Comment

Global stimulus is running out before the pandemic has been defeated

Wall Street is being held up by a diminishing handful of equities primarily composed of the big tech companies such as Microsoft and Amazon

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Global bond markets refuse to ratify a V-shaped economic recovery. Futures contracts in fixed income derivatives are even more bearish, signalling nothing less than a worldwide deflationary slump as far as the eye can see.

“If markets are pricing a 'V', they’re going about it in an odd way,” says Andrew Sheets from Morgan Stanley.

It is simply not true that investors are ignoring the massive economic shock of the pandemic. The picture is being distorted by equities, and within that by a clutch of US tech stocks in the grip of a parabolic spike all too like the final phase of the dotcom bubble in 2000. But debt markets are three times bigger and ultimately matter far more.

Yields on 10-year US Treasuries have not rebounded as you would expect if the economy is genuinely healing. They are trading at 0.62pc, close to their all-time low during the panic flight to safety in late March.

You can perhaps rationalise such low yields on the grounds that the Federal Reserve has repressed the Treasury market with its $3 trillion blast of pandemic QE, although be aware that the Fed balance sheet peaked at $7.2 trillion in early June and has since fallen by $200bn.

What you cannot so easily rationalise is the long-range pricing of futures contracts. They imply that yields will remain pinned to the floor until the mid-2030s and that the Fed will not come close to meeting its inflation target by the middle of the century.

Fixed income funds are telling us central banks will fail to generate more than a flicker of inflation despite heroic efforts. It is the portrait of a truncated recovery with corrosively high unemployment.

Mr Sheets says a slew of market signals are disturbing. People are willing to pay nosebleed sums for disaster protection, the "skew" in hedge fund parlance. Volatility has refused to settle down. “Neither suggest a market that’s pricing a return to normal any time soon,” he said.

A rising tide ought to be lifting all boats. Yet swaths of the US stock market remain in distress. David Rosenberg from Gluskin Sheff says the sectoral tally is: auto stocks (-23pc), advertising (-34pc), energy and regional banks (-37pc), hotels (-43pc), and airlines (-55pc).

I notice a growing unease among the equity gurus at the big US banks. JP Morgan says the risk no longer justifies the reward. Tobias Levkovich from Citigroup says his "panic/euphoria" model is now signalling an 80pc chance of an equity correction. He has cut his year-end target for the S&P 500 to 2,900, a 10pc drop from current levels. Citigroup estimates that global profit forecasts for the next year are 30pc too high.

The nagging worry is that US lending has rolled over. Bank credit has dropped by $170bn since May. Commercial paper has shrunk by $150bn.

The $1.2 trillion market for leveraged loans is visibly fraying, especially the $600bn segment of speculative debt that is sliced and diced into CLO (collateralised loan obligation) packages.

Moody’s has placed much of the sector on downgrade watch, warning of a 16pc default rate in a pessimistic scenario. That would wipe out the equity and speculative tranches.

There are echoes of subprime since the banks are again exposed. Citigroup holds $35bn of CLOs on its books, Wells Fargo $29bn, and JP Morgan some $20bn, though mostly the better quality tranches.

Berkeley professor Frank Partnoy, who used to create these instruments as a banker, says CLOs were not made to resist an economic shock on this scale and again threaten to ravage the capital base of the banking system.

His piece in the Atlantic – "The Looming Bank Collapse" – has set off a furious debate.

Wall Street is being held up by a diminishing handful of equities. Microsoft and the FAANGs (Facebook, Amazon, Apple, Netflix, and Google/Alpahbet) added half a trillion dollars in capitalisation over the six trading days up to the end of last week.

I can appreciate Tesla’s first-mover advantage in electrification but I do not believe that it is worth more than VW, Daimler, and BMW combined.

This tech surge has pushed Wall Street capitalisation to a record 152.2pc of GDP even as the pandemic spins out of control across the US deep South, with a similar pattern building up in the Mid-West.

Total hospitalisations in the US are back near their peak in early May. "Not to be hyperbolic, it really is the perfect storm," says Anthony Fauci, the US pandemic tsar. And remember, he warns us, this is still only "wave one".

Europe is unlikely to escape without a sobering relapse of its own, judging by the 5,000-strong weekend rave in Nice and the "Covid parties" being held by northern European tourists in Mallorca. The rush to save the European tourist season is going to look like a bad economic bargain.

The FAANGs and Microsoft are not the US economy. They make up a quarter of the S&P 500 index by value, and 8pc of revenues, but employ just 1pc of the American workforce.

Leaving aside the obvious point that a significant bloc of their customers is in difficulty, American society will not allow these companies to attain monopolistic supremacy for long. They will be broken on the democratic wheel.

I find it hard to believe that there will be a surge in pent-up spending in this atmosphere of pervasive angst.

It is more likely that large numbers of people will save frantically in self-defence, and this will combine with efforts by thousands of over-leveraged companies to pay down loans taken out during the crisis to stave off collapse. It will take years to rebuild damaged balance sheets.

Nor is the European stimulus large enough or fast enough. The fiscal component of the Recovery Fund does not kick until next March at the earliest. Until then it is a patchwork of national plans, vastly differing in intensity.

The monetarist view is that the sheer scale of QE and money creation by central banks trumps all else and will drive an explosive surge in activity almost by mechanical effect, probably culminating in a inflationary boom in 2021. I do not rule that out.

But the monetarist premise, anchored on the theories of Milton Friedman, is that the velocity of circulation will return to normal over time and ignite this reservoir of monetary jet fuel. If they are wrong on that core point, the monetary expansion could prove to be inert.

Nobel economist Myron Scholes told me over the weekend that the monetarists were likely to lose their bet this time. I pay attention because he cut his teeth under Friedman in Chicago before going on to master the arcane world of financial derivatives.

His view is that the pandemic shock has broken large parts of the American economic system and accelerated the “death of Thatcherism” as dirigiste ideologies come back into favour. It will be a very long time before the process of creative destruction unleashes fresh growth.

Specifically, he predicts that velocity will keep falling and the extra money created by the Fed will accumulate in idle excess reserves. “Milton Friedman was wrong; velocity can keep on falling,” he said.

“The banks cannot figure out how to lend in this environment and the multiplier only works if there is an opportunity to lend. You can bring a horse to water but you can’t make it drink."