what might cause a dollar swoon

government saving/spending–in theory

In theory, governments spend more than they take in to ease the pain and speed recovery during bad economic times. They spend less than they take in during booms to moderate growth and repay borrowings made during recession.

what really happens

In practice, this occurs less than one might hope. Even so, the Trump administration is one for the books. Despite coming into office after seven growth years in a row, Trump endorsed an immediate new dose of government stimulus–a bill that cut personal income tax for his ultra-wealthy backers and reduced the corporate tax rate from nosebleed levels to around the world average. While the latter was necessary to prevent US companies from reincorporating elsewhere, elimination of pork barrel tax breaks for favored industries that would have balanced the books was conspicuously absent.

The country suddenly sprouted a $1 trillion budget deficit at a time when that’s the last thing we needed.

Then came the coronavirus, Trump’s deer-in-the-headlights response and his continual exhortations to his followers to ignore healthcare protocols belatedly put in place have produced a worst-in-the-world outcome for the US. Huge economic damage and tens of thousands of unnecessary deaths. Vintage Trump. National income (and tax revenue to federal and state governments) is way down. And Washington has spent $2 trillion+ on fiscal stimulus, with doubtless more to come.

To make up a number, let’s say we end 2020 with $27 trillion in government debt (we cracked above $26 billion yesterday). That would be about 125% of GDP, up where a dubious credit like Italy has typically been. It would take 7.7 years worth of government cash flow to repay our federal debt completely. These are ugly numbers, especially in the 11th year of economic expansion.

At some point, potential buyers of government bonds will begin to question whether/when/how they’ll get their money, or their clients’ money, back. In academic theory, foreigners work this out faster than locals. In my experience with US financial markets, Wall Street is the first to head for the door. The result of buyers’ worry would be that the Treasury would need to offer higher interest rates to issue all the debt it will want. To the degree that the government has been borrowing short-term (to minimize its interest outlay) the deficit problem quickly becomes worse. Three solutions: raise taxes, cut services, find some way of not repaying borrowings.

not repaying

Historically, the path of least resistance for governments is to attempt the last of these. The standard route is to create inflation by running an excessively loose monetary policy. Gold bugs like to call this “debasing the currency.” The idea is that if prices are rising by, say, 5% annually and the stock of outstanding debt has been borrowed at 2%, holders will experience a 3% annual loss in the purchasing power of their bond principal.

The beauty of this solution in politicians’ eyes is the ability it gives them to blame someone else for what they are doing.

The downside is that international banks and professional investors will recognize this ploy and sell their holdings, creating a potentially large local currency decline.

The issue with the devaluation solution in today’s world is that sovereign debtors have been trying for at least the past decade to create local inflation–without success.

This would leave either tax increases or default as options. The slightest inkling of either would trigger large-scale flight from the country/currency, I think. Again, Wall Street would likely be the first. Holders of local currency would assume third-world-style capital controls would soon be put in place to stop this movement, adding to their flight impulse.

The most likely signal for capital flight to shift into high gear, in my view, would be Trump’s reelection.

where to from here?

signs of excess

The US is now awash in money being pumped into it by the federal government, both through Federal Reserve buying bonds and offering overnight money to banks basically for free and Congress sending out trillions of dollars in stimulus money. Why? …to combat the enormous and unnecessary damage done to the economy by the pandemic (not by the virus itself but by Trump’s bizarre implosion under pressure–calling the pandemic a hoax, urging citizens to ignore medical advice, fomenting race conflict to cover up his failure).

For the stock market, most of this is in the near-term rear view mirror. There are clear signs that there’s no shortage of cash in circulation. Barstool Sports’ shift from sports betting to day trading stocks is one. The increasing popularity of Robinhood–and the response of traditional discounters in offering trading in fractional shares is another. The weird resurrection of the stocks of bankrupt companies like Hertz (I can’t think of an instance where common shareholders have ever come out of a Chapter 11 proceeding with anything at all).

it’s all about the money (supply)

Yes, these are serious warning. But healing at least some of the damage Trump has done during his time in office takes priority for now, as I see it. And until there’s a change in government policy to “take away the punch bowl,” stocks will likely continue to hold up relatively well. This was certainly the case during the gigantic bull market in Japan during the 1980s as well as in the runup in the US stock market during the Y2K/Internet bubble of 1999.

my biggest question marks today

–is the market rotation toward domestic economy-centric stocks that began in late March over? My guess is not yet.

The winning strategy for Wall Street since the positive effect of the 2017 corporate income tax cut began to wear off in early 2018 has been to hold the US-traded stocks that have the least to do with the domestic economy. From late March to late April, these laggards, as measured by the Russell 2000, began to keep pace with the broader market. For the past 6 weeks or so, thanks (I think) to Washington stimulus, they have been outperforming. A counter-trend rally, which is what I think this is, typically lasts about two months. I regard the start as the end of April, not the end of March. So even though price movement can be read as the R2000 rally being over, my guess is that it still has some weeks to run.

–will Trump be reelected? Former Wall Street economist, Stephen Roach, now teaching at Yale, is the first public figure to be talking about my Mexico-1980s analogy as a possible future for the US. He does so in a Bloomberg article that reads in part:

“Look no further than the Trump administration. Protectionist trade policies, withdrawal from the architectural pillars of globalization such as the Paris Agreement on Climate, Trans-Pacific Partnership, World Health Organization and traditional Atlantic alliances, gross mismanagement of Covid-19 response, together with wrenching social turmoil not seen since the late 1960s, are all painfully visible manifestations of America‚Äôs sharply diminished global leadership.”

He thinks a fall in the dollar of about a third is possible.

Although Roach doesn’t put it this way, a very big question to be answered in November is whether the US doubles down on the Trump anti-growth, anti-science, white supremacist agenda or tries to start to repair the damage done to date.

A final point: Mexico in the 1980s was a horrible place economically, where the currency lost 90+% of its value. But because the government did not permit citizens to move assets abroad the stock market there was the best-performing in the world over that period.

more tomorrow

Hong Kong, ironies and all

The British seized Hong Kong in the mid-nineteenth century if furtherance of its plan to balance its trade accounts by forcing China to buy the opium it was cultivating in India.  When China announced it was not renewing the 99-year lease forced on them by British arms, Parliament vetoed the idea of granting Chinese residents of the colony citizenship.  The reason for the abandonment?   …England was too cold for Hong Kongers to feel comfortable.

Last month, however, Parliament is now responding to China’s effectively ending Hong Kong’s status as a Special Administrative Region 25 years earlier than promised by offering a path to British citizenship to all pre-Handover (July 1, 1997) Hong Kong citizens.

This at the same time Donald Trump is taking the opposite tack, fomenting anti-Chinese prejudice and apparently condoning race violence in Minnesota by quoting ur-racist George Wallace on Twitter.

The circumstances of the reintegration of Hong Kong into China are, strictly speaking, not a US diplomatic problem. The seizure of land and its return to China are an issue between China and the UK. There is a possible US connection, however. Xi may feel that both the White House and 10 Downing Street are occupied at the moment by epic incompetents, whose shelf life must be limited. So there will be no easier time than now to break the handover agreement and meld Hong Kong back into China.

Trump is framing his response to the Beijing move as opposition. In reality his opting to treat Hong Kong just like any other part of China is giving Xi exactly what he wants. Given that Trump has disavowed cooperation with international allies, he may have no choice.

In another irony, China is now discussing joining the Trans-Pacific Partnership. That’s the anti-China influence group created by the US that Trump withdrew us from early in his administration. If so, Trump will have transformed an anti-Beijing coalition into an anti-US one.

I do think the US and China are in a contest for world economic and cultural dominance. China has the advantage of a much larger population. The US has incumbency, global allies grateful for past support, the dollar, its research universities, its worldwide financial system and its dominance in semiconductor manufacturing. It seems to me that the effect so far, if not the intent, of Trump’s making America “great” again has been to blunt the US edge in all these areas without any thought of gain in return.

I think that this is forcing US-based multinationals to consider the possibility that they may not be able to remain both world leaders and American. Arguably, this train of thought runs much deeper in American society, and is the basis of the massive outperformance of NASDAQ over the Russell 2000 over the past several years.

it’s mostly about interest rates

There are three big categories of liquid investments: stocks, bonds and cash. Typically, the progression for individuals as they begin to save is: cash first, then bonds, then stocks.

There’s also an age-related progression, generally from riskier stocks to the steadier returns of government bonds. The old-fashioned formulation is that your age in years is the percentage of savings that should be in bonds, the remainder in stocks. A 30-year old, for example, would have 70% of savings in stocks, the rest in fixed income.

A strong tailwind has been aiding bond returns in the US since the early 1980s, since after the Fed raised short-term interest rates to 20%+ to choke off an inflation spiral spawned by too-loose money policy during the Seventies. The financial collapse of 2008 required another huge dose of money policy stimulus. Recently, Trump has been badgering the Federal Reserve to push short rates below zero to cover up the damage he has done to the domestic economy since being elected, in addition to the big hole he punched in the bottom of the boat this year by his pandemic denial.

No matter how we got here, however, and no matter how bad the negative long-term consequences of Trump’s bungling, the main thing to deal with, here and now, is that one-month T-bills yield 0.13%. 10-year notes yield 0.91%. That’s because during times of stress investors almost always shrink their horizons very substantially. They’re no longer interested in what may happen next year. They just want to get through today.

My sense is that we’re bouncing along the bottom for both short and long rates–and that we’re going to stay this way for a long time. If so, not only is income from Treasures of all maturities substantially below the 1.9% yield on stocks, a rise in interest rates toward a more normal 3% will result in a loss for today’s holders of any fixed income other than cash.

So for now at least, for investors it’s all stocks, all day long.

Looked at this another traditional way, the inverse of the yield on the long Treasury should be the PE on the stock market. If we take the 10-year as the benchmark, the PE on the stock market should be 111; if we take the 30-year (at 1.68%), the PE should be 59.5.

We have to go back to the gigantic bubble of 1980s Japan to see anything similar. If the comparison is valid, then bonds are already in full bubble mode; stocks are halfway there.

are stocks overvalued?

data registering with market observers

frothy individual stocks For instance, Zoom (ZM), a stock I owned a while ago but have sold, reported a blowout quarter after yesterday’s close ($.20 a share vs. analysts’ estimates that averaged $.09, but ranged from a loss of $.16 to a gain of $.12). Thanks to this stellar earnings performance the stock’s PE, has shrunk to 1224x trailing earnings, according to Fidelity, or 38x its anticipated growth rate. ZM has tripled since February. Nevertheless, analysts are overwhelmingly bullish.

(Why have I sold? I’m a frequent user of the service and I like it. I imagine, though, that ZM will end up as a feature of someone else’s app. This could happen through a high-priced takeover, which would mean shareholders would make money from here …or it could happen by rivals making their services better, which would be a less happy outcome. And I didn’t have a strong conviction about which way things would go.)

the trailing (that is, based on pre-pandemic results) PE on the S&P 500 is a higher than average 23x+, even though earnings reports for index companies over the next six months or more are likely to be ugly

–the continuing economic, pandemic response and now civil liberties, train wreck of the Trump administration. My sense is that the stock market, which normally pays little attention to politics, is focused on the here and now of an inept leader beginning to channel his inner George Wallace. I don’t think the potentially disastrous long-term economic consequences of his policies are fully in today’s prices, nor the chillingly real possibility that he will be reelected in November. But his epic dysfunction is impossible to ignore.

So why is the market going up every day? More tomorrow.