Why I am worried about the next Phase in stocks

It’s been a while since we’ve done a big macro piece for stocks.

I love global macro investing, so in today’s article, I’m going to condense all my latest views on global macro into one single article, just for FH readers.

Whether you agree with me or not, I absolutely want to hear your views below!

BTW: Anniversary Promo for the FH Course and REITs MasterClass ends this Sunday! Don’t miss the chance to pick up both courses at big discounts – with big freebies thrown in! Check it out here.

FYI we’ll share commentary on the 2020 crisis every weekend going forward, so for those of you who haven’t signed up for our mailing list, please do – its absolutely free.

It’s a weekly newsletter that goes out at noon every Sunday, and rounds up the week’s posts so you never miss anything.

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Basics: What’s happened so far?

A quick recap of what’s happened in 2020.

In March, when COVID started spreading to Europe and US, it sparked a massive risk off.

The dollar index surged to 102.5, and there was a liquidity crisis reminiscent of Lehman in 2008. Everyone was scrambling for the exits, and there were no buyers. Risk havens like gold and treasuries plunged together with stocks.

So the Feds stepped in in a big way. Over the course of March, they:

1. Slashed interest rates all the way to 0%
2. Committed to unlimited Quantitative Easing – buying as much treasuries as required to stabilize markets
3. Committed to buying corporate bonds

Number 3 was the line in the sand. The Fed had never bought corporate bonds, ever. Their willingness to cross this line so easily was a big signal to the markets that they would do whatever it takes.

From there, the markets rallied all the way till today.

Investment Grade and High Yield spreads (above) measure the cost of borrowing for companies (low is good).

It spiked massively in March, but has come down drastically since.

I’ve used the 15 year charts so you can compare it to Lehman 2008. This time around, the Feds acted super quickly.

Feds committing to unlimited QE on 23 March 2020 marked the short-term bottom in this crisis. Markets rallied from panic all the way to euphoria in 2.5 months, making this the shortest bear market in history… ever.

But that’s all the in the past now. As investors, we’re always forward looking.

So we need to ask – what does the future hold?

The Insolvency Phase

In our earlier articles from March, we mentioned that after the liquidity event of March, we would move into a Hope phase. In the Hope phase, there would be a rally from oversold conditions, and investors adopt the view that COVID would be a short term event with a V-shaped recovery.

The Hope phase played out very strongly from April to June, and from July it started slowing as the second wave in US/Europe came back.

Either way, it looks like we’re nearing the end of the Hope phase now.

What comes next is the insolvency phase. And unlike the liquidity event in March or the Hope phase, which play out as shock and awe with big movements in financial markets, the insolvency phase tends to be more of a miserable grind.

The insolvency phase is characterized by corporate bankruptcies, widespread layoffs, and reduced consumer / business sentiment. Exactly what we’re going through now, and will continue going through in the next 6 – 12 months.

A Song of Ice and Fire – Inflation, or Deflation?

Medium to longer term, I see only 2 ways out of this crisis.

To quote a popular TV show – It is A Song of Ice and Fire.

We either emerge from COVID19 in the icy embrace of deflation, or the fiery grasp of inflation.

To understand how deflation plays out, we can look at Japan. It’s 10 years of slow growth, grinding insolvencies and unemployment, low levels of corporate investment and growth, and stagnant wages. It’s no fun.

For the inflation scenario, we actually don’t have any recent example. We need to go back to the 1970s or the 1940s to understand how it plays out.

Both were very tricky periods to be investing in. Hold the wrong asset class and you lose a big chunk of your wealth because of inflation.

Why is the Great Depression the holy grail in economics?

I’ve been doing a lot of reading on how the Great Depression played out.

Why is the Great Depression so important?

It is the only other time in the past 100 years that the US interest rates hit zero, and stayed there.

Now a bit of context to understand why this is so important. The dominant tool in economics over the past 50 years has been monetary policy (ie. interest rates).

The thinking was that whenever you have a bad recession, the central bank cuts interest rates, and the global economy will recover. People are rational right, so lower the cost of money, and people will borrow money to start businesses, and the recession is over.

This was what happened from the 1970s till today.

Everytime there was a recession, the Feds cut rates (usually about 5% before the recession is over). When the economy recovered, they raised rates.

But, and this is important, the increase in rates during the good times, are less than the cuts they made during the bad times.

2008 was a good example. Feds cut rates from 5% to 0%. But from 2008 to 2020? They only raised rates from 0% to 2.5%.

This means that over time, the broader trend in interest rates is downwards.

That’s exactly what we’ve seen.

Leaving aside the short term cycles, the broader trend in interest rates from the 1970s till now has been downward.

The death of Monetary Policy

So now that interest rates are zero, what happens next?

Which is where the Great Depression comes in handy. Because this was the only other time interest rates were at zero for 10 years or more.

You can see this from the chart below. And if the Great Depression is any guide, what happens next is that:

• Interest rates stay low… for a long time
• Money printing is going up… a lot

And what is the impact of that?

If the Great Depression is any guide – inflation, big inflation.

3 things that worry me short term

But the Great Depression was also unique because it eventually resulted in World War II, which skewed things in a big way.

I don’t think inflation is a done deal just yet.

Short term, there are 3 crucial macro points to keep a lookout for.

1. Monetary Policy

The Federal Reserve is the most important central bank in the whole world. 70% of global trade is denominated in USD, and USD liquidity determines financial conditions for the whole world.

That is why as investors, we hang onto every word Jerome Powell says.

The recent remarks though, are worrying.

What they’ve been saying, is that they will commit to keep interest rates low at least until 2024. They will also keep up the current pace of QE.

But very little mention of what else they are going to do next.

This is important because without big new steps from the Feds, a big tailwind for stocks is removed. And that’s why I think we’ve seen major indices mostly rangebound since June when Fed buying started to taper.

2. Fiscal Policy (Singapore Budget and Global Budget)

Fiscal is the other big one.

We’re in the midst of the worst economic recession since the Great Depression / World War II.

US unemployment is in excess of 10%. Singapore’s unemployment will tick up in the coming months too.

A lot of countries and companies have been kept afloat because of massive budgets run by their local government.

Just take Singapore for example – we dipped into our reserves for a $100 billion budget. That’s 20% of our GDP – putting us right up there close to the top.

We’ve never touched our reserves this way in Singapore’s history, which gives you an idea of how unprecedented this is. And we used that for cash handouts to the population, and income support, corporate assistance etc.

Same in the US, where unemployed were getting more than what they were getting from their day jobs.

A lot of this stimulus was possible because back in March, COVID19 looked like an unprecedented natural disaster. And just like any big natural disaster, it was assumed it would pass, and everything would go back to normal. V shaped recovery right?

Well, it’s become obvious that’s not happening. COVID19 is here to stay at least until we get large chunks of the world vaccinated.

What started out as a sprint, has evolved into a marathon.

And I believe fiscal policy will become more challenging going forward. We’re already seeing that in the US budget delay, Singapore’s reduced $8 billion budget, and in Europe.

COVID19 started out as a supply and demand shock. Increasingly, it looks like supply can recover quickly, but demand is much slower.

Once COVID goes away, the factories reopen, and they start building cars. But because people are unemployed or worried about their job, they no longer buy cars at the same pace they used to.

So going forward, I expect more fiscal policies directed at the demand side rather than supply side. Cash handouts direct to consumers, or something like the SingapoRediscovers campaign for example.

3. Virus Situation

We’ve talked about the virus in the past, so I won’t dwell on it too much here.

Long story short – there are still many ways that this can play out, from vaccine by early 2021, to second wave in winter, to evolving into more deadly strain.

Which outcome plays out, will have big economic consequences.

A lot of people are assuming this will all be over by next year. That may not play out.

Bonus Mention: Inequality

The last point I wanted to mention, is inequality.

I don’t know if you guys feel it, but inequality has gone up massively.

It’s been trending up for years now, but it’s really accelerated during COVID.

The rich who own stocks and financial assets have seen a big recovery from the bottom. The poor who work service or frontline jobs have seen retrenchments or paycuts. And frankly, it’s hard to see that changing in the coming months.

It’s no coincidence that the 1930s Great Depression ended in World War II.

Inequality leads to political change.

When people feel the system is unfair and doesn’t look after their interests, they will change the system. In democracies, they will vote for the candidates that can deliver what they want. In autocracies, they topple governments.

Happens all throughout history. Either the system changes by choice, or the system changes by force.

We’re still at the early days for this one. But I think the years to come will bring more social and political instability, that will surprise most of us.

Inflation, or Deflation?

Imagine this – As a government, you have two choices:

• Choice A: In response to COVID, you go into austerity. You raise taxes, and cut government spending. This causes soaring unemployment, increased social instability – but you balance your budget.
• Choice B: In response to COVID, you run a fiscally irresponsible budget. You spend more than you earn in tax revenue, and you flood the economy with stimulus. This reduces unemployment, improves consumer / business confidence up, and the population is happy. The cost is that you run a big budget deficit, which results in inflation and a weaker currency.

Which choice do you go with?

It’s a no brainer right. You go with B.

With A – you run the country into the ground, and eventually you get voted out, to be replaced by someone who goes with B.

With B – you solve the short-term problems, in exchange for longer term problems. But hey – in the longer term we are all dead, so let’s save the longer-term problems for someone else.

Well, the exact same thing played out in the 1930s. When faced with this choice, the world eventually embarked on Choice B.

In fact, the easiest way to solve the budget deficit is also via Choice B – inflation.

Think of it this way, you have a mortgage on your house. The house is worth $1 million, and the mortgage is worth $500,000. If the value of your house goes up to $2 million due to inflation, the value of your mortgage drops drastically relative to the house, because the mortgage amount doesn’t change.

Now imagine you’re the US and you owe the world $22 trillion. And then imagine that your central banks sets monetary policy for the whole world, and you can create inflation if you want.

Same logic here.

How should investors position their portfolio?

The positioning for each scenario is clear:

• If its inflation – you want to own stocks, REITs, real estate, gold, commodities. You want to sell treasuries, bonds and cash.
• If its deflation – you want to own treasuries, safe government bonds and cash. You want to sell stocks, REITs, real estate, gold, commodities.

And that’s exactly the problem.

If you position for inflation, and it turns out to be deflation, you get killed. And vice versa.

Which will we see?

My own view is that mid-term, it will be inflation. It has to be inflation.

The deflationary path is so painful that few governments will be able to withstand it for long. Think about Japan during the 1990s, but multiply that for the whole world. It’s a decade of low growth, soaring inequality, and rising poverty. It’s really the 21^st century version of the Great Depression.

It would undo the good work achieved by humanity over the past few decades.

So I don’t believe the deflationary track will last long.

Timing is tricky though. The exact timing depends on the 3 factors above, what governments do, what central banks do, what the virus does. This cannot be predicted with a high degree of certainty, so it pays to be flexible and nimble here.

Interest Rate Increase

One of the Patrons (as did the EndowUs CIO) pointed out to me that if inflation truly gets underway, the classic response is to raise interest rates, which will hit asset prices.

That’s a really good point to be honest.

My personal view though, is that this time is different. I think this time around, the budget deficits the US government are running are so high that interest rates cannot be allowed to go up, otherwise the cost of financing the debt would become prohibitive.

Some of the latest comments from Jerome Powell hint at this as well, that they’re going to run an irresponsible monetary policy that allows inflation to overshoot their 2% target.

Because of this, I think the Feds will eventually implement yield curve control – where they artificially set interest rates from the short end to the long end, and buy as much treasuries as required to effect that.

The last time this was done was in the 1940s, where there was a soaring budget deficit (to fund WWII) coupled with zero interest rates due to the Great Depression.

Very similar dynamic today – where a soaring budget deficit (to fight the effects of COVID19) meets zero interest rates due to the end of the long term debt cycle that started in the 1970s.

If so, Feds will buy all the new treasuries issued by the US government to keep long term interest rates low, and the US government will take that money and spend on whatever they want (unemployment checks, infrastructure investment etc). That would be inflationary.

I could be wrong of course. Time will tell.

Update: Had some really great comments and discussions with readers. To sum up my views here:

1. We were nearing the end of the long term debt cycle even pre-COVID, so this was always going to happen. What was unexpected was that it was a pandemic that set everything off.
2. COVID is short term deflationary, but the eventual response here will *most likely* be inflationary in the mid term.
3. So from a positioning perspective, if I am right – it will be for deflation short term, transitioning into inflation mid term.
4. The timing is tricky though, because no one knows when deflation transitions into inflation (some may argue we are already transitioning into inflation as we speak). As investors, options are to go early, or build a balanced portfolio, or try to remain flexible and nimble.
5. And the worry comes in because very few of us alive have experience investing in an inflationary environment. The last one was 1970s (and before that the 1940s). Both were very volatile periods in global financial markets. Stocks may have gone up, but picking the right ones, and ensuring they outpace inflation, were not so straightforward.

Love to hear your views!:)

Closing Thoughts: Am I being overly dramatic?

Some people may think I’m being hyperbole horse here.

And you know what, I hope they’re right.

I hope I’m wrong, and after COVID, everything goes back to normal. The economy recovers, unemployment drops, interest rates go back to normal, and we have low inflation. That’s the best case outcome here.

But I genuinely don’t see that happening. I think whether we like it or now, we’re on the cusp of the greatest financial, economic and geopolitical reset since World War II.

We have the end of the long term debt cycle, together with a once in a 100 year pandemic that triggered the biggest economic downturn since World War II, together with record levels of inequality and unemployment. Throw in a rising China seeking to disrupt the existing status quo, and we have the receipe for massive change.

As the quote by Lenin goes: “There are decades where nothing happens; and there are weeks where decades happen”.

The pre-COVID world has ended. The world we emerge into, will be fundamentally different from the one that went into COVID.

Denying that, will not prevent it.

Better to embrace it early, and to figure out where we want to stand in this new world.

Love to hear your thoughts below!

BTW: Anniversary Promo for the FH Course and REITs MasterClass ends this Sunday! Don’t miss the chance to pick up both courses at big discounts – with big freebies thrown in! Check it out here.

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