by Asset Allocation Committee

The recent strong rally in equities has befuddled investors—how can equities rally with such vigor when the economy is historically weak?  We suspect there are two reasons for this recovery:

1. Although the drop in economic activity is deep, it will likely be short.
2. Supportive monetary policy is a powerful elixir for equities.

Equity markets are forward-looking; investors put their money to work on expectations of future economic conditions and earnings, not based on what is occurring today.  The current downturn is historic.  The decline in the economy has been very fast and deep, but it will likely be short.  In fact, the recovery should begin by midsummer at the latest.  We use these words to mean something specific.

This chart shows a stylized path of the business cycle.  Orange represents expansion, when the economy is making new peaks in an indicator.  This can be GDP, industrial production, coincident indicators, etc.  Blue is recession and is measured from peak to trough.  Green is recovery, which lasts from trough until a new peak occurs.  Finally, once a new peak is made, a new expansion is underway.

We expect this recession to end quickly because the trough will probably occur in Q2.  However, the recovery will be long and likely dictated by the path of the virus.  We currently estimate the new expansion will start in H2 2021.

This table shows the declines in the S&P 500 for the postwar recessions.  On average, equities tend to peak about six months before the onset of the economic downturn, while the low occurs about six months after the peak in economic activity.  From the market low to recovery, the S&P 500 usually rebounds by about 20%.  But, notice from deep recessions that the rebound from the low is about 33%.  The rebound we have witnessed thus far is in line with a deep downturn, but it appears unusual due to the compressed nature of the current recession.

Also noted above are the aggressive actions taken by the FOMC.  Below is a chart that will be familiar to regular readers.

From early 2009 until November 2016, the path of the S&P 500 closely matched the Fed’s balance sheet.  There was always concern that the relation was a spurious correlation, and the behavior from December 2016 into August 2019 suggested it was.  However, it is important to note that equities were buoyed by expectations of a massive corporate tax cut.  Taking the balance sheet and incorporating the tax cut gives us a model that offers some insight into the impact of current monetary policy.

Fair value is derived from smoothing the higher marginal rate of the corporate tax and the balance sheet.  Adding the impact of the tax cut accounts for some of the rally in equities.  The sharp rise in the fair value in recent months reflects the massive expansion of the balance sheet.

This is not our forecast for the S&P 500, but it does offer some insight into how powerful the Fed’s actions have been.  We doubt the equity index will track this model due to the level of uncertainty surrounding the path of the economy.  Nevertheless, a projected short, sharp downturn coupled with the most rapid increase in the balance sheet since WWII have created strong support for equities that will likely prevent significant corrections, barring a major policy error or an unexpected negative turn in the toxicity of the virus.

View the PDF

by Asset Allocation Committee

Beginning in the late 1990s and becoming an even bigger issue after Dodd-Frank regulations were imposed following the Great Recession, many market participants worried that bond market liquidity would be absent in the face of a crisis.  Strict regulations discouraged banks and brokerage firms from holding large inventories of corporate bonds, thereby precluding them from their former role as willing buyers in the face of a wave of selling by investors.  Compounding the concerns were the sheer size of flows into traditional open-end and ETF bond portfolios.  Over the 10-year period from 2009 through 2019, a total of $2.7 trillion flowed into these instruments, almost a third of which were in ETFs.  Entering the fray was the popularity of risk parity funds that levered their bond holdings.  Though each risk parity scheme has a nuanced approach, they all act in a similar fashion.  The concerns were that when risk parity funds and individual investors rushed to exit their bond holdings, market liquidity would be absent, particularly for corporate bonds.  Numerous studies and articles appeared over this time frame warning of dire consequences for bond investors, notably violent price movements due to the fact that banks and brokerage firms were no longer participating to a significant degree to assist in maintaining order to the bond market.

In March, the veracity of these concerns was tested as the bond market worked its way through the financial stress triggered by the pandemic.  During this episode, ETFs proved their endurance by moving into the void and providing the necessary stabilization of the market.  The use of creation/redemption units on the part of Authorized Purchasers [APs] mitigated the severity of the downturn, especially among investment-grade corporate bonds.  As the accompanying chart illustrates, spreads for BBB/Baa-rated corporates relative to the 10-Year Treasury gapped to their widest level since the Great Financial Crisis, yet quickly repaired.

An examination by Blackrock of the trading during this critical period in its largest corporate bond ETF, the iShares iBoxx Investment Grade Bond ETF [LQD], provides evidence that not only did the activities of the APs aid in maintaining market liquidity, but the market price of LQD actually led the price discovery process.  In other words, rather than the market price exacerbating the premium/discount to net asset value [NAV], the market price was the precursor of the daily NAV print.  Moreover, the direction of the market price of LQD often preceded the direction of LQD’s indicative value [IV], which is the real-time estimate of its fair value, based on the most recent prices of its underlying bonds.  Since LQD’s 2,169 underlying bonds trade over the counter, and therefore many may contain stale pricing, the price discovery proved invaluable to market functioning.  After the dust settled, it was evident that LQD and other bond ETFs provided market pricing that was at least as good as, and oftentimes better than, individual bonds.

Although the market function provided by LQD during the period is not necessarily indicative of every bond ETF in each bond sector, it does underscore the notion that ETFs can provide the necessary liquidity during a period of crisis.  The creation/redemption mechanism of ETFs allow for arbitrage opportunities and allow the supply/demand of the ETFs to achieve equilibrium with the value of the underlying bonds.  In essence, ETFs are now creating most (if not more) of the liquidity previously provided by banks and brokerage firms, often doing so with greater efficiency.

View the PDF

by Asset Allocation Committee

As the Federal Reserve expands its balance sheet and the federal deficit balloons, there is a legitimate concern about the potential for inflation.  In this week’s report, we will examine inflation from a theoretical perspective.

There are two simple tools we use to discuss inflation, the equation of exchange and the intersection of aggregate supply and demand.  To start, this is the equation of exchange:

MV=PQ

M is the money supply and V represents the speed at which it is spent; on the other side of the equation is P, the price level, and Q, output.  In the calculation of the variables, the right side of the equation is nominal GDP and M is one of the various formulations of the money supply.  However, the power of the equation, in our opinion, comes from what the variables represent.  For example, Q is best thought of as the productive capacity of the economy, the ability of an economy to procure goods and services.  It would include not just actual production, but also excess capacity.  And V isn’t just a residual; it can tell us the effectiveness of money policy.

The classical economists assumed that V and Q were fixed; V represented the institutional structure of money demand and thus only changed when spending and income patterns were adjusted.  Since prices were flexible, Q was always at full employment and thus didn’t change.  If these assumptions were true, any increase in M would lead to a proportional rise in P.  However, it turns out neither V nor Q were fixed; in some periods, increasing M led to higher price levels, but in others, it did not.

In the last episode of the Federal Reserve balance sheet expansion, velocity fell, leaving prices and quantity mostly unchanged.

This chart shows calculated velocity and the Fed’s balance sheet.  The gray shaded areas indicate periods of official QE.  Note that there is a strong inverse correlation between velocity and the balance sheet expansion, suggesting that households and businesses are not demanding the funds being provided to the banking system.  Thus, the inflationary impact of expansionary monetary policy has been reduced.  Given current risks in the economy and markets, we would expect the current balance sheet expansion to lead to a similar result in the short run—another decline in velocity.

The second tool is aggregate supply and aggregate demand.  Although neither of these can be calculated with any degree of confidence, we can use the tools for illustration.

The key point to this schematic lies in the supply curves, labeled S, S₁ and S₂.  The latter is what we believe is our current supply curve; demand has shifted from D to D₁.  One of the consequences of COVID-19 is that we expect the trend toward deglobalization to accelerate, which would likely mean a shift in the supply curve from S₂ to S₁.  As deglobalization is eventually tied to reregulation of the economy, we will shift to S.  Of course, the key to rising prices will be the path of demand.  The longer it takes for demand to recover, the less likely it is that inflation will return with any significance.  However, when demand returns, we will likely see upward price pressures; if rising demand coincides with the eventual shift to the terminal supply curve S, the markets could be in for a notable inflation surprise.  We don’t expect this terminal shift to occur in the next three years, but it is highly likely in the latter half of the decade.

Tying this back to the equation of exchange, the supply curves above are represented by Q.  So, as supply becomes increasingly constrained, velocity will need to fall further in order for prices to remain steady as the money supply rises.  If inflation expectations change, it would be reasonable to expect velocity to increase, which would tend to lead to higher inflation.  The key points from this analysis are that (a) Fed policy actions, in isolation, are not necessarily inflationary, and (b) constraining supply, which is an element of deglobalization, could lead to higher price levels once demand recovers.

View the PDF