Daily Comment (September 20, 2021)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT] | PDF
Good morning on a rather blue (or, better said, red) Monday. U.S. equity futures are down hard this morning as stocks appear to be in a corrective phase. There is a lot of news this morning. There was a volcanic eruption on the Canary Islands. Ash from these eruptions can lead to cooler temperatures. China’s markets were closed for the autumn holidays. Canadians go to the polls today. PM Trudeau called snap elections in a bid to build a majority government, but polling suggests the plan failed. They voted in Russia yesterday, and despite severe restrictions and allegations of voting irregularities, Putin-aligned parties didn’t do very well. There is no danger he will be pushed from office, but Putin uses these votes as proof of legitimacy, so his weak showing won’t sit well. In a bit of a departure from our usual lineup, we will start today with a look at issues that are weighing on equities. Next will be economics and policy, followed by international issues, and we will close with the pandemic update.
What’s weighing on equity sentiment? We think the following items are causing investor concern:
- Is Evergrande (EGRNF, USD, 0.40) Lehman or LTCM? There is little doubt that Evergrande is going to fail.
It has interest payments due today and later this week and has already indicated it won’t make them. As we have noted over the past couple of weeks, there are broadening ripple effects from the decline of Evergrande. Contractors and workers are losing out and social unrest is rising. Many employees were encouraged to buy Evergrande wealth management products, which can best be described as having preferred stock characteristics. It now comes to light that executives cashed out early while they still had value. The company’s biggest boosters are bailing out, usually a signal the end is near.
The company is too big to fail. It has 200,000 direct employees but creates 3.8 million jobs per year. It has diversified beyond real estate, including EV’s and a theme park. It currently owns 1,300 projects in 280 cities across China. Evergrande is a classic “grey rhino.” Unlike a “black swan,” which is an unpredictable event, the company and the real estate industry have had a problem for a long time.
So, what’s the difference between a Lehman event and an LTCM event? The former creates a hard to control systemic event, while the latter is isolated and controlled. The LTCM event was resolved by the Fed and the Treasury, forcing large banks to buy up LTCM’s positions and prevent the financial markets from locking up. Both events are related; regulators were upset over the moral hazard caused by the LTCM bailout, and thus, allowed Lehman to fail and set an example. We don’t think Beijing wants a Lehman event, and it has the power to prevent it. However, by doing so, it creates a moral hazard. It will be hard to argue that real estate speculators will be less open to continue speculating in the aftermath. We expect some differences. Evergrande executives will probably be arrested to act as a deterrent to others. We doubt it will work. If we are correct, the good news is that Evergrande won’t bring down the financial system, so market conditions from this event will improve in the next few weeks; the bad news is the rot caused by real estate malinvestment won’t be fixed either. Investment-grade corporate bonds are not showing signs of stress, which suggests the Evergrande problem, so far, is contained.
- How will the infrastructure, debt ceiling, and budget work out? What we see at present looks like a mess, but it should be noted that the process is usually messy. After all, Bismarck’s warning that one should never watch the process of making sausage and legislation still holds. Still, what is happening now is a mess. There are three moving parts—the budget, a $3.5 trillion behemoth, a $1.2 trillion infrastructure package, and the debt ceiling. The root problem is that the Democrats have such a narrow majority that it gives power to small groups of lawmakers. The fight is between moderates, who want to vote first on the infrastructure package and second on the budget. Progressives fear, rightly, that if this is the sequence, the budget will fail or be much smaller. Sen Manchin (D-WV) has already suggested that the budget be shelved until 2022, which will effectively doom its passage. The infrastructure package is bipartisan and narrow, while the budget is a wish list of progressive goals. We have seen enough legislation over our lives to think that what we are seeing may not necessarily be the usual brinkmanship before legislation gets passed. However, due to the stark differences between the moderates and progressives, the expectation that the other side “has to cave” and the ambition of the legislation with such a narrow majority may lead to nothing getting done. The uncertainty of these measures is a concern for markets. As for the debt ceiling, the GOP will likely force the Democrats to put the hike into the reconciliation bill, giving the Republicans a potent campaign issue for the midterms.
- Will the Fed start tapering, and who will be on the committee? The FOMC meets this week. There is no doubt the committee will at least discuss the beginning of trimming QE. We may see details on when the buying slowdown will begin. Up to now, Chair Powell has been able to separate QE from rate hikes, but if the market starts to tie rate hikes to QE, the impact to monetary tightening will begin to affect equities adversely. It should also be noted that if Powell is going to be replaced, Biden has to make that call in the next few weeks; we expect him to be renominated. After all, Congress doesn’t have a lot of bandwidth for another issue. But, again, monetary policy is another source of uncertainty.
- What about the economy? Growth is slowing, and it is difficult to sort out what is a secular change from the pandemic and what is merely cyclical. For example, some elements of inflation may stay with us for a while. Inventory management will change and be less efficient. The labor force has contracted and may not fully recover for a long time. Some items are not going to persist. Auto prices will fall from current levels as supply returns, for example. Supply chains should stabilize. Although a recession is unlikely, as monetary policy will likely remain supportive, this recession/recovery/expansion is completely unique to our experience over the past 40 years. Thus, some element of uncertainty is bound to weigh on sentiment.
- What about the path of earnings? S&P earnings have been fabulous and will remain elevated, but the pace of earnings growth will very likely slow. That fact is raising some caution among investors.
- Aren’t we due for a correction? In a word, yes. It has been 367 trading days since the last 10% pullback in the S&P 500. The average since 1979 is 252 days.
Overall, we think equity markets are simply going through a correction. What would change our minds? If Evergrande is really a Lehman event or if monetary policy rapidly reverses. Although both are possible, we don’t see them as likely. Soon we will be in Q4, which is a seasonally positive period for equities. A pullback in front of that period would set the market up for a year-end rally.
Economics and policy: Overtime and revolving doors are an issue.
- Because companies are scrambling to find workers, they are relying on overtime to meet demand. Workers can become accustomed to higher pay and might rebel against normalization and/or burnout and leave the job, exacerbating the labor supply problem. All this points to higher wages.
- It’s not just a U.S. problem. Australia is looking for coal truck drivers and paying large bonuses to find them.
- Big tech is buying up smaller rivals; look for this practice to catch the attention of regulators.
- The White House is issuing new rules to deal with ransomware.
- There is a well-known practice in public administration known as the “revolving door.” Essentially, a regulator’s next job is usually in industry, so the regulator has a vested interest in currying favor from those he regulates. The problem is known as “regulatory capture” and expresses why regulation always disappoints. Apparently, there is a new twist on this problem; lawyers from top accounting firms are doing short stints for the Treasury and crafting favorable tax treatment for former clients. They are then rewarded when they leave government “service.”
International roundup: The French are angry.
- After the U.S., U.K., and Australia agreed to share nuclear submarine technology, Paris got really angry. Ambassadors were recalled, and there was talk of “stabbing in the back.” Why such a strong reaction? First, the deal France had with Australia was worth €60 billion, by far the largest that the country’s defense industry had with an outside power. Losing that business will smart. On the other hand, the program was plagued with trouble, and diesel submarines are just not the proper tool for containing China. Second, France is upset because this affair is additional data showing just how inconsequential Europe is becoming. There is much commentary about how the White House is struggling to maintain alliances, but since President Bush (the 2nd), the U.S. has shown little regard for Europe. In retaliation, the EU has called off free trade negotiations with Australia, but the trade amounts involved are small.
- With a week before the German elections, not much has changed, despite debates over the weekend.
- Islamic State is attacking the Taliban in Afghanistan, highlighting continued instability.
COVID-19: The number of reported cases is 228,630,066, with 4,693,750 fatalities. In the U.S., there are 4,291,156 confirmed cases with 673,768 deaths. For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics. The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors. The CDC reports that 466,561,785 doses of the vaccine have been distributed with 385,586,785 doses injected. The number receiving at least one dose is 211,776,515, while the number receiving second doses, which would grant the highest level of immunity, is 181,382,976. For the population older than 18, 65.8% have been vaccinated. The FT has a page on global vaccine distribution.
The FDA has voted against Pfizer’s (PFE, USD, 43.89) booster shot plan, limiting boosters to at-risk patients. Meanwhile, physicians are making vaccination decisions on who can get boosters.
 For those younger readers, LTCM is Long-Term Capital Management. It was a heavily levered hedge fund, loaded with PhD finance and economists that failed spectacularly in August 1998. Perhaps the best book on the event is Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management.