector as it imports more than it exports, bringing in goods and services and sending US dollars abroad.

(5) Changing the rules. For years, Congress has followed three main rules when it comes to the federal budget: PAYGO, the Byrd Rule, and the deficit ceiling. In 2018, Congress, led by Speaker Nancy Pelosi (D-CA), reinstituted PAYGO to “demonstrate their commitment to good, old fashioned household budgeting” (p. 22). With PAYGO, federal borrowing to finance new expenditures is not permitted. So lawmakers must cover any new spending proposals with revenue from new taxes. Under the Byrd rule, on the Senate side, deficits can increase, but not beyond a 10-year budget window. Finally, the debt ceiling puts a legal limit on the allowable federal government debt. Kelton points out that while these rules may be politically useful, they are completely artificial. She says: “Because all of these constraints were imposed by Congress, they can all be waived or suspended by Congress” (p. 38).

(II) MMT Prescriptions: It’s All About Power. Kelton promotes lots of controversial policy prescriptions based on MMT. “The question is,” she writes, “How do we want the federal government to use its great power? … Can we trust Congress to make the right choices, at the right time, making productive choices when there is fiscal space and exercising the necessary restraint as resources become scarce?” (p. 237). She clearly is all for bigger government with more power.

Kelton’s reader can easily detect her political leanings. She is decidedly for the policies of Representative Alexandria Ocasio-Cortez (D-NY and Green New Deal proponent) and Senator Bernie Sanders (D-VT; universal healthcare). She writes against the policies of President Donald Trump (China trade), former President Bill Clinton (budget surplus), and former President Barak Obama (recession response). Her agenda focuses on how the nation’s real resources should be allocated by government programs rather than how extensive and big those programs should be or how they should be financed. Here’s more:

(1) Real deficits. Kelton contends that, rather than focusing on the fiscal deficit, politicians should focus on the real deficits in our economy. According to Kelton, these deficits can be addressed with fiscal policies (and spending) as follows: a good-jobs deficit (a minimum standard of living), a household-savings deficit (free higher education and affordable childcare), a healthcare deficit (insurance for all and more real healthcare resources), an education deficit (retire all student debt), an infrastructure deficit (fix it), an inequality deficit (taxes and redistribution). Clearly, Kelton advocates replacing Adam Smith’s invisible hand with Uncle Sam’s hugely visible one.

(2) Taxing & redistributing. As we see it, one of the major flaws of MMT is that excessive spending that causes inflation would have to be offset with higher taxes for the private sector. Kelton herself admits that if the government wants to boost spending in a targeted area, it may “need to remove some spending power from the rest of us to prevent its own more generous outlays from pushing up prices” (p. 33). One way to create this room is through higher taxes. Taxes are also a “powerful way for governments to alter the distribution of wealth and income” (p. 33). Governments can also use taxes “to encourage or discourage certain behaviors” (p. 34).

(3) Federal jobs guarantee. “Capitalist economies chronically operate” without “enough combined spending (public and private) to induce companies to offer employment for every person who wants to work,” Kelton writes (p. 56). She adds: “There isn’t a capitalist economy on earth that has found a way to eradicate the business cycle” (p. 65). Kelton argues that MMT could be used to get the economy to full employment and smooth the business cycle.

Kelton envisions a “universal right of employment” whereby a “Public Service Employment (PSE) program” would offer “paid work at a living wage” of $15 per hour “with a basic package of benefits that include health care and paid leave” (p. 249). “Think of it” as binders on a shelf “filled with a wide variety of available jobs.” Enough jobs to “allow people with different skills and interests to walk in without a job and walk out with one that fits them.” The program would be focused on utilizing workers to build a “care economy” oriented around our aging society.

This remarkable program would automatically stabilize fiscal spending to where it needs to be to balance full employment with stable inflation. When the economy hits a recession (or recovers), the PSE program ramps up (or down). This raises some obvious questions. If people are content with their government job, why would they leave? What about workers who say they want to work but are routinely absent? How do you address structural problems like mismatches between the government’s skill needs in a particular region and their availability in the local job market?

(4) The Wizard of Oz. MMT reminds Kelton of the end of the classic 1939 film The Wizard of Oz, when Dorothy discovers that she always had the power to return home simply by clicking the heels of her red shoes three times. Kelton uses this analogy to describe the power of MMT, which has always been there, in her opinion. But remember, the story was all a bad dream Dorothy had after getting hit on the head. Free market capitalists might exclaim: “Pay no attention to the professor behind the curtain!”

(III) MMT Utopia: Free-for-All. Kelton’s views must strike many conservatives as unrealistic. They must see her as another Utopian promising Heaven on Earth—a people’s economy where everything is provided for free thanks to MMT.

But whether one is for MMT or against it, Kelton’s book leaves no doubt about what MMT is all about: It’s an agenda for more big government and higher taxes. She probably would welcome the opportunity to be Treasury Secretary if the Democrats win the White House in November. Ironically, her views already are reflected in the current Republican administration’s fiscal policymaking! Consider the following:

(1) Huge federal deficits. At the beginning of 2018, the Trump administration lowered taxes and agreed to an increase in government spending. The result was a massive upward revision in the federal budget deficit and debt projections of the Congressional Budget Office (CBO) (Fig. 1 and Fig. 2). Last year, the CBO projected that deficits would exceed $1.0 trillion every year from 2020 to 2030. By the end of this period, the CBO projected that the public debt would be close to 100% of nominal GDP, up from 79.2% during 2019.

Then the Great Virus Crisis (GVC) hit at the start of this year. In March and April, four laws were enacted in response to the 2020 coronavirus pandemic. They included lots of programs to support workers and businesses. The 12-month federal budget deficit jumped to a record $2.1 trillion through May, as outlays soared while revenues plunged (Fig. 3 and Fig. 4).

On April 13, the Committee for a Responsible Federal Budget stated: “Our latest projections find that under current law, budget deficits will total more than $3.8 trillion (18.7 percent of GDP) this year and $2.1 trillion (9.7 percent of GDP) in 2021. We project debt held by the public will exceed the size of the economy by the end of Fiscal Year 2020 and eclipse the prior record set after World War II by 2023.”

(2) Another round of support. These projections almost certainly underestimate deficits, since they assume that no further legislation is enacted to address the crisis and that policymakers stick to current law when it comes to other tax and spending policies. In a June 30 briefing, Senate Majority Leader Mitch McConnell promised to “stay on the schedule that I announced earlier in the year” for making a decision in July on the next stimulus bill, and by extension, if that contains another stimulus check. He has also warned that the next relief package will also be the last. White House Chief of Staff Mark Meadows on Monday said he expects the Trump administration and lawmakers to hammer out another coronavirus stimulus package within the next two to three weeks before Congress’s August recess, with President Donald Trump backing both another round of checks to taxpayers as well as a payroll tax deduction.

(3) QE4Ever. In his February 26, 2019 congressional testimony on monetary policy, Fed Chair Jerome Powell trashed MMT and rejected the idea that the Fed ever would help combat the impact of spiraling deficits by keeping interest rates low. Specifically, Powell said, “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong.” Furthermore, “US debt is fairly high to the level of GDP—and much more importantly—it’s growing faster than GDP, really significantly faster. We are going to have to spend less or raise more revenue.” During his congressional testimony, he refused to cross the border between monetary and fiscal policies: “And to the extent that people are talking about using the Fed—our role is not to provide support for particular policies,” Powell said. “Decisions about spending, and controlling spending and paying for it, are really for you.”

What a difference a GVC makes! On Monday, March 23, the Fed announced QE4Ever, an open-ended commitment to buy Treasuries and mortgage-backed securities. By the end of the week, Friday, March 27, President Trump signed the $2.2 trillion CARES Act, which provided $450 billion for the Fed to support $4 trillion in loans to Main Street.

Now Powell is all for MMT all the time, or at least until there is a vaccine. In his April 29 press conference, he crossed the line, mentioning the word “fiscal” 11 times. A central theme of his comments was that “[t]his is the time to use the great fiscal power of the United States … to do what we can to support the economy and try to get through this with as little damage to the longer-run productive capacity of the economy as possible.” He implied that the Fed would do everything possible to enable more fiscal stimulus.

That all adds up to MMT. Kelton has won the debate, for now, with the assistance of the GVC.

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More on MAMU & MAMD

July 07 (Tuesday)

Strategy I: Meltups Are Followed by Meltdowns. Joe and I have some advice for the stock market: Give it a rest, please!

In our ideal world, the S&P 500 would move sideways over the rest of this year, consolidating its gains since March 23 and giving earnings, along with the economic fundamentals, time to catch up with the extraordinary rally since then. The S&P 500 stock price index is up 42.1% since the March 23 low through yesterday’s close (Fig. 1 and Fig. 2).

The index would have to rise just 6.5% to match the February 19 record high of 3386.15. Back then, S&P 500 forward earnings hit a record high of $179.01 per share with the forward P/E rising to 19.0 (Fig. 3 and Fig. 4). Currently, forward earnings is $144.81, and the forward P/E is 22.0. Forward earnings has recovered very modestly for the past seven consecutive weeks, but it still remains 19.1% below its record high.

All we are saying is give forward earnings a chance—a chance to catch up. Nevertheless, we’ve recently recognized that the meltup that started on March 24 might continue, leading to the Mother of All Meltups (MAMU), or at least might challenge the MAMU of 1999, when the S&P 500 jumped 63.5% from August 31, 1998 through March 24, 2000. Over that same period, the Nasdaq soared 231.0%. Currently, this index is up 52.1% since March 23.

In his December 5, 1996 speech, then-Fed Chair Alan Greenspan famously asked: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?”

In yesterday’s Morning Briefing, I asked a similar question: “What should the forward P/E of the S&P 500 be when the federal funds rate is zero, the 10-year US Treasury bond yield is below 1.00%, and the Fed is providing plenty of liquidity to facilitate the resulting rebalancing from bonds to stocks?” I also observed that prior to the Great Virus Crisis (GVC), we all thought that the S&P 500’s fair-value P/E was around 15.0. Under the current circumstances, it might be twice as much. When we hear more investors saying the same, let’s remember to get out of stocks, since MAMUs tend to be followed by MAMDs (Mothers of All Meltdowns).

Then what? Well, the Fed might start buying stocks, after lowering the federal funds rate below zero. I’m just thinking out loud about where this is all heading. We are still very much in the Twilight Zone, with no obvious way out.

Contributing to yesterday’s stock-market rally in the US were the following developments:

(1) Chinese stocks soaring. CNBC reported: “A front page editorial in state-owned China Securities Journal is getting credit for fueling a strong rally in Chinese markets overnight that spread to global equities. Shanghai stocks jumped 5.7%, after the publication said investors should look forward to the ‘wealth effect of the capital markets’ and the prospect for a ‘healthy bull market.’” Shanghai’s gain was on top of a jump of 5.8% last week (Fig. 5).

On Friday, we learned that China’s Caixin Services PMI rose to 58.4 during June, up from the February lockdown low of 26.5 (Fig. 6). That’s the highest reading in a decade.

(2) US services sector rebounding. Yesterday, we learned that June’s NM-PMI in the US jumped to 57.1 from its lockdown low of 41.8 during April (Fig. 7). The increase was led by the production (66.0) and new orders (61.6) sub-indexes, while the employment component remained well below 50.0 at 43.1 but up from the recent low of 30.0 during April.

(3) Buffett is buying. Warren Buffett’s Berkshire Hathaway finally pulled the trigger yesterday. The conglomerate is spending $4 billion to buy the natural gas transmission and storage assets of Dominion Energy. Including the assumption of debt, the deal totals almost $10 billion. It’s Berkshire’s first major purchase since the coronavirus pandemic and subsequent market collapse in March. As one of our savvy accounts observed: “[I]t is sensible that energy assets—valued at minimal levels—would move from weak hands (cash-starved utilities) to strong hands (portfolio acquirers, both private and public). Acquisitions often signal bottoms. Are we at a bottom for strategic energy assets?”

Strategy II: Nominal Interest Rates Are Nominal. For now, the federal funds rate remains at zero, and the rest of the US Treasury yield curve remains slightly above zero. The yield-curve spread between the 10-year bond yield and the federal funds rate has been slightly positive in recent weeks after it fell slightly below zero late last year and early this year (Fig. 8). The 10-year yield has been consistently below 1.00% since March 20 (Fig. 9).

The S&P 500 dividend yield was 1.92% during Q2-2020, or more than twice as much as the bond yield during June (Fig. 10). A very simple valuation model is our Blue Angels framework showing the implied fair-value levels of the S&P, which we calculate by dividing four-quarter trailing S&P 500 dividends by dividend yields of 1% to 6% (Fig. 11). At 1.92%, the S&P 500 is currently trading where it should be according to the model.

S&P 500 dividends totaled a record $494.3 billion during the four quarters through Q2-2020 (Fig. 12). The actual Q2 payout was $118.6 billion, up 0.3% y/y and down 6.6% q/q. The quarterly total might very well start to recover during H2 given that the economy bottomed during April and showed signs of a V-shaped initial rebound during May and June.

As long as investors believe that the GVC recession is likely to be a short one that doesn’t significantly dent the dividend-paying power of the S&P 500, then the case for stocks remains compelling. That’s because bonds are yielding close to nothing, while stocks are yielding more than twice as much and have the capacity to grow dividends.

 Strategy III: Real Interest Rates Are Unreal. While nominal US Treasury interest rates remain north of zero, they are negative on an inflation-adjusted basis. That makes the case for rebalancing out of bonds and into stocks even more compelling, since dividends tend to grow faster than inflation (Fig. 13). Since Q1-2009 through Q2-2020, inflation-adjusted S&P 500 dividends are up 128.8%. Here are the current dividend yields on an S&P 500 portfolio purchased in 1970 (69.2%), 1980 (44.0), 1990 (18.0), 2000 (4.5), and 2010 (4.7) (Fig. 14). Those all beat the inflation rate in the US, which has been mostly under 2.0% since 2012. Now consider the following:

(1) Really negative. During May, the inflation rate in the US was only 1.02% based on the yearly percent change in the personal consumption expenditures deflator excluding food and energy (Fig. 15). As noted above, the 10-year bond yield has been below 1.00% since March 20. The inflation-adjusted bond yield was -0.35% during May (Fig. 16). Not surprisingly, it is highly and closely correlated with the 10-year TIPS yield, which was -0.76% on Monday, the lowest reading since December 12, 2012 (Fig. 17).

(2) Good for gold. The price of an ounce of gold is highly correlated with the inverse of the 10-year TIPS yield (Fig. 18). The price has rallied 51% from a 2018 low of $1,178 on August 17 to $1,773 on Friday. Over the same period, the TIPS yield has dropped from 0.79% to -0.73%, widening to -0.76% yesterday.

The strength in the price of gold has yet to show up in a solid rebound in the CRB raw industrials spot price index (Fig. 19). However, the price of copper, which is one of the components of the CRB index, is up 29% from its recent low on March 23. Not surprisingly, the price of copper is highly correlated with the China MSCI stock price index (in yuan) (Fig. 20).

The Fed: An Extremely Accommodative Message. One of the reasons why the stock market rally is continuing so far this month is this: In the Minutes of the June 9-10 meeting of the Federal Open Market Committee (FOMC), released on July 1, the adjective “accommodative” appeared seven times:

(1) “The [econometric model] simulations suggested that the Committee would have to maintain highly accommodative financial conditions for many years to quicken meaningfully the recovery from the current severe downturn.”

(2) “Various participants noted that the economy is likely to need support from highly accommodative monetary policy for some time …”

(3) “Participants agreed that asset purchase programs can promote accommodative financial conditions by putting downward pressure on term premiums and longer-term yields.”

(4) “These participants noted, however, that large-scale asset purchases could still be beneficial under current circumstances by offsetting potential upward pressures on longer-term yields or by helping reinforce the Committee’s commitment to maintaining highly accommodative financial conditions.”

(5) “Participants agreed that lowering the federal funds rate to its ELB [effective lower bound] had established more accommodative financial conditions and that the Federal Reserve’s ongoing purchases of sizable quantities of Treasury securities and agency MBS had helped restore smooth market functioning to support the economy and the flow of credit to U.S. households and businesses.”

(6) “Participants also regarded highly accommodative monetary policy and sustained support from fiscal policy as likely to be needed to facilitate a durable recovery in labor market conditions.”

(7) “Participants noted that a highly accommodative stance of monetary policy would likely be needed for some time to achieve the 2 percent inflation objective over the longer run.”

In addition, the noun “accommodation” appeared six times in the context of monetary policymaking. We will spare you the excerpts. Our point is that the FOMC’s use of forms of this word have proliferated with the latest Minutes release; in the previous Minutes, for the April meeting, the adjective appeared just once, while the noun didn’t appear at all!

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The Fed & the FAANGMs That Ate the Market

July 06 (Monday)

Central Banks: Leap, Then Look. In a May 29 Princeton University webinar, Fed Chair Jerome Powell acknowledged that the Fed under his leadership “crossed a lot of red lines that had not been crossed before.” He added that he was comfortable with what the Fed had done given that “this is that situation in which you do that, and you figure it out afterward.”

I always prefer to look before I leap. However, I can understand why Powell decided to leap first and to look afterwards: On March 11, the World Health Organization declared a viral pandemic. On March 15, the Fed lowered the federal funds rate by 100bps to zero and announced a QE4 program aimed at purchasing $700 billion of US Treasury and mortgage-backed bonds. That same week, state governors started to impose lockdowns to enforce social distancing. On March 23, QE4 was turned into QE4Ever with no set amount or end date for purchasing those securities. The press release was titled “Federal Reserve announces extensive new measures to support the economy.”

Among the extensive new measures was the establishment of two facilities to support credit to large employers—the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds. The Fed would, for the first time in its history, purchase corporate bonds, up to a total of $750 billion.

On Sunday, June 28, the Fed released a list of 794 companies—including Apple, Walmart, and ExxonMobil—whose newly issued corporate bonds it will purchase as the sole investor in the coming months in an effort to keep borrowing costs low and smooth the flow of credit. The central bank also said that so far it has purchased nearly $429 million in corporate bonds from 86 of those companies, including AT&T, Walgreen’s, Microsoft, Pfizer, and Marathon Petroleum. Consider the following:

(1) Lending a hand to corporations that don’t need it. Powell has said that by ensuring that large companies can borrow more, the Fed is seeking to keep those firms from having to lay off workers. But the corporations aren’t required to keep all their workers. At a June 16 congressional hearing, Senator Pat Toomey (R-PA) questioned Powell about whether the purchases still were necessary given that the corporate bond market had largely recovered. Powell said the Fed had to follow through on its promises. That was a lame response, in our opinion.

To avoid criticism that it might favor a specific industry, the Fed said that it would use a broad-market-index approach, ensuring that a wide range of companies’ bonds are purchased. Consumer product companies make up roughly 33% of the index, utilities and energy firms roughly 10%, and other industries make up the rest; notably, there are no banks.

(2) No Asset Left Behind. In the April 13 Morning Briefing, Melissa and I wrote: “The credit-quality spreads narrowed in the bond market because the Fed introduced QE4ever on March 23 and NALB (no asset left behind) on April 9. Under QE4ever, the Fed would continue to purchase US Treasuries, agency debt, and MBS [mortgage-backed securities] as it had done in the past but without any set schedule or end date. In addition, it would start buying agency commercial mortgage-backed securities (agency CMBS [commercial MBS]). At the same time, the Fed committed to providing liquidity to the commercial paper market, the investment-grade bond market, and the short-term muni market, as well as to money-market funds. On April 9, NALB was expanded to support so-called ‘fallen angels’ in the corporate bond market, i.e., BBB credits that had been on the edge of falling into junk credit ratings and finally did just that. Melissa and I prefer to call these credits ‘zombie bonds.’ Just as the GVC [the Great Virus Crisis] was about to bury these walking dead, the Fed resuscitated them.”

(3) The Great Rebalancing. We continued: “But didn’t the Fed forget to include equities in its NALB program? It doesn’t need to support the stock market directly. By flooding the credit markets with liquidity and keeping bond yields near historical lows, the Fed has enabled individual and institutional investors to rebalance away from bonds toward stocks.”

Vineer Bhansali, our good friend and loyal subscriber, provided a more detailed analysis of this process in an excellent July 1 Forbes article titled “How The Fed Is Using Financial Engineering Alchemy And Leverage To Boost Stock Prices Without Buying Any.” He concluded: “As long as the Fed has the authority to buy assets, print money, and under-write risk taking, as it currently has, don’t fight the Fed. But be ready to bail out as soon as they start thinking about thinking about raising rates.”

Last Thursday, at the Bloomberg Global Asset Owners Forum, Ray Dalio said, “Today the economy and the markets are driven by the central banks and the coordination with the central government.” As a result, “capital markets are not free markets allocating resources in traditional ways.” He is correct: The Fed and the other major central banks ate the markets for breakfast, lunch, and dinner. There’s nothing left for free marketeers to chew on.

(4) Buoying drowning debt with liquidity. The global economy was on the verge of drowning in debt as cash flow to service the debt evaporated when the GVC first hit. But the Fed and the other major central banks responded with shock-and-awe programs that rescued all the drowning debt by buoying them up with a sea of liquidity. Since the end of February through the end of June, the total assets of the three major central banks soared $5.6 trillion to a record $20.1 trillion, as follows: the Fed ($2.9 trillion to $7.0 trillion), the ECB ($2.0 trillion to $7.0 trillion), and the BOJ ($0.7 trillion to $6.1 trillion) (Fig. 1 and Fig. 2).

The Fed’s holdings of Treasuries, agencies, and MBS rose to a record high of $6.1 trillion during the July 1 week (Fig. 3). Its liquidity-related facilities have decreased by a total of $370 billion over the past seven weeks (Fig. 4). The ECB’s Long-Term Refinancing Operations have soared by €1.5 trillion since the end of February (Fig. 5 and Fig. 6).

(5) The valuation question. All of the above raises an interesting question: What should the forward P/E of the S&P 500 be when the federal funds rate is zero, the 10-year US Treasury bond yield is below 1.00%, and the Fed is providing plenty of liquidity to facilitate the resulting rebalancing from bonds to stocks? Notice that we didn’t ask what the “fair value” of the forward P/E is, which would imply that the market operates freely enough—unaffected by Fed interventions—to determine that value. Clearly, that’s no longer the case. Frankly, we don’t know the answer to this question, since there is no precedent for the current situation. However, we do know that prior to the GVC, we all thought that the S&P 500’s fair-value P/E was around 15.0. Could it be double that now? Maybe.

 (6) Yield Curve Targets. But what if the bond yield starts moving higher notwithstanding the Fed’s current ultra-easy monetary stance? Have no fear: The Fed will be here with more tools from its bottomless toolkit! The Minutes of the June 9-10 FOMC meeting was released last Wednesday, July 1. It was chock-full of mentions of “YCT,” or Yield Curve Targets. Indeed, the latest Minutes mentioned the acronym 15 times versus not even once in the previous Minutes, for the April 28-29 meeting. YCT was discussed in the first section of the latest minutes, which reviewed research conducted by the Fed’s staff on this potential monetary policy tool.

The basic message of the latest minutes is that the Fed may need to keep interest rates across the yield curve close to zero for many years. YCT might be a tool for doing just that. However, the Fed’s not ready to go there yet: “All participants agreed that it would be useful for the staff to conduct further analysis of the design and implementation of YCT policies as well as of their likely economic and financial effects.”

Nevertheless, just by studying YCT, the FOMC is clearly signaling its intention to keep interest rates near zero for a long time.

 Strategy I: The Magnificent Six. The S&P 500 stock price index includes 500 companies. On Friday, five of the six so-called FAANGM stocks (all but Netflix) occupied the top spots as the largest S&P 500 companies by market capitalization. They were: Apple ($1,578 billion), Microsoft ($1,564 billion), Amazon ($1,442 billion), Alphabet ($1,002 billion), and Facebook ($665 billion). Netflix ($210 billion) was the 20th largest company in the S&P 500. Collectively, their record-high $6.5 trillion market cap accounted for a record 25% of the S&P 500’s market cap on July 3 (Fig. 7 and Fig. 8). That’s up from around 8% during 2013.

The Magnificent Six are widely referred to by their awkward “FAANGM” acronym. “MAGFAN” would be easier to pronounce. In any event, count us among the fans of these mega-cap companies, though they aren’t cheap since they have so many fans. Consider the following:

(1) Viral stocks. All six of the FAANGMs are among the biggest beneficiaries of the economic upheaval caused by the GVC and are likely to continue to benefit from its aftershocks well after the crisis is over. That’s because their businesses are Internet-based, so the more that people’s work, education, and entertainment are home-based, the more these businesses thrive.

(2) One for all and all for one? While all six are widely perceived to be technology stocks, only Apple and Microsoft are actually constituents of the S&P 500 Information Technology sector, accounting for 44.4% of the sector’s market cap (Fig. 9). Classified as members of the S&P 500 Communication Services sector are Alphabet, Facebook, and Netflix, accounting for 66.4% of the sector’s market cap (Fig. 10). Amazon is actually a member of the S&P 500 Consumer Discretionary sector, and accounts for an eye-popping 50.8% of the sector’s market cap (Fig. 11).

(3) All Growth, no Value. All six are included in the S&P 500 Growth index, accounting for a whopping 40.7% of its market cap during the June 25 week (Fig. 12). Given the rapid growth in their earnings and their relatively high valuation multiples, there’s no mistaking the FAANGMs for stocks that should be in the S&P 500 Value index.

(4) Galloping revenues and earnings growth. Since the start of 2015 through the July 3 week of this year, the forward revenues of the FAANGMs is up 115.1%, well ahead of the 2.5% increase for the rest of the S&P 500 (Fig. 13). Over the same period, their forward earnings is up 95.0%, significantly outpacing the 1.9% drop for the rest of the market (Fig. 14). Much of that outperformance occurred this year. Nevertheless, even before the GVC struck, the FAANGM forward revenues rose 101.1% from the start of 2015 through the end of 2019, while the remaining 494 stocks in the S&P 500 registered a 10.9% gain in forward revenues. Over the same period, the FAANGMs’ forward earnings rose 88.1% while those of the other 494 S&P 500 stocks rose 25.3%.

Collectively, the profitability of the FAANGMs is boosted not only by their revenue growth but also by their relatively high profit margins. Their forward profit margin was 15.5% during the July 3 week, well above the 10.3% for the rest of the S&P 500 (Fig. 15). If we exclude low-margin Amazon from the FAANGMs, their collective forward profit margin rises from 15.5% to 21.7%.

(5) Leading from in front. The FAANGMs have led the bull market for quite a while. Since the end of 2012 through the July 3 week, their market cap is up an astonishing 467%, while the rest of the S&P 500 is up just 70.5% (Fig. 16). Since the March 23 bottom, the FAANGMs are up 51%, while the rest of the index is up 35%.

(6) Not cheap. Everyone knows all the above, which is why the stocks are so expensive. The forward P/E of the FAANGMs soared from a recent low of 26.1 during the March 20 week to 40.1 during the July 3 week (Fig. 17). The forward P/E of the S&P with and without the FAANGMs is 21.5 and 18.8 (Fig. 18). Here are the current forward P/Es of each of the Magnificent Six: Alphabet (29.9), Amazon (97.7), Apple (25.2), Facebook (26.9), Microsoft (33.2), and Netflix (62.1) (Fig. 19).

(7) Buying back shares. Collectively, the FAANGMs’ number of basic shares outstanding fell 12.7% from Q1-2013 through Q1-2020 (Fig. 20). That’s a decline of 1.8% per year on average. An amount of share-count decline that small is not a big contributor to their earnings-per-share (EPS) growth rate, which suggests that much of their stock buybacks have been motivated by reducing EPS dilution from shares awarded to employees through compensation plans.

Strategy II: FAANGMs Imposing Their Styles. The FAANGMs dominate the discussion of all investment-style categories, whether Growth versus Value, LargeCaps versus SMidCaps, or Stay Home versus Go Global:

(1) Growth vs Value. As noted above, the FAANGMs currently account for 25.0% of the S&P 500’s market capitalization and 40.7% of the S&P 500 Growth index, which accounts for a record 59.5% of the S&P 500’s market cap (Fig. 21). On July 2, Growth’s forward P/E was 27.5, while Value’s was 17.0 (Fig. 22). Both were the highest since 2002. But keep in mind that the 10-year Treasury bond yield was around 5.0% back then. By the way, the top six Value stocks by market cap are currently Berkshire Hathaway ($434 billion), Johnson & Johnson ($371 billion), Walmart ($338 billion), Procter & Gamble ($299 billion), and UnitedHealth Group ($283 billion).

(2) LargeCaps vs SMidCaps. Within the S&P 500, the equal-weighted version of the index has underperformed the market-cap weighted version since the start of 2017 (Fig. 23). The former is up 18.5%, while the latter is up 39.8% through Friday’s close. The S&P 500 market-cap weighted has been underperforming the S&P 100 market-cap weighted over the past year, with the former up 4.0% and the latter up 8.6% (Fig. 24).

The S&P 400 MidCaps and the S&P 600 SmallCaps have been underperforming the S&P 500 since September 20, 2018, just before the severe correction that occurred at the end of that year (Fig. 25). Over this period through Friday’s close, the S&P 500/400/600 are up 6.8%, down 13.0%, and down 23.7%, respectively. Since March 23 of this year, there’s been a bit of a reversal, with the three up 39.9%, 46.0%, and 38.3%.

(3) Stay Home vs Go Global. Finally, since the start of the current bull market in 2009, the US MSCI stock price index has outperformed the All Country World ex-US MSCI in both dollars and in local currencies (Fig. 26). In recent years, the FAANGMs undoubtedly contributed greatly to this trend, which we expect will continue through 2021.

Movie. “Chernobyl” (+ + +) (link) is five-part 2019 HBO docudrama about the nuclear power plant disaster of April 1986 and the cleanup efforts that followed in the Ukrainian Soviet Socialist Republic of the Soviet Union. In effect, the power plant turned into a nuclear bomb when the plant’s managers were conducting a badly botched safety test. The fail-safe mechanisms obviously failed. The Soviet government’s attempts to cover up the cause of the meltdown might have caused an even bigger disaster were it not for the courage of the managers and the bravery of the workers assigned to clean up the horribly dangerous mess.

This is a relevant excerpt from my 2018 book, Predicting the Markets: “One of the most momentous events during my career was the end of the Cold War in 1991. I had seen it coming a few years earlier and wrote a Topical Study during August 1989 titled “The Triumph of Capitalism.” I observed that about one year after Mikhail S. Gorbachev became the General Secretary of the Soviet Communist Party, the nuclear reactor at Chernobyl blew up. The explosion, on April 26, 1986, released at least as much radiation as in the atomic bomb attacks on Hiroshima and Nagasaki. That event and other recent disasters in the Soviet Union were bound to convince Gorbachev of the need to restructure the Soviet economic and political systems, I surmised. Likely, he would conclude that a massive restructuring was essential and urgent because the disasters were ‘symptomatic of a disastrous economic system that is no longer just stagnating; rather, it is on the brink of collapse,’ I wrote back then. The Berlin Wall was dismantled in late 1989.”

I drew some comparisons earlier this year between Chernobyl and the COVID-19 outbreak in China. In both instances, authoritarian governments made the situations worse than they had to be. However, I’m not expecting that the COVID-19 disaster will lead to any significant reforms in China. Instead, the Chinese Communist Party seems to be using its success in fighting the virus to tighten its grip on power.

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Mostly Good News

July 02 (Thursday)

US Economy: Gasoline & Jobs. As Debbie and I observed yesterday, one of our favorite economic indicators lately has been the four-week average of gasoline usage in the US. As a result of the lockdowns, it plunged 43.0% from the March 13 week through the April 24 week, when it bottomed at 5.3mbd (Fig. 1). Since then, through the June 26 week, it is up 54.7% to 8.2mbd. It needs to rise another 15.9% to get back to a normal 9.5mbd pace of fuel consumption. There has also been a 6.2% recovery in the usage of other petroleum products since the week of May 29 (Fig. 2).

We acknowledged that gasoline usage may be overstating the extent of the economic recovery if more people are choosing to return to work by car rather than by taking public transportation and taking their summer vacations in the US rather than overseas. Then again, more people are driving back to work. Yesterday’s ADP report for private payrolls showed a gain of 2.37 million for June. And WOW: May’s tally was revised from down 2.76 million to up 3.07 million, confirming the 3.09 million gain reported for May by the Bureau of Labor Statistics! The ADP data show that payrolls have bottomed for large, medium, and small companies in both service-providing and good-producing industries (Fig. 3 and Fig. 4).

There was also lots of good news in June’s composite indexes for general business, new orders, and employment for the five regional surveys conducted by the Federal Reserve Banks of Dallas, Kansas City, New York, Philadelphia, and Richmond. As Debbie reports below, they were all confirmed by the comparable indexes reported yesterday for June’s national survey of manufacturing purchasing managers (Fig. 5). Other than the employment component, the other major components of the M-PMI were solidly above 50.0 last month: total (52.6), new orders (56.4), production (57.3), and employment (42.1).

Industrials: How Far Can They Bounce? With 2020 at the halfway mark, the S&P 500 index’s 4.0% ytd drop through Tuesday’s close belies the COVID-19-induced turbulence experienced by the stock market so far this year. The S&P 500 volatility index, which spiked to a record of 82.69 on March 16, remains at an elevated 30.43 through Tuesday’s close (Fig. 6).

There’s also a 51ppt spread between the best-performing S&P 500 sector, Information Technology, and the worst performing sector Energy. Here’s the S&P 500 performance derby ytd through Tuesday’s close: Information Technology (14.2%), Consumer Discretionary (6.6), Communication Services (-1.0), Health Care (-1.7), S&P 500 (-4.0), Consumer Staples (-7.1), Materials (-8.0), Real Estate (-10.0), Utilities (-12.6), Industrials (-15.5), Financials (-24.6), and Energy (-37.0) (Fig. 7).

Like other underperforming sectors, Industrials have bounced back sharply. They were down 42.6% from their record high on February 12 to their low on March 23 and have since rebounded by 41.0%. The Industrials sector’s future will depend heavily on Boeing’s ability to return the 737 MAX to the air and on consumers’ willingness to return to the skies.

Here’s the performance derby for some of the largest industries in the S&P 500 Industrials sector ytd through Tuesday’s close: Trucking (20.1%), Air Freight & Logistics (-4.9), Railroads (-6.2), Electrical Components & Equipment (-9.7), Construction Machinery & Heavy Trucks (-11.8), Industrial Machinery (-12.4), Industrial Conglomerates (-19.1), Aerospace & Defense (-26.2), and Airlines (-49.5) (Fig. 8 and Fig. 9).

Let’s take a look at some of the recent news out of Boeing and the airline industry to judge whether the index might head higher:

(1) Back in the air. It has been more than a year since the Federal Aviation Administration grounded Boeing’s new airliner, the 737 MAX, after two of the planes crashed. The road to redemption has been long. This week, the plane completed the first of three test flights it will need to be recertified. The FAA said “a number of key tasks remain” before the plane can be recertified.

(2) But on the other hand. With passenger traffic down sharply due to COVID-19, it’s not a surprise that some carriers are canceling orders for new planes. On Tuesday, Norwegian Air Shuttle canceled an order for 92 planes, and Singapore-based leasing company BOC Aviation reportedly will cancel 30 of the 737 MAX jets from its order. So far this year, orders for more than 300 planes have been canceled, but Boeing still has a backlog of roughly 4,200 jets, a June 30 article in Barron’s reported.

(3) It all comes down to the consumer. Boeing’s fate depends on how fast consumers are comfortable climbing back on flights. If consumers fly, airlines will be profitable and will be able to afford new planes. Transportation Security Administration (TSA) data show that 500,054 consumers went through TSA checkpoints during the week of June 30, which is up nicely from the low of 87,534 on April 14, but nowhere near the more that the 2.0 million passengers who flew at this time last year (Fig. 10).

Airlines are responding to the improvement in demand. Most recently, United Airlines announced plans to add about 25,000 flights in August in hopes of capitalizing on an uptick in air travel, a July 1 CNBC article reported. “While travel demand remains a fraction of what it was at the end of 2019, customers are slowly returning to flying, with a preference for leisure destinations, trips to reunite with friends and family, and getaways to places that encourage social distancing,” United said in its announcement on Wednesday. Despite the increase in flights, United is flying about half of last year’s domestic capacity and a quarter of its international capacity.

(4) Looking at the numbers. Analysts expect the S&P 500 Aerospace & Defense industry’s revenue will fall 8.3% this year, only to rise by 11.1% in 2021 (Fig. 11). Likewise, the industry’s earnings are expected to decline by 30.5% in 2020 before rising 44.8% next year (Fig. 12).

Analysts seem to have exhausted their 2020 earnings estimate cuts in the first two quarters of this year (Fig. 13). And in the past four weeks, forward earnings estimates for the industry actually increased 0.6%. For the S&P 500 Industrials sector as a whole, analysts increased their forward earnings estimates by 3.6%.

But Industrials isn’t alone in this respect. Several other sectors hard hit by the pandemic have seen similar estimate increases in recent weeks. Here are the four-week changes in forward earnings for the S&P 500 and its 11 sectors: Energy (70.8%), Consumer Discretionary (3.6), Industrials (3.6), Financials (2.8), Materials (2.5), S&P 500 (1.7), Communications Services (0.8), Health Care (0.8), Consumer Staples (0.8), Information Technology (0.6), Utilities (0.4), and Real Estate (-1.4) (Table).

Disruptive Technologies: The Fight Against COVID. The recent spike in COVID-19 cases has reinforced just how important it is for everyone to wear a mask. It has also turned up the pressure on the scientific community to find a cure or vaccine that can keep this scourge at bay. Here’s Jackie’s look at the progress being made on the technological and medical advancements that could save our lives:

(1) Zapping face masks. Face masks and other personal protective equipment (PPE) are vital to keeping nurses and doctors safe. But they are problematic: If you touch any of the PPE, you are at risk of transferring germs to your hands. One of our accounts kindly passed on an article that reports a solution may have been found: PPE made of “electroceutical” materials.

“The polyester material is printed with alternating spots of silver and zinc resembling polka dots. They are one to two millimeters wide and spaced one millimeter apart. When the electroceutical material is dry, it functions as an ordinary fabric. But if it gets dampened—say, with saliva, vapor from a coughed up droplet or other bodily fluids—ions in the liquid trigger an electrochemical reaction. The silver and zinc then generate a weak electric field that zaps pathogens on the surface,” a June 24 Scientific American article reported.

The material was originally developed for use in wound care by researchers at the Indiana Center for Regenerative Medicine and Engineering at Indiana University and biotechnology company Vomaris Innovations. They’ve since tested the material’s impact on a non-COVID-19 coronavirus strain that causes respiratory illness in pigs and on lentivirus. The study, which has yet to be peer-reviewed, left both viruses unable to infect cells.

Another set of researchers are working on a textile coating that would repel bodily fluids, proteins, and bacteria. The material hasn’t been tested on single-use masks, and would more likely be used on the homemade, reusable cloth masks, said Paul Leu, director of an advanced materials laboratory at the University of Pittsburgh, in a June 24 Scientific American article. He also envisions the coating being used on other reusable medical textiles, like hospital bed linens, drapes and waiting room chairs.

Just in case you need convincing that masks protect you and those around you, take a look at this June 29 BuzzFeed article. A microbiologist sneezed, sang, talked, and coughed in front of four Petri dishes of agar cultures. When he wore a mask, the cultures were clear of bacteria; when he didn’t wear a mask, bacteria clearly grew in each of the cultures. It’s not a pretty picture, but it’s certainly an illustrative one.

(2) A simple steroid. Dexamethasone is a cheap steroid—without patent protection—that is being considered for use in patients with COVID-19. A trial randomly assigned 2,104 people hospitalized for COVID-19 to receive the steroid. It has traditionally been used to treat rheumatoid arthritis and other inflammatory conditions.

“The drug reduced deaths by one third among patients on ventilators and by one fifth among those receiving oxygen therapy alone. It did not have any benefit for patients who did not need breathing support,” a June 17 article in Scientific American reported. It also shouldn’t be used by patients with only a mild infection, because the steroid could prevent the body’s immune system from fighting the virus effectively.

(3) Other anti-inflammatories under investigation. In some patients, COVID-19 causes a cytokine storm, where the immune system goes overboard and inflammation can’t be controlled. So drugs that can tame the body’s immune response and block the cytokine storm are being tested.

Actemra, a drug for rheumatoid arthritis, blocks a protein involved with our immune responses, a June 18 article in GoodRx reported. A small study in France indicated that those who received the drug were less likely to require ventilation or die. Other drugs that affect a body’s immune response are being tested as well, including: Calquence, Xeljanz, Jafai, Olumiant, Kineret, Ilaris, Otezla, Mavrilimumab, Colcrys, and Kevzara.

(4) Antivirals may help. Remdesivir is an antiviral drug that reduced the recovery time of COVID-19 patients in a trial by almost a third, and it has since been approved for emergency use in some patients in the US. The median recovery time of COVID-19 patients in the trial who received Remdesivir was 11 days compared to 15 days for patients who received a placebo. The randomized controlled trial involved 1,069 COVID-19 patients.

Gilead has priced Remdesivir at $2,340 for a five-day treatment in the US and other developed countries. The revenue potential for the drug is $2.3 billion in 2020, helping to offset more than $1 billion in development and distribution costs, according to analysts at Royal Bank of Canada quoted in a June 29 Reuters article. The US Department of Health and Human Services has secured more than 500,000 treatment courses of the drug for US hospitals through September, which equates to 100% of Gilead’s production in July, and 90% of its production in August and September. The company has agreements with generic drug makers to supply the drug in developing countries at a far lower price, roughly $66.

Another antiviral under consideration is Kaletra, an HIV medication that contains two antivirals, lopinavir and ritonavir. A small study found that patients who used Kaletra, interferon beta-1b, and ribavirin improved in seven days, compared to the 12 days it took those who got only Kaletra.

Other antivirals being tested include Tamiflu, favipiravir, galidesivir, and umifenovir.

(5) Convalescent plasma. Plasma is the liquid part of blood, and it contains antibodies. Doctors have used convalescent plasma from patients who have recovered from a disease and given it to patients suffering from a disease, in hopes the antibodies in the plasma will heal the sick patient. This method, which some date as far back as 1890, is often used when there is no other medicine available to treat the disease. Most recently, it was used to treat Ebola patients, and now some doctors are using it to treat COVID-19 patients.

“In China, 10 adults with severe COVID-19 symptoms were given convalescent plasma. The researchers reported that all symptoms (such as fever, cough, shortness of breath, and chest pain) had greatly improved within 3 days,” a June 18 article in GoodRx reported. “A physician can request convalescent plasma on an individual basis by contacting their local blood center, but it’s not widely available since centers have just recently begun collecting it.”

(6) China starts vaccinations. There are more than 100 vaccines being developed in labs around the world. The first to be used on humans outside of a trial is being developed by a research arm of China’s military and CanSino Biologics, Ad5-nCoV. The vaccine, which has been approved to vaccinate the Chinese military, is based on an Ebola vaccine that was developed but did not go into mass production, a June 29 South China Morning Post article reported.

Phase 1 and 2 trials of the vaccine “showed it has the potential to prevent diseases caused by the coronavirus … but its commercial success cannot be guaranteed,” the company said according to a June 29 Reuters article. The country has not done Phase 3 trails, which are consider more robust and done in the US before vaccine or drug approvals. China also has two other vaccine candidates that are being offered to employees at state-owned firms travelling overseas.

(7) The worldwide vaccine race. Pfizer and its partner BioNTech SE reported positive results from an early-stage trial of its COVID-19 vaccine on Wednesday, sending its shares up 3.2% and giving the broad stock market support. The pharma company joins Moderna, Johnson & Johnson, and AstraZenca, which are also on track to have vaccines available the earliest—but still not before year-end, according to Bill Gates in a June 29 Fast Company article.

In the US, Moderna is the furthest along in testing its vaccine. It’s currently in Phase 2 testing and hopes to enter Phase 3 in July. The vaccine uses messenger RNA, which enters cells and instructs them to produce a small amount of COVID-19 protein. This protein triggers cells to produce antibodies to provide immunity to COVID-19. The May 19 Morning Briefing discussed early positive findings: Forty-five patients who received the vaccine and two booster shots had antibodies equal to or greater than those found in patients who had recovered from COVID-19.

Pfizer’s vaccine trial involved 45 people, each of whom were given 10, 30 or 100 microgram doses of the vaccine or a placebo, according to a July 1 CNBC article. Volunteers who received the vaccine, which also uses mRNA, had higher levels of antibodies than recovered COVID-19 patients, both four weeks after being vaccinated the first time and seven days after the second dose. The vaccine also had few side effects. Pfizer and its partner plan to start the next stage of testing as early as this month, and they already have plans to manufacture up to 100 million doses by the end of 2020 and more than 1.2 billion doses by the end of next year.

In the UK, The University of Oxford and AstraZenca began Phase 1/2 trials for its vaccine in April, and it started recruiting individuals to enroll in Phase 2/3 trials. The vaccine contains a weakened common-cold virus taken from chimpanzees in addition to the genetic material of SARS-CoV-2 spike protein. The virus is altered so it can’t reproduce itself, but the cells that house it produce the spike protein and provide protection against COVID-19 for a year.

Johnson & Johnson’s COVID-19 vaccine is based on the same technology the company used to make an Ebola vaccine, which was used in the Democratic Republic of Congo. It’s expected to be in Phase 1/2a trials in the second half of July.

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Warning: Hazardous Data

July 01 (Wednesday)

US Economy I: Good Data. Most of our commentary today is about the unreliability of several important sources of data we need to assess the impact of the Great Virus Crisis (GVC) on the economy as well as the course of the pandemic itself. Not only are there still lots of known unknowns about the virus, but there are also lots of known deficiencies with the data needed to track it and its impact on the economy.

Let’s start with the good data. Half in jest, I’ve often defined good data as “any series that confirms my economic outlook.” Any series that doesn’t do so is either likely to be revised to show I was right after all or is just plain bad data. Now let’s get serious about the good, the bad, and the ugly data:

(1) Good economic data. Most of the major monthly economic indicators confirm that the US economy plunged during March and April as a result of lockdowns imposed by state governors to enforce social distancing. Most of them started to recover during May as lockdown restrictions gradually eased. The open question (i.e., the known unknown) is whether the recovery continued in June and will continue over the rest of the summer given that some state governors are responding to recent surges in case counts (mostly after Memorial Day get-togethers) by either slowing their re-openings or reinstating some restrictions.

Here are the March and April drops and the May rebounds in some of the key US economic indicators: nominal retail sales (-21.8%, 17.7%), real consumer spending (-17.8, 8.1), durable goods orders (-31.8, 15.8), manufacturing production (-20.0, 3.8), and pending home sales (-38.1, 44.3) (Fig. 1, Fig. 2, Fig. 3, Fig. 4, and Fig. 5).

The four-week average of mortgage applications to purchase a new or existing home soared 63% over the past eight weeks through the June 19 week to the highest reading since mid-January 2009 (Fig. 6). So far this year, the Citigroup Economic Surprise Index soared from a record low of -144.6 on April 30 to a record high of 168.2 on June 25 (Fig. 7). It edged down briefly to 162.1 on June 26, before rising to 167.4 on June 29.

(2) Good earnings data. Given what we do for a living, Joe and I are particularly pleased to see that S&P 500 forward earnings is showing more and more signs of bottoming. We predicted that this might happen by mid-year given how quickly analysts slashed their earnings estimates during April and May. The re-openings of state economies are undoubtedly causing analysts to turn more optimistic about the second half of this year and next year. That should continue to be the case as long as state governors take no more than one step back for every two steps forward.

Industry analysts stopped cutting their S&P 500 earnings-per-share estimates for Q2-Q4 of this year in recent weeks (Fig. 8). As a result, their 2020 estimate (using I/B/E/S data) has flattened out around $125, just above our $120 target for this year (Fig. 9). Their 2021 estimate has recently flattened out at $164, which is unchanged from 2019’s actual result. Joe and I are still using $150 for next year.

The bottom line is that S&P 500 forward earnings—which is the time-weighted average of the latest weekly consensus estimates for this year and next year—has been rising every week for the past six weeks through the June 25 week, after falling 21.2% over the previous 11 consecutive weeks, from the March 5 week through the May 14 week (Fig. 10). By the way, S&P 500 forward revenues has also been showing signs of bottoming for the three weeks (i.e., through June 18).

US Economy II: Low-Octane Gasoline? One of our favorite economic indicators lately has been the four-week average of gasoline usage in the US. As a result of the lockdowns, it plunged 43.0% from the March 13 week through the April 24 week, when it bottomed at 5.3mbd (Fig. 11). Since then, through the June 19 week it is up 50.9% to 8.0mbd. It needs to rise another 18.8% to get back to a normal 9.5mbd pace of fuel consumption. It currently seems to be on the road to doing just that in coming weeks, though a slowing of state re-openings could place some roadblocks in the way of this indicator’s road to recovery.

Admittedly, gasoline usage may be overstating the extent of the economic recovery if more people are choosing to return to work by car rather than by taking public transportation. In addition, very few Americans are likely to be vacationing overseas this summer. That means that more of them are likely to be taking driving vacations in the US.

 US Labor Market I: Hard To Account for Jobless Claims. On Monday, I questioned whether the weekly unemployment insurance (UI) report might be double-counting some of the claimants. On page 4 of the report, a table titled “Persons Claiming UI Benefits All Programs” shows the total number of claimants was 18.5 million in “regular state” programs and 10.5 million in two pandemic programs at the end of May, adding to 29.0 million. Those two programs—the Pandemic Unemployment Assistance (PUA) and the Pandemic Emergency Unemployment Compensation (PEUC) programs—had 9.4 million and 1.1 million participants, respectively, at the end of May.

The 29.0 million total compared to 20.5 million unemployed workers during May, according to the official monthly tally produced by the Bureau of Labor Statistics (BLS), which has its own issues, as discussed in the next section (Fig. 12). Let’s start with the weekly tally, but be warned: It will make your head spin:

(1) Scrambled scrabble. A June 11 AEI blog post stated that the PUA program “was created [by] the March 2020 CARES Act and is designed to assist the self-employed, independent contractors, and others not typically eligible for UI who are currently unable to work. While operated by state UI agencies, PUA is supported entirely by federal funds, and its benefits (which include [a] $600 per week federal bonus through July) are available for up to 39 weeks per person through December 2020.”

The Center on Budget and Policy Priorities explained (emphasis ours): “[PUA] provides assistance for those unable to work due to COVID-19 who previously wouldn’t have qualified for UI due to reasons such as a short work history or self-employment. Pandemic Unemployment Compensation (PUC) provides an additional $600 per week for all UI recipients, including those receiving PUA benefits, through July 31. Pandemic Emergency Unemployment Compensation (PEUC) provides additional weeks of benefits for recipients who exhaust state benefits.”

(2) Shouldn’t overlap. In other words, PUA is a new federal program that is for those not eligible for regular state benefits, and claimants to both programs are eligible for the extra $600. An Economic Policy Institute (EPI) blog post noted that “Claims for UI and PUA should be completely non-overlapping because that is how the Department of Labor has directed state agencies to report them.” A note from legal firm Proskauer observed: “As long as states are able to discern those who are filing under the PUA program from those filing for regular unemployment benefits, they are not required to have a separate application for PUA benefits.”

From all this, Melissa and I gather that the way the counting should work is that if a claimant files for regular state UI (plus the extra federal $600 per week), that worker should be counted as one regular state UI claim. If a claimant files for PUA (plus the $600), they should be counted as one PUA claim. But the way it should work may not be the way it is working. The EPI blog post observed that “some states may be misreporting claims so there may be some double-counting.”

(3) Overcounting and undercounting. A May 28 New York Times article reported that “several economists suspect that there is a lot of double counting and warn against simply adding figures” from the state and federal programs. The article explained: “Some states, flooded with applicants, were slow to put the pandemic program into effect. Initially, many people were mistakenly told they were ineligible. Others were instructed to apply for state benefits first and be rejected before applying for the federal benefits.

“That confused application process has caused potentially millions of laid-off workers to be counted twice. States are also weeding out duplicate applications from frustrated filers who had trouble getting through or did not receive any response after weeks of waiting.” Some states have otherwise erroneously inflated the data for reasons that are unclear, the article said.

Delays in pandemic program implementation and reporting by states may also have created undercounting issues for May and overcounting issues for June. For more on these head-spinning counting issues, see Bloomberg’s June 29 article titled “U.S. Jobless-Claims Figures Inflated by States’ Backlog-Clearing.” Needless to say, there could be massive amounts of fraud occurring in these massively difficult programs to manage.

 US Labor Market II: Hard To Count the Unemployed. All eyes will be on June’s employment report when it is released Thursday morning. The BLS is having some challenges doing its job under the circumstances. The BLS posted a 15-page hedge clause along with its employment report on Friday, June 5. It is titled “Frequently asked questions: The impact of the coronavirus (COVID-19) pandemic on The Employment Situation for May 2020.” Let’s review the key takeaways:

(1) First and foremost, the FAQ warns this on page 11: “If the workers who were recorded as employed but not at work for the entire survey reference week had been classified as ‘unemployed on temporary layoff,’ the overall unemployment rate would have been higher than reported.” In that case, the number of unemployed would have increased by 4.9 million from 20.5 million to 25.4 million, and the jobless rate would have been 16.1% (nsa) rather than 13.0% (nsa).

“As was the case in March and April, household survey interviewers were instructed to classify employed persons absent from work due to coronavirus-related business closures as unemployed on temporary layoff. However, it is apparent that not all such workers were so classified. BLS and the Census Bureau are investigating why this misclassification error continues to occur and are taking additional steps to address the issue.” Got that? The household survey data has a misclassification error.

(2) The payroll survey may also be misleading since workers who are paid by their employer for all or any part of the pay period including the 12th of the month were counted as employed, even if they were not actually at their jobs. The Payroll Protection Program (PPP) undoubtedly boosted the number of such workers. The concern is that when the program expires in a few weeks, many of them will lose their jobs unless the reopening of the economy succeeds, allowing them to remain employed.

The bottom line is that the household survey data has a misclassification error. The payroll data may also be distorted. But both will be fine if those who are counted as employed because they are still getting a paycheck (thanks to PPP) but aren’t actually working return to their jobs as the economy reopens.

(3) The data-collection rates were adversely affected by pandemic-related issues, but “BLS was still able to obtain estimates that met our standards for accuracy and reliability.” For the safety of both interviewers and respondents, the Census Bureau did not conduct in-person interviews in May, relying on telephone interviews instead. The response rate for the household survey was 67% in May 2020, following rates of 70% in April and 73% in March. For comparison, the average response rate for the 12 months ending in February 2020 was 83%.

(4) Don’t expect any major revisions in the data: “However, according to usual practice, the data from the household survey are accepted as recorded. To maintain data integrity, no ad hoc actions are taken to reclassify survey responses.”

 Epidemiology I: Stressful Testing Data. Melissa and I are not epidemiologists. But we are doing our best to evaluate and analyze the available data on the pandemic. The problem is that the quality of much of the data is poor. Before going there, let’s begin with what the available data presently tells us. Unfortunately, we can confirm that the pandemic spread is worsening, as is widely reported and perceived. But it is spreading more among younger people, which may or may not be a good thing. Consider the following:

(1) Positives results outpacing testing. “The US saw more new cases this week than any week since the US COVID-19 outbreak began,” according to The Atlantic’s COVID Tracking Project (CTP) June 25 blog post. We prefer CTP’s data to other virus data trackers, as discussed below. However, the number of tests performed also has greatly expanded. That begs the question, “Is the number of positive cases going up simply because the nation has expanded its testing capacity?”

The answer is “no,” as two statistics highlighted in a June 24 CTP blog post show. First, the CTP data analysts have found that positive tests as a percentage of total tests performed has increased. Second, they’ve found that the rate of increase in positive cases has increased faster than the rate of increase in tests performed. That’s especially true for the southern areas of the country that reopened earliest and with the least restrictions among the states. (Arizona offers dramatic a case in point—see our technical note.)

(2) More younger positives. The good news (maybe) is that state-level data suggest more young people are testing positive. For example, in Florida, where the outbreak has dramatically picked up, the median age of those testing positive fell from 65 to 35 from March until now, according to Florida Governor Ron DeSantis, as reported a June 25 CNN article. Why this is so will determine whether the age drop will eventually lead to a good or bad outcome.

A “good” outcome would be increased positive tests but fewer relative hospitalizations and deaths than would be expected if the median age were higher. It would be “bad” if the increased positives lead to increased hospitalizations and deaths, as a June 26 CTP blog post discussed. The post quoted a Twitter thread from University of Florida biostatistics professor Dr. Natalie Dean, in which she outlined three possible reasons that we are seeing more young people testing positive: i) younger people being less careful (a “bad” scenario); ii) older people being more careful (good); and iii) testing capacity expanding (good). The reality may reflect a combination of these good/bad scenarios.

Epidemiology II: Bad Data About a Bad Virus. For now, we surmise that the most comprehensive and best source for reasonably accurate nationwide COVID-19 data is The Atlantic’s The COVID-19 Tracking Project (CTP). Researchers for the magazine began compiling data from state websites as the pandemic began because they found other sources to be lacking.

Johns Hopkins University & Medicine’s (JH) Coronavirus Resource Center is frequently quoted in the media, especially for worldwide confirmed cases and deaths. But JH’s website does not include hospitalizations, and it only recently began displaying the number of tests performed in the US. The Centers for Disease Control’s (CDC) COVID Data Tracker has improved since the pandemic began, but it isn’t as user-friendly as CTP, and there are questions about its accuracy. Consider the following:

(1) Inconsistent states. Each day, CTP refreshes its full dataset directly pulled from state websites. According to a May 20 blog post, CTP identified 13 states for which the state-level testing data did not reconcile to CDC data by over 25%. CTP said at the time that it was attempting to work with the CDC on these discrepancies, but they have yet to be resolved, as far as we can tell. CTP further critiqued the CDC data in a detailed May 18 assessment.

(2) Testing data dump. In its CDC assessment, CTP observed that it is unclear whether certain states are reporting viral specimen test counts or counts by the number of individuals tested. JH’s website notes that issue and another: Some states may be lumping together antibody and initial diagnostic tests. Also, both false positives and false negatives are possible, according to JH.

(3) Scary hospitalizations. It’s impossible to get an accurate picture of current COVID-19-related hospitalizations on a national level. However, we can see trends at the state level where available. The CDC’s separate COVID-NET hospitalization tracker includes a rather large pop-up disclaimer about its national hospitalizations data. Essentially, the CDC’s coverage is extremely limited and based on a surveillance approach of just 14 states.

CTP pulls its hospitalizations data directly from all the states that capture it. But some capture cumulative data while others capture current data, and some do not report on hospitalizations at all. (For details, see CTP’s quality grading spreadsheet.) It seems that JH has yet to bother with hospitalizations from the lack of info on its website.

(4) Delayed deaths. Death data may severely lag, not only because of how the virus works but also because there may be significant lags in reporting, as Bloomberg recently discussed. The coding of cause of death on death certificates also happens to be quite subjective, according to our evaluation of the CDC’s website discussion on the completeness and accuracy of death certificates. (Also see CTP’s mention on a separate but related issue of NYC’s “probable” deaths here.)

(5) Help wanted. The country badly needs a COVID-19 data czar to curate good data for monitoring the current pandemic and future ones.

Technical Note: If the percentage of positive test results relative to tests performed is too high, it may indicate that the scope of testing is not broad enough—i.e., that only the sickest persons are being tested and many milder cases not captured. The World Health Organization suggests that a 5% positivity rate for the virus would indicate sufficient testing, according to JH. Arizona’s rate was much higher, at 28%, for the week ending June 22, as the June 24 CTP blog post noted.

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