When Federal Reserve Chair Jerome Powell and the Fed went all in, this author and many others complained that the Fed was possibly behind the curve, and perhaps too late, and was trying to make up for it by being overly aggressive by slashing rates to zero and promising unlimited QE and asset purchases. Other critics have been harping about the wedge between economic outcomes and market outcomes, as equity markets reach record highs, even though the economy is a mess.
The big question is whether the market will catch down to the economy or the economy will catch up to the markets. Today’s amazingly positive payroll report might give a reason for all to cheer, and most of the credit goes to the Fed for averting disaster. For now.
As I wrote a few months ago, my wife has rightly suggested that in the US the market is the economy and the economy is the market. Since the Fed cannot impact the economy directly, but can impact the markets by buying assets, it did so. Miraculously the economy seems to be catching up to the markets. Today’s payroll data, where unemployment fell sharply instead of rising as was widely anticipated by economists, shows that the Fed’s bet of engineering economic outcomes through market support is possibly paying off. The biggest risk now for the economy is a widespread escalation of the protests that we have witnessed over the last few weeks, and while a high stock market can amplify perceptions of inequality, getting people back to work can only help to soothe frayed nerves. And yes, boosting the markets comes with moral hazard whose outcomes are unknown.
After three months of driving blissfully empty roads, I was in my first traffic jam yesterday. Airlines bookings are up, and many airline stocks have doubled in the last week (e.g. American AirlinesAAL stock closed at 11.11 on Monday June 1, 2020 and has doubled to 22.22 as I write this on Friday June 5, 2020. Source: Bloomberg). Restaurants are opening, Southern California beachgoers are dipping their toes in the water without risk of citation, barbers are clipping shaggy hair, and offices are gradually allowing people to come back to work. This sure looks like a V shaped recovery to me at the moment. And I hope it keeps going.
So where does this leave us when it comes to investing?
In the early part of this year, three things happened that were negative for the stock market. First, retail investors pulled out of the market and moved into the safe harbors of cash and short term bonds. Second, companies cancelled buybacks, and it is common knowledge now that buybacks have supported the stock market over the last decade. Third, systematic strategies such as trend followers, risk-parity and others who buy and sell the market based on algorithms went short the stock market or reduced their stock exposure close to zero.
There are signs that all of these sidelined buyers are coming back. Aided by trillions of Fed dollars sloshing through the system, generationally low interest rates, and an implicit commitment to easy financial conditions, a food fight is in the making for beaten-down assets. What went down hard — e.g. airlines, energy, leisure — are beginning to scream back. On the other hand, should anyone really want to hold negatively yielding bonds — à la Europe — as trillions of Dollars, Euros and Yen are printed to raise inflation? I expect investors to bail out en masse from bond markets where money is being confiscated surreptitiously.
As the US equity markets make new highs, I suspect that criticism of the Fed will rise, just like it did after the global financial crisis. The risk to markets is that the Fed pivots again, and starts to back-track on its promise of support just as the economy is healing. The Fed remains the only game in town, and the sooner investors understand that the one thing that saved their retirement accounts and their savings from being decimated this time (like last time during the global financial crisis) is the Fed, they should allow that making everyone well-off means some will benefit more than others. Those who bought credit in front of the Fed’s purchase of credit benefited handsomely and possibly unfairly, but this is not the first or last time that this dynamic has played out.
It is too soon to tell if this crisis is done. But it is easy to see that as the markets resume their march toward all-time highs, the next cycle of boom and bust is possibly in the making. Intelligent investors should, and will, start to prepare for it. For now, it is time for risk-on, but with one eye toward what happens when the Fed takes its metaphorical punch bowl away just when the party gets going.