Economy

Your feedback is important to us. Please take our client survey today. Highlights Portfolio Strategy Today we recommend investors shift to a small versus large cap size bias on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Recent Changes Prefer highly-cyclical small caps at the expense of more defensive large caps. Table 1 Feature The SPX was rudderless last week as another week of intense fiscal policy drama dominated headline news both in Washington, D.C. and on Wall Street, overshadowing Q3 earnings season. Markets remain hostage to the stimulus tug-of-war and the renewed uncertainty has cast a shadow on the short-term prospects of durable gains in the broad equity market. We continue to recommend investors stay patient and opt to put fresh cash to work after the election-related uncertainty lifts. Odds remain high that the SPX glides lower into November before it resumes its cyclical bull market. Recently, we read Marko Papic’s (Chief Strategist at Clocktower Group) seminal book Geopolitical Alpha and we participated in a vibrant webcast hosted by our sister Geopolitical Strategy service last Wednesday celebrating Marko’s milestone. Marko’s book is a page turner and lived up to our high expectations: he concisely delivered content full of bold out-of-consensus predictions. Pages 92/93 reveal Marko’s most important forecast in our view: “The transition from the Washington to Buenos Aires Consensus will dominate markets over the next decade. This transition is more relevant than the US-China geopolitical rivalry, risks to European integration, and technological change. All assets will be influenced by the deluge of fiscal and monetary policy”. In recent research, we have been writing about the transition to the fiscally irresponsible Buenos Aires Consensus, and COVID-19 has not only made the US government profligate, but also insensitive to rising debt loads (Chart 1). Chart 1Buenos Aires Consensus  However, borrowing from Marko’s framework and applying a material constraint in the form of interest rates is instructive. We turned cyclically bullish on the SPX in mid-March and on March 23 we published the QE shaded chart that we are updating today; from the three asset classes we showcase only the 10-year US Treasury yield has yet to rise to a level consistent with some semblance of economic normality (Chart 2). The Fed has likely slayed all the Bond Vigilantes, but the Fed itself is the mega Vigilante, at the moment in a multi-year hibernation. Pundits use the 1994 example for the massive selloff in the bond market (the one that produced Democratic political adviser James Carville’s great quote: “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.”). However, they neglect to mention that the Fed doubled the fed funds rate (FFR) from 3% to 6% in a short time span, first igniting and then turbocharging the selloff in the bond market (Chart 3). Chart 2QE Is Always Bullish Chart 3Lessons From History This cycle, the Fed is acting as an enabler of the transition to the Buenos Aires Consensus. Thus the interplay between the Fed and the bond market will be critical to monitor in coming quarters and years. More specifically, understanding the Fed’s reaction function to a potential doubling in the 10-year US Treasury yield and jump in the FFR change expectations is essential. The most recent and relevant example was during the GFC, when the Fed held the FFR near zero from December 2008 until December 2015. In this seven-year period, the interplay between the FFR change expectations and the 10-year US Treasury yield reveals that the sensitivity of interest rates to FFR change expectations stood near 2-to-1; i.e. a 50bps increase in the FFR change expectations would push the 10-year yield 100bps higher and vice versa (Chart 4). Chart 4Rates Sensitivity At The Zero-Bound Back Then... The most important divergence occurred in May 2013, with the now infamous Bernanke taper tantrum speech, following which the bond market sold off violently, but the FFR change expectations stayed relatively calm near the zero line (Chart 4). Year-to-date, the 10-year US Treasury yield’s sensitivity to FFR change expectations has ranged between 1-to-1 and 2-to-1 (Chart 5). Looking ahead post the election, the odds are rising of a mammoth fiscal package, especially if there is a “Blue Sweep” but also potentially in a renewed Trump administration. Under such a backdrop the 10-year US Treasury yield would spike and so will FFR hike expectations. Tack on the real possibility of a vaccine landing some time in 2021 and the economy will likely roar, creating a feedback loop further underpinning long bond yields. The only regulatory mechanism for fiscal prudence comes from the bond market. Put differently, only rising interest rates on an expanding debt pile can concentrate politicians’ minds (Chart 6). Therefore, the Fed’s reaction function will be critical in how they deal with the looming increase in interest rates and FFR hike expectations. Chart 5...And Today Chart 6Interest Rates Are The Only Constraint               In that scenario, will the Fed try to talk the bond market down, utilize some form of yield curve control (YCC), or do nothing? With the YCC option similar to the 1940s as the most likely outcome as we posited in late summer, we expect that inflation will make a comeback and that would aid the Fed as it will accomplish its recent mission to finally generate inflation. It will also aid the government by inflating its way out of a debt trap by reversing the current dire debt-to-GDP arithmetic (please refer to our June 1 Inflation Special Report for more details on US equity sector implications). From an equity market’s perspective, the Fed’s reaction function poses a short-term risk: an unchecked selloff in the bond market will trigger a more pronounced tech sector underperformance period and unlock excellent value in beaten down financials (Chart 7). This week we continue to add more cyclicality to our portfolio and recommend a small versus large cap size bias on the back of rising odds of a “Blue Trifecta” and a massive stimulus package, and in accordance with our reopening of the economy theme we have been recently exploring. Chart 7Rotation Looming   It’s A Small World After All We recommend investors implement a small size bias either via the Russell 2000 IWM:US exchange traded fund versus the SPY or via the S&P small cap IJR:US exchange traded fund at the expense of the SPY. These two small cap ETFs offer the most liquidity and each have roughly $40bn AUM. On March 20 in the middle of the pandemic and then on April 28 we monetized handsome gains for our portfolio by closing out our high- conviction and cyclical large cap bias, respectively. In hindsight, we should have flipped and implemented a small cap bias as up until early June, small caps were outshining large caps. Since then, they have retraced almost half the gains and now present an exploitable opportunity (top panel, Chart 8). The bearish small cap story is by now well ingrained. Small caps are plagued by a heavy debt load, have no or little trailing earnings to show for let alone nearly 1 in 3 small caps have no forward EPS and profit margins have collapsed near the zero line (Chart 8). While debt saddled small caps are a tough pill to swallow, the untold story is warranting some attention. First, according to a recent FT article, there is so much sloshing liquidity around that asset managers cannot raise private debt funds fast enough.1 Not only is the fiscal stimulus providing a lifeline to debt burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, top panel, Chart 9). Chart 8All The Bad News Is Priced In Chart 9Catch Up Phase… Second, the sector composition of small versus large caps represents a high-octane version of the SPX cyclicals/defensives portfolio bent that we have been exploring since late-July/early August. Table 2 shows that industrials comprise the largest market cap weight in small cap indexes. Tack on the materials and energy laggards and the deep cyclical (ex-tech) weight increases to 26% or twice the SPX weight. With regard to defensives the small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points, confirming the small cap universe’s higher beta status. As a result we expect a narrowing of the gap as laggard small caps play catch up (bottom panel, Chart 9). Meanwhile, inflation expectations have recovered smartly from the depths of the COVID-19 accelerated recession and have formed an unmistakable V-shape (top panel, Chart 10). However, the small/large share price ratio has yet to follow suit. In fact, the Commodity Research Bureau’s overall index is also on fire signaling that commodity inflation is making a comeback. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirting around with two-year highs (not shown). Table 2S&P 600/S&P 500 Sector Comparison Table If our thesis that the economic recovery will accelerate in the New Year as a vaccine will make possible a full reopening of the economy, then the upshot is that relative share prices will converge higher to rising commodity prices (bottom panel, Chart 10). Chart 10…Looms Large Another way to depict the deep cyclicality of the small cap index is to compare it with the emerging markets (EMs). The small/large ratio is back to where it was at the turn of the century, giving back 15-20 years of outperformance depending on which small cap index one uses (Russell 2000 or S&P 600). Similarly, EMs performance versus the SPX has returned to a depressed level last seen in the aftermath of the dotcom bust and is a carbon copy of the small/large ratio (middle panel, Chart 11). The implication is that small caps go as EMs go and an EM recovery bodes well for a small cap outperformance phase. Circling back to Table 2, the financials sector delta is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues up the reopening path and a vaccine is nearing (bottom panel, Chart 11). Similarly, the VIX has collapsed from north of 80 to below 30 recently confirming that the intense ‘risk off’ phase is over. Nevertheless, there is ample room for the VIX to fall further as it remains stubbornly at an historically elevated print 10 points above the mean. Importantly, the VIX has remained above 20 for over 160 trading days. Were it not for the GFC this would be a record streak (VIX shown inverted, top panel, Chart 11). Finally, the two year drubbing of small caps has worked off some of the overvaluation and our relative Valuation Indicator has returned back to the neutral zone. Importantly, small caps are so unloved and under-owned that our relative Technical Indicator is probing multi-decade lows. Historically, such a depressed relative positioning level has been contrarily positive and served as a launch-pad to significantly higher relative share prices on a cyclical time horizon (Chart 12). Chart 11High Beta ‘Risk On’ Beneficiary Chart 12What’s Not To Like? Adding it all up, a small versus large cap outperformance period looms on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Bottom Line: Initiate a long small caps/short large caps trade today with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.ft.com/content/b7e29f0d-d906-421c-9a0a-910099e6eed9 Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Your feedback is important to us. Please take our client survey today. Highlights For now, there is little evidence that the pandemic has adversely affected the global economy’s long-run growth potential. Even if one counts those who will be unable to work due to long-term health complications from the virus, the pandemic will probably reduce the global labor force by only 0.1%-to-0.15%. Labor markets have healed more quickly over the past few months than after the Great Recession. In the US, the ratio of unemployed workers-to-job openings has recovered most of its lost ground. Thanks in part to generous government support for businesses and the broader economy, commercial bankruptcy filings remain near historic lows. Meanwhile, new US business formation has surged to record highs. The combination of a vaccine and a decline in rents in city centres should persuade some people who were thinking of fleeing to the suburbs to stay put. This will ensure that most urban commercial and residential real estate remains productively engaged. Judging from corporate surveys, capital spending on equipment and intellectual property should continue to rebound. While the pandemic has caused numerous economic dislocations, it has also opened the door to a variety of productivity-enhancing innovations. An open question is whether all the debt that governments have taken on to alleviate the economic damage from the pandemic could in and of itself cause damage down the road. As long as interest rates stay low, this is not a major risk. However, today’s high government debt levels could become a problem if the pool of global savings dries up. Investors should continue to overweight stocks for the time being, while shifting their equity exposure from “pandemic plays” to “reopening plays.” A more cautious stance towards stocks may be appropriate later this decade.  The Pandemic’s Potentially Long Shadow In its latest World Economic Outlook, the IMF revised up its growth estimates for this year. Rather than contracting by 4.9%, as it expected in June, the Fund now sees the global economy shrinking by 4.4%. That said, the IMF’s estimates still leave global GDP in 2020 7.5% below where it projected it to be in January. Perhaps even more worrying, the IMF expects the global economy to suffer permanent damage from the pandemic (Chart 1 and Chart 2). It projects that real global GDP will be 5.3% lower in 2024 compared to what it expected last year. In the G7, real GDP is projected to be nearly 3% lower, with most of the shortfall resulting from a downward revision to the level of potential GDP (Chart 3). Chart 1Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part I) Chart 2Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part II)     The Congressional Budget Office is no less gloomy in its forecast. The CBO expects US real GDP to be 3.7% lower in 2024 than it projected last August. By 2029, it sees US GDP as being 1.8% below what it had expected prior to the pandemic, almost entirely due to slower potential GDP growth (Chart 4). Chart 3G7 Real GDP Growth Projections Have Been Revised Sharply Lower Due To The Pandemic Chart 4A Gloomy Forecast For The US Thanks To Covid-19 The worry that the pandemic will lead to a major permanent loss in output is understandable. That is precisely what happened after the Global Financial Crisis. Nevertheless, as we discuss below, there are good reasons to think that the damage will not be as pervasive as widely believed. The Drivers Of Potential GDP An economy’s potential output is a function of three variables: 1) the number of workers available; 2) the amount of capital those workers have at their disposal; and 3) the efficiency with which this labor and capital can be transformed into output, a concept economists call “total factor productivity.” Let us consider how the pandemic has affected all three variables. The Impact Of The Pandemic On The Labor Market At last count, the pandemic has killed over 1.1 million people worldwide, 222,000 in the US. While the human cost of the virus is immense, the economic cost has been mitigated by the fact that about four-fifths of fatalities have been among those over the age of 65 (Table 1). In the US, less than 7% of the labor force is older than 65. A reasonable estimate is that Covid deaths have reduced the US labor force by 55,000.1 Table 1Pandemic-Related Deaths Are Tilted Towards The Elderly, Who Are The Least Active Participants Of The Labor Force Chart 5The Number Of New Cases Continues To Increase Globally Granted, mortality is not the only way that the disease can impair one’s ability to work. As David Cutler and Larry Summers point out in a recent study, for every single person who dies from Covid-19, seven people will survive but not before manifesting severe or critical symptoms of the disease.2 Based on the experience from past coronavirus epidemics, Ahmed, Patel, Greenwood et al. estimate that about one-third of these survivors will suffer long-term health complications.3 If one assumes that half of these chronically ill survivors are unable to work, this would reduce the US labor force by an additional 65,000.4 Of course, the pandemic is not yet over. The number of new cases continues to rise in the US and globally (Chart 5). The only saving grace is that mortality and morbidity rates are lower than they were earlier this year. Nevertheless, many more people are likely to die or suffer debilitating long-term consequences before a vaccine becomes widely available. Using the US as an example, if the total number of people who end up dying or getting so sick that they are unable to work ends up being twice what it is so far, the pandemic will reduce the labor force by about 240,000. This is not a small number in absolute terms. However, it is less than 0.15% of the overall size of the US labor force, which stood at 164 million on the eve of the pandemic. The impact of the pandemic on the labor forces of other major economies such as Europe, China, and Japan will be even smaller. Labor Market Hysteresis People can drop out of the labor force even if they do not get sick. In fact, 4.4 million have left the US labor force since February, bringing the participation rate down from 63.4% to 61.4%. How great is the risk of “hysteresis,” a situation where the skills of laid-off workers atrophy so much that they become unwilling or unable to rejoin the labor force? At least so far, hysteresis has been limited. According to surveys conducted by the Bureau of Labor Statistics, most US workers who have dropped out of the labor force still want a job. The pandemic has made it more difficult for people to work even when they wanted to. During the spring, more than four times as many employees were absent from work due to childcare requirements than at the same time last year. Now that schools are reopening, it will be easier for parents to go back to work. Admittedly, not everyone will have a job to return to. While about a third of US unemployed workers are still on temporary layoff, the number of workers who have suffered permanent job losses has been steadily rising (Chart 6). The good news is that job openings have recovered most of their decline since the start of the year. Unlike in mid-2009, when there were 6.5 unemployed workers for every one job vacancy, today there are only two (Chart 7). Chart 6US: Permanent Job Losses Have Been Rising Steadily... Chart 7...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year It is also worth noting that the vast majority of job losses during the pandemic has been among lower-income workers, especially in the retail and hospitality sectors. Most of these jobs do not require highly specialized sector-specific skills. Thus, as long as there is enough demand throughout the economy, unemployed workers will be able to find jobs in other industries. Wither The Capital Stock? The pandemic may end up reducing the value of the capital stock in two ways. First, it could render a portion of the existing capital stock unusable. Second, the pandemic could reduce the pace of new investment, leading to a smaller future capital stock than would otherwise have been the case. Let us explore both possibilities. On the first point, it is certainly true that the pandemic has left a lot of the capital stock idle, ranging from office buildings to shopping malls. However, this could turn out to be a temporary effect. Consider, for example, the case of China. After the pandemic began in Wuhan, China first shut down much of its domestic economy and then implemented an effective mass testing and contact tracing system. The strategy worked insofar as China is now nearly free of the virus. Today, few Chinese wear masks, the restaurants are full again, and domestic air travel is back to last year’s level. Even movie theatre revenue has rebounded. The rest of the world may not be able to replicate China’s success in combating the virus, but then again it won’t need to if an effective vaccine becomes available. Chart 8US Housing Is In A Good Place Even if the pandemic ends up leading to deep and lasting changes in the way people live, work, and shop, the market mechanism will ensure that all but the least desirable parts of the capital stock remain productively employed. As first year economics students learn, if the supply curve is vertical and the demand curve shifts inward, the result will be lower prices rather than diminished output. By the same token, if more companies and workers decide to relocate to the suburbs, urban rents will fall until enough people decide that they are better off staying put. An economy’s productive capacity does not change just because rents go down. What falling demand for urban real estate and increased interest in working from home will do is encourage people to buy larger homes in suburban areas. We have already seen this play out this year. Despite flagging commercial real estate construction in the US, residential construction has boomed. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales have reached new cycle highs. Homebuilder confidence hit a new record in October (Chart 8). The Service Sector Is Not Particularly Capital Intensive Most recessions take a greater toll on the goods-producing sectors of the economy than the service sector. The pandemic, in contrast, has mainly afflicted services. The service sector is the least capital-intensive sector of the economy. This is especially the case when it comes to spending on capital equipment and investment in intellectual property (Chart 9). Chart 9Capex-Intensive Industries Have Let Go Of Less Workers During The Pandemic Chart 10Capex Intentions Have Bounced Back As such, it is not surprising that investment in equipment and IP fell less during this recession than one would have expected based on the historic relationship between investment and GDP growth. According to the Atlanta Fed’s GDPNow model, investment in equipment and IP is set to increase by 23% in the third quarter. The snapback in the Fed’s capex intention surveys suggests that investment spending should continue to rise in the fourth quarter and into next year (Chart 10). Productivity And The Pandemic Just as the impact of the pandemic on the labor supply and the capital stock is likely to be limited, the same is true for the efficiency with which capital and labor is transformed into output. For every person whose productivity is hampered by having to work from home, there is another person who feels liberated from the need to spend an hour commuting to work only to attend a series of pointless meetings. In fact, it is quite possible that the pandemic will nudge society from various “low productivity” equilibria to “high productivity” equilibria. For example, greater use of video conferencing could negate the need to take redeye flights to attend business meetings in person. Remote learning could enhance educational opportunities. More widespread use of telemedicine could eliminate the need to waste time waiting in a doctor’s office. Who knows, the pandemic could even fulfill my life-long mission to replace the unhygienic handshake with the much more elegant Thai wai. Granted, disruptive shifts could produce unintended consequences. There is a fine line between creative destruction and uncreative obliteration. If the pandemic forces otherwise viable businesses to close, this could adversely affect resource allocation. Chart 11New Business Applications Have Surged To Record Highs Chart 12Commercial Bankruptcy Filings Remain In Check Fortunately, at least so far, this does not seem to be happening on a large scale. After dropping by 25%, the number of active US small businesses has rebounded to last year’s levels. New business applications have surged to record highs (Chart 11). According to the American Bankruptcy Institute, commercial bankruptcy filings remain near historic lows. While Bloomberg’s count of large-company bankruptcies did spike earlier this year, it has been coming down more recently (Chart 12). Fiscal Stimulus To The Rescue Chart 13Personal Income Jumped Early On In The Pandemic How did so many households and businesses manage to avoid the financial suffering that usually goes along with deep recessions? The answer is that governments provided them with ample income support. In the US, real personal income rose by 11% in the first few months of the pandemic (Chart 13). Small businesses also benefited from the Paycheck Protection Program, which doled out low-cost loans to businesses which they will be able to convert into grants upon confirmation that the money was used to preserve jobs. Similar schemes, such as Germany’s Corona-Schutzschild, Canada’s Emergency Business Account program, and the UK’s Coronavirus Job Retention Scheme were launched elsewhere. The failure of the US Congress to pass a new stimulus bill could undermine the sanguine narrative presented above. Small businesses, in particular, are facing a one-two punch from the expiration of the Paycheck Protection Program and tighter bank lending standards. Ultimately, we think the US Congress will pass a new pandemic relief bill. However, the size of the bill could depend on the outcome of the election. In a blue sweep scenario, the Biden administration will push through a $2.5-to-$3.5 trillion stimulus package early next year, while laying the groundwork for a further 3% of GDP increase in government spending on infrastructure, health care, education, housing, and the environment. A fairly large stimulus bill could also emerge if President Trump manages to hang on to the White House, while the Democrats take control of the Senate. Unlike some Republican senators, Donald Trump is not averse to big increases in government spending. A continuation of the current political configuration in Washington would result in the smallest increase in spending. Nevertheless, some sort of deal is likely to emerge after the election. Even most Republican voters favor a large stimulus bill (Table 2). Table 2Strong Support For Stimulus A Double-Edged Sword? Bountiful fiscal support has undoubtedly lessened the economic scarring from the pandemic. However, could the resulting increase in government debt lead to supply-side problems down the road? The answer depends on what happens to interest rates. As long as interest rates stay below the growth rate of the economy, governments will not need to raise taxes to pay for pandemic relief. In fact, in such a setting, the public debt-to-GDP ratio will return to its original level with absolutely no change in the structural budget deficit (Chart 14). GDP growth in most developed economies has exceeded government borrowing rates for much of the post-war era (Chart 15). Thus, a free lunch scenario where governments never have to pay back the additional debt they incurred for pandemic relief cannot be ruled out. That said, it would not be prudent to bank on such an outcome. If the excess private-sector savings that have kept down borrowing costs run out, interest rates could rise. In a world awash in debt, this could lead to major problems. Thus, while the structural damage to the global economy from the pandemic appears to be limited for now, that could change in the future. Chart 14A Fiscal Free Lunch When r Is Less Than g Chart 15The Rate Of Economic Growth Has Usually Been Higher Than Interest Rates     Investors should continue to overweight equities for the time being. With a vaccine on the horizon, it makes sense to shift from favoring “pandemic plays” such as tech and health care stocks to favoring “reopening plays” such as deep cyclicals and banks. A more cautious stance towards stocks will be appropriate later this decade if, as flagged above, a stagflationary environment leads to higher interest rates and slower growth.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 To estimate the direct impact of Covid-19 on the labor force, we calculate the decline in the labor force by age cohorts using Covid-19 death statistics and labor participation rates. 2 David M. Cutler, and Lawrence H. Summers, “The COVID-19 Pandemic and the $16 Trillion Virus,” JAMA Network, October 12, 2020. 3 Hassaan Ahmed, Kajal Patel, Darren Greenwood, Stephen Halpin, Penny Lewthwaite, Abayomi Salawu, Lorna Eyre, Andrew Breen, Rory O’Connor, Anthony Jones, and Manoj Sivan. “Long-Term Clinical Outcomes In Survivors Of Coronavirus Outbreaks After Hospitalisation Or ICU Admission: A Systematic Review And Meta-Analysis Of Follow-Up Studies,” medRxiv, April 22, 2020. 4 Calculated as 0.5 x (decline in labor force due to Covid-19 deaths) x 7 x (1/3).   Global Investment Strategy View Matrix Current MacroQuant Model Scores

Special Report

Your feedback is important to us. Please take our client survey today. Highlights The signaling of QE programs by central banks has the greatest short-term impact on financial markets. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created excess reserves and deposits, respectively. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Therefore, going forward QE programs will have a greater impact on financial markets than they did in the past ten years. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation in the coming years. Rising velocity of money will be the key to inducing and sustaining higher inflation. Feature There are varying explanations in the investment community over how quantitative easing (QE) programs affect asset prices and consumer price inflation. For example, investors often struggle to dissect the impact of QE on equity prices and exchange rates: (1) Is it the level of central bank assets or their rate of change that affects financial markets? or (2) Is it the signaling mechanism of QE that moves asset prices and currencies? (3) Why did QE programs in the last decade not lead to higher consumer price inflation? We use a question-answer format to elaborate on these and other questions related to QE programs.  QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. Question: Do QE programs amount to money printing? Answer: Not always. QE operations by central banks might or might not create new money supply. First, we have to define money. In all countries, broad money supply is commonly defined and calculated as the sum of cash in circulation and all types of deposits in the commercial banking system. Cash in circulation makes only 11% of broad money supply in the US, 9% in the euro area, 3.8% in China and 7.3% in Japan. Hence, various types of deposits in commercial banks constitute the overwhelming portion of broad money supply. Deposits in commercial banks are not a part of a central bank’s balance sheet. Therefore, neither central bank assets nor liabilities are valid measures or proxies of money supply. Chart I-1A and I-1B illustrates that changes in central bank assets and broad money supply have contrasted greatly.     Chart I-1ACentral Bank Assets ≠ Money Supply Chart I-1BCentral Bank Assets ≠ Money Supply   When central banks expand their balance sheets, they create excess reserves (ERs) “out-of-thin air”. ERs are commercial bank deposits at the central bank. There is a close relationship between ERs and central bank balance sheets as ERs constitute a large part of the latter’s liabilities. As a mirror image of ERs, the asset side of central banks’ balance sheet expands as they acquire securities or originate loans.  However, ERs are not a part of either narrow or broad money supply. In fact, in the last decade QE programs in the US, Japan and the euro area created a lot of ERs but little money supply as can been seen in Chart I-2A and I-2B. Chart I-2ATrends In Excess Reserves And Money Supply Differ Chart I-2BTrends In Excess Reserves And Money Supply Differ   In China, it was the opposite: commercial banks have created a lot of money and expanded their assets even as the central bank has provided little ERs (Chart I-2B, bottom panel).  ERs are liquidity for the banking system; commercial banks use ERs to settle payments among themselves and with the central bank. ERs do not spill over into the real economy as commercial banks do not lend out ERs to companies and households. When a central bank buys securities or lends money, it always creates ERs but it does not always create money supply. Households, companies, non-bank financial institutions, organizations and governments (hereafter, economic agents) use money supply – deposits in the banking system and cash in circulation – to buy goods, services and assets. They do not have access to or do not use ERs. Given that central bank QE operations create ERs but not always money supply (deposits), they have a much more nuanced impact on the money supply. Question: In which cases do QE operations create money supply (or not)?  Answer: Whether a QE operation will lead to money creation depends on the counterparty of the central bank transaction: 1. When the central bank lends to or buys securities from commercial banks, it creates ERs but not money supply (deposits). In this case, the central bank’s balance sheet expands but the amount of deposits/money supply in the banking system does not change (Figure I-1). Figure I-1 This operation creates ERs (liquidity for the banking system) but not money supply/deposits at banks that economic agents can use to purchase goods, services, and assets. That said, commercial banks with a large quantity of ERs might decide to originate more loans/lend more to economic agents so that money supply (purchasing power) can expand. In this scenario, QE operations do not affect money supply directly, but they may do so indirectly. 2. When the central bank lends to or purchases securities from economic agents, both ERs and new money supply/deposits are created “out of thin air” (Figure I-2). In this case, not only do commercial banks get ERs but economic agents also get deposits that did not exist before. These newly created deposits constitute an increase in money supply and boost the purchasing power of these economic agents. Figure I-2 3. Absent QE operations, central banks do not typically directly alter money supply; money is almost entirely created by commercial banks. When a commercial bank buys securities from or lends to economic agents, ERs do not change but a new deposit is created “out of thin air”, therefore the money supply expands. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e., the amount of deposits in the banking system) shrinks. To sum up, QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. When central banks purchase assets from commercial banks, no new money is created. Importantly, the main source of money creation outside QE programs is commercial bank purchases of securities from or loans to economic agents. Changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies. Question: How can we forecast if any particular QE program is going to create more or less money? Answer: There is no way to predict it. All depends on the counterparties involved in central bank transactions. One can only observe the evolution of money supply to gauge the direct impact of a QE program on money supply. Further, commercial bank actions have a great deal of impact on money supply. When the commercial banking system as a whole shrinks its assets (loan book, holdings of securities and other claims or assets), money supply contracts, ceteris paribus. In short, to forecast changes in money supply one need to not only forecast central bank transactions with economic agents (non-banks) but also commercial banks loans to, and purchases of securities from, economic agents. Chart I-3Broad Money Growth: Now Versus Last Decade Question: In regard to their impact on money supply, how do QE programs presently differ from those of the last decade? Answer: The key difference between the outcomes of QE programs this year and the ones undertaken in the last decade is that broad money growth in advanced economies is skyrocketing now but it was tame during the QE programs of the last decade (Chart I-3). To recap, QE programs in the US, Japan and the euro area, over the past 10 or so years have created a lot of ERs but little money supply. The reasons for this are as follows: deleveraging by banking systems in the last decade – commercial banks assets shrank or grew modestly – partially offset QE operations’ boost to money supply. Chart I-4 illustrates commercial banks’ assets contracted in 2009-10 in the US, in 2012-17 in the euro area and in the 1990s in Japan. Shrinking commercial bank assets reduces money supply, ceteris paribus. That is why QE programs of the last decade had a muted impact on broad money supply. Presently, commercial banks assets are rising rapidly in the US, the euro area and Japan. Hence, the simultaneous expansion of both central bank and commercial banks assets ensures much more robust money growth now than during the past two decades. Further, advanced economies are moving from monetary to fiscal dominance as their fiscal policies become much more proactive in stimulating growth. This entails running larger fiscal deficits. Mushrooming government bond supply will have to be absorbed by central banks to preclude a substantial rise in bond yields that can threaten economic expansions. Consequently, central banks will purchase a lot of government bonds not from commercial banks but from governments or other investors. This will directly boost money supply. Finally, commercial banks in DM have plenty of ERs and they do not need to sell their bonds in exchange for ERs like they did when they deleveraged last decade. Hence, DM central banks will primarily be purchasing bonds from non-banks resulting in new money creation. All in all, money supply in advanced economies will grow much faster this decade than it did in the past ten years.       Question: Does the current booming money supply in the US not reflect an overflow of excess savings? Answer: As we discussed in our previous reports on money, credit and savings, changes in money supply are not at all contingent on national or household savings. As was discussed above, outside of QE operations, money is primarily created by commercial banks “out-of-thin air” when they lend to or purchase assets from non-banks. Chart I-5 illustrates that there has been no positive correlation between the savings rate and money supply in China, Korea, Japan and the US. The same holds true for any other economy. Chart I-4Commercial Bank Assets Have Great Impact On Money Supply Chart I-5National Or Household Savings Do Not Drive Changes In Money Supply Chart I-6The US: Household Savings Rate And Money Supply The reason why the surge in US money supply this year has coincided with the rise in the US savings rate is as follows (Chart I-6): the Federal Reserve bought an enormous amount of US Treasury securities creating new money “out of thin air”; households received these fiscal transfers from the government in their bank accounts in the form of deposits. Hence, new money was created as a result of public debt monetization and this occurred before consumers made their choice between spending and saving. Critically, changes in economic agents’ propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. In brief, changes in the propensity to save alter the velocity of money, but not the amount of money supply. Chart I-7Velocity Of Money Explains Changes In Core Inflation Question: What is more important to inflation in goods and services: money supply or the velocity of money? Answer: Empirical evidence shows that the changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies (Chart I-7). Overall, there is no direct link between interest rates and money supply on the one hand and goods and service inflation on the other hand. That said, low interest rates or rapid money growth might encourage economic agents to save less, i.e., spend a larger share of their income. Stronger spending – which leads to an acceleration in the velocity of money – will raise inflationary pressures in the real economy. Even if QE programs succeed in generating rapid money growth, the latter does not automatically bring about higher inflation in goods and services. The willingness of consumers and businesses to consume more is critical to generating consumer and producer price inflation. Question: How does money supply differ from liquidity that flows into financial markets? Answer: Investors and market commentators often refer to “liquidity” as a driving force for financial markets. Yet definitions and calculations of liquidity vary tremendously. What investors refer to as “liquidity” can by and large be classified into three groupings: (1) banking system liquidity (excess reserves); (2) broad money supply (all deposits and cash in circulation) available to purchase goods, services and assets, including securities; and (3) liquidity in asset markets – the portion of broad money supply that is channeled to purchase financial assets. Figure I-3 provides a visual representation of money supply and liquidity groupings. All other measures of “liquidity” generally fall into one of these three groupings. Figure I-3Liquidity Groupings And Linkages Deposits/money supply can be used to acquire both financial and real assets as well as to purchase goods and services. They could also be kept idle. In a given period of time, it is impossible to envisage what portion of deposits in the banking system will be allocated to securities investments. Ultimately, this decision rests with each individual and institutional investor. Therefore, it is impossible to forecast the true size of liquidity flow into and out of asset markets. Chart I-8Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Overall, gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve. In contrast, deteriorating investor confidence can lead to a dearth of liquidity in asset markets, despite abundant broad money supply. This topic of liquidity flows into and out of financial markets was extensively discussed in our report titled A Primer On Liquidity. Question: Is there a shortage of financial assets relative to available liquidity? Answer: Probably yes. QE programs in advanced economies have removed high-quality financial assets – valued at about $22 trillion – from global markets. Yet, money supply has expanded tremendously. This has left more money chasing few assets. The top panel of Chart I-8 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines – presently stand at $4 trillion. Notably, the Fed and US commercial banks have increased their debt securities holdings by $3.2 trillion since February and are currently holding $10.9 trillion of debt securities (Chart I-8, middle and bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. We reckon that cash on the sidelines is equal to 8% of the combined value of US equities and US-dollar debt securities available to non-bank investors, i.e. excluding debt securities owned by the Fed and commercial banks (Chart I-9). There is room for this ratio to drop further to its January 2020 level. Chart I-9Investors' Cash Holdings Ratio Has Room To Drop Further To recap, the amount of liquidity flowing into and out of financial assets is ultimately contingent on investor behavior. When investors are willing to invest, liquidity flows into asset markets. On the contrary, when investors turn cautious, they withhold liquidity and asset prices drop.   Overall, barring negative shocks and relapses in growth, risk assets will be supported by tailwinds of expanding money supply. Conclusions And Investment Strategy The signaling of QE programs by central banks has the greatest short-term impact on financial markets – positive on risk assets and negative on the exchange rate. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created ERs and deposits, respectively. Besides, the amount of securities withdrawn from circulation by central banks relative to assets under management also determines the impact of QE operations on asset prices. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Going forward, QE programs will have a greater impact on financial markets than they did in the last decade because they will create more money supply (Chart I-10). Besides, as central banks absorb more securities, the availability of securities to private investors will decline. This will be especially pertinent if the pool of assets under management expands faster along with rapidly growing money supply. This ceteris paribus warrants high asset prices. Interestingly, Chart I-11 demonstrates that during the last decade there was no positive correlation between G4 QE programs - central banks’ balance sheets - and EM risk assets and currencies. Based on this Chart I-11, during the last decade we often downplayed the importance of QE programs for EM financial markets. Chart I-10Global Money Does Not Always Drive Share Prices Chart I-11DM Central Banks' Assets And EM: No Correlation In The Last Decade   However, we have changed our view on the impact of the current round of QE programs on financial markets since May when we published a report titled Understanding QE Programs In EM And DM.  3. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation. A rising velocity of money will be the key to inducing and sustaining higher inflation. De-globalization, policies targeting income redistribution from high- to low-income households, and the oligopolistic structure of a growing number of industries all argue for higher price inflation in the real economy this decade. Only technological advances and automation will be working the opposite way and thus keeping a lid on consumer price inflation. In short, odds favor higher inflation this decade.  4. Concerning EM financial markets, QE programs in EM and DM are especially positive for EM local currency bonds and sovereign and corporate credit markets. We remain long duration in EM domestic bonds but neutral on their currencies versus the US dollar. We expect a rebound in the US dollar before the end of this year. We will use this rebound in the greenback to recommend investors to be long local bonds without hedging currency risk. As for EM credit markets, we are neutral and expect to buy on a dip. The ability of governments to finance themselves locally will limit the supply of US dollar bonds and support this asset class. The latter will also benefit from DM QE programs. While EM and DM QE programs can meaningfully affect the trend in share prices and currencies, the primary long-term trend in EM equities and exchange rates will depend on the return on capital in their respective economies. A high or rising return on capital will supercharge share prices and lead to substantial currency appreciation. A low or plunging return on capital will weigh on both stock prices and currencies, regardless of QE programs. Equity investors should remain neutral on EM equities versus DM. We are presently short a basket of EM currencies versus the euro, CHF and JPY. For country allocation with equities, local bonds, credit markets and currencies, please refer to tables at the end of each report (pages 17-18). The signaling of QE programs by central banks has the greatest short-term impact on financial markets. 5. Finally, Chart I-12 presents a graph that combines two variables: the increase in broad money supply since February as a share of GDP (X-axis) and each country’s central bank purchases of government bonds as a share of net government bond issuance since February (Y-axis).  Chart I-12Monetization Of Fiscal Deficit And Rapid Money Growth This chart gauges the degree of public debt/fiscal deficit monetization by central bank QE operations and aggregate money creation by the central bank and commercial banks. It reveals that the US, the euro area, the Philippines and Poland since February have experienced a money boom stemming from their central banks buying government bonds. India and Turkey are a notch below them. In the majority of EM countries, central bank QE programs and money creation by banks have been timid. This confirms our theme that the majority of EM except China, Korea, and Taiwan are facing tight budget constraints. This will slow down a recovery in these economies. However, it will also force companies and commercial banks to restructure and boost efficiency. The ones that undertake such restructuring will enjoy a bull market in share prices and their currencies will appreciate in the long run.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations