Don’t look now, but something foul is floating in the punch bowl. Not many participants seem to notice that fact because the Fed is adding more liquor. We advise avoiding the punch. A financial system that demands outright funding support in the repo market from the Fed should lead to more caution by investors, not less. At the same time, central bank policies are becoming even less effective in supporting the real economy and that thought is gaining acceptance.
The Treasury bond market seems wary of the punch. Equities have priced in an enormous improvement in growth, while the 30-year bond refuses to rise in yield to any meaningful degree. Something has to give because the disconnect sticks out like a sore thumb right now in this heavily hyped environment.
Maybe the bond market recognizes the policy failure that is starting to be talked about openly in the media. Rates have been negative outside the U.S. for years, so we don’t see the relative yield argument as holding much water in explaining the firmness in U.S. Treasuries. We think it is more likely due to a growing realization that the central bank practice of encouraging reckless borrowing is having a diminishing effect with each passing day.
As we have discussed before, additional debt no longer provides nearly the amount of stimulus it once did. It is becoming clearer that the PhD’s are “pushing on a string.”
We often talk about how China provided a large portion of the growth in this cycle, but now even it can’t propel growth higher like it once could before it became weighed down with $30 trillion of debt in the last decade. A 38% collapse in the growth-generating capacity of each increment of new debt suggests that depending on China to derive future growth may not be a wise idea. The story elsewhere is similar, but less dramatic.
Not heeding these policy failures, stocks prices have become the most decoupled from fundamentals we have ever seen. We got here because no one is worried about the future consequences of current short-term thinking or questioning popular narratives because such concerns would interfere with the speculative frenzy of the day. Few are out there warning about runaway deficit spending or ludicrous monetary policy. No one seems too worried about the fact that a select few stocks dominate market activity or that analysis of individual companies’ financial statements has been largely abandoned in this age of passive ETF investing.
How long can piling into the same few stocks because they are currently popular work? History suggests it won’t go on forever. It may well be called passive investing, but investors are, in reality, actively betting that those companies that have performed well will continue to do so. Some, like Apple, have posted weak underlying growth or even shrinking earnings and/or revenues yet the stock market often treats them like they are performing extremely well simply because buybacks and/or index weightings push them higher.
The last decade began with Bernanke declaring that his reckless policies were temporary as the economy collapsed. 2019 was the year when the Fed finally realized it can’t tolerate letting markets free of its grip. While Wall Street, the Fed, and the powers that be may be celebrating the charade of riskless riches for now, at some point it will become clear that due to extreme overvaluation, the future return profile for stocks is quite close to zero and maybe negative over the long-term. Meanwhile deranged monetary policies seem to be reaching their limits. It’s possible that Sweden’s abandonment of the farce of negative rates recently marks an inflection point of some sort on that front.
The Fed seems hell-bent on fostering the belief that stocks are a one-way bet. It knows its policies do not work to promote growth and it has allowed the system to become incredibly leveraged as it encouraged a rapid pace of debt creation and speculation. Much like the mantra of 2006-07 that there was no need to worry because “housing prices never go down,” the current dogma is that stock prices will never fall because the Fed has our backs.
We have witnessed reckless investor behavior before. The current environment takes the prize. We continue to think that problem credits will become more common in the corporate bond market and that poor liquidity there will change sentiment across all risk assets.