The macroeconomic environment is evolving and has implications for investing.
Before we get into the current backdrop, we’ll talk a bit about where we were before the Covid-19 pandemic and work our way into the realities and challenges of today and what that means going forward.
Before the Covid-19 pandemic
Before the pandemic we were in a situation where all three of our main equilibrium points were pointing to less upside and more risk for asset prices.
1. Interest rates couldn’t be lowered much throughout the developed world. This was a headwind to growth and a risk for asset prices because if there’s a shock this traditional offset isn’t available. The US had about 150bps of room, which was wholly insufficient (and no room in the other main developed economies). The average recession alone requires about 500bps of easing to rectify the income, spending, and debt imbalance.
2. We were also at a point where labor markets were relatively tight, signaling economic capacity utilization was high. Growth wasn’t likely to get much better. Central banks were reluctant to ease policy and were very limited.
3. Asset prices were running higher, compressing their forward returns. The risk premium of stocks over bonds and cash was low. The rates on cash and bonds in absolute terms (not only in relative terms) were already low.
We were in an environment where going forward we’d have slow growth, low inflation, zero or near-zero interest rates, but plenty of liquidity to support asset prices.
Because traditional monetary policy forms were more or less maxed out, this shifted more of the dependency over to fiscal policy.
In a downturn, central banks would have to coordinate with fiscal policymakers to get the type of results needed. You can think of it as basically joint monetary and fiscal policy. When someone refers to “MMT” that’s essentially what they’re referring to in some form.
A downturn would test how ready they truly were. The downturn that occurred was sudden and worse than anyone would imagine. When markets rise and volatility is low, leverage builds in the system as yield becomes more important to investors than the risk associated with price movement and mark-t0-market losses.
The huge fall in income and spending when the market aggregate was priced for improving conditions caused the most violent sell-off in history. Those who sold OTM or far OTM derivatives had to dynamically hedge these bets and many investors sold out due to cash flow problems rather than fundamentals.
Transitioning to the new macroeconomic backdrop
When the sell-off hit, the primary form of monetary policy (driven by short-term interest rates) was taken down to its floor. Once those get to zero or a little below, they don’t work in pushing more money and credit into the system because lenders’ profit margin is eroded.
The secondary form of monetary policy (asset buying, also known as quantitative easing, or QE) has more or less run its course. Long-term rates are now also down around zero percent in all the main reserve currency countries (US, developed Europe, Japan). Once that spread is gone, it stops working well for the same reason.
So, both of the policies that we’ve become accustomed to since the 2008 financial crisis have reached the end of their useful life.
That means markets and the economy faced a policy asymmetry even before the Covid-19 crisis. Policymakers could get the rate structure down a little bit but not much.
If the effective duration of equities is about 20 and you have 150bps of easing available along the curve (as was the case in the US), that’s about 30 percent worth of returns you can pull forward. But if there’s a big income, spending, and/or credit shock, that’s not enough to offset the plunge.
That was the dynamic over 10 years into the market recovery from 2008. It takes a very long time to work off a bad debt overhang. Markets were roiled when the Fed tried to raise rates off the zero-bound in 1937, eight years after the beginning of the downturn. They did the same in late 2018, more than ten years after the beginning of that downturn, for the same cause-effect relationships.
That policy asymmetry is now even more true. This means there’s virtually no limit to the amount central banks could tighten, but there was very limited ability to ease and reverse a downturn.
And because the Covid-19 pandemic blew such a big hole in incomes and spending, it’s very unlikely we’ll see much of the way in inflation or any pre-emptive tightening. The pandemic increased global debt burdens while also reducing income. This also means the world is more sensitive to higher interest rates with a higher debt stock against a lower level of output (i.e., less income to service more debt).
The new key dynamics
The best way to look at the pandemic-related downturn is that there’s three basic overarching characteristics.
1. There was a global income shock from the pandemic shutting down large swaths of business activity.
2. Short-term interest rates were at zero.
3. Long-term interest rates were also at zero. (As mentioned, this reduces creditors’ incentives to lend when there’s little to no spread to capture that doesn’t compensate for the risk.)
This scenario requires a fiscal policy supported by a monetary policy involving the tertiary forms we’ve covered in other articles.
This is a policy format resembling a joint coordination that is not typical and not available to all countries. It’s more viable for reserve currency countries and less available to those without reserve currencies.
We see this with the Covid-19 pandemic recovery with developed markets spending more fiscal juice than emerging markets.
The collapse in income has produced a collapse in spending, which reinforces the drop in income, in a self-reinforcing way.
That’s a difficult thing to get out of in normal times. It’s even more difficult when the normal means of getting out of it (i.e., a drop in short-term interest rates) is not available.
Without the normal offsetting force of a drop in interest rates and the positive wealth effects that creates, the downside for the economy and markets is a lot greater.
The lack of that interest rate stabilizer takes away the safety net that had been around for decades in the US.
This is what made 2008 bad for the US economy and markets, and what made the 2020 Covid-19 crisis bite as hard as it did when the debt overhang was still large and the nature of the crisis wiped out a huge amount of income and spending.
The magnitude of the fiscal and monetary response was sufficient to fill the income and spending gap that had been created in the US.
The issue is that the pathways for that money and credit to sustain income and spending are not guaranteed.
I think the biggest risk is a duration mismatch in terms of how long income and spending is disrupted relative to the quantity and length of the fiscal and monetary response.
If there’s a big drop in income and spending and it’s not offset by the fiscal and monetary response, that’s a big potential risk because it’s a self-reinforcing process that, as mentioned, is very difficult to get out of.
What’s most important is looking at the mechanics of what’s happening in the economy, how that’s impacting the markets, and the corresponding policy response and what will be required for that policy response to work.
An economy is built up of many different transactions. There are two sides to a transaction: a buyer and a seller.
The buyer is an entity that spends their income to the seller, which then takes that income and spends it.
When this gets going, it can feed off itself. Transactions pick up, people become more creditworthy, they can borrow more, which increases lending, which increases spending, the value of assets, which makes them more creditworthy, in a self-perpetuating cycle.
Spending requires a source of funds. And that spending provides funds for others, so it works both ways.
So, we can think of it from a “sources and uses” perspective.
At a basic level, you have three sources of funds:
You have three basic uses of funds:
– savings (also commonly called reserves)
– purchases of financial assets
M + C + I = S + R + F
(Money) (Credit) (Income) (Savings) (Reserves) (Financial assets)
Each category can flow to another category on its own side of the equation or that on the other side. The sources are required to provide the uses, but the uses also provide sources (e.g., income).
For example, when the central bank buys financial assets, that pushes more money, credit, and income into other types of financial assets that then produce income over time, that can then go into spending, cash reserves, or additional purchases of financial assets.
The main reinforcing process in the real economy is when one person spends that produces income. That is then a source for that person to then go spend and create that self-perpetuating loop for an economic system.
Recessions typically occur due to a tightening of monetary policy caused by a rise in interest rates. Debt servicing costs increase and eventually swamp the cash flow available to service it.
Under the sources and uses framework, when you get a rise in interest rates, this causes a reduction in borrowing (i.e., credit). This drop in credit then requires a decrease in spending on the uses side of the equation. This could either mean less spending in the real economy (i.e., on goods and services) or it could mean fewer purchases of financial assets.
This downturn is unique because it has been caused by big drops in income. Many people – some 40 million in the United States alone – stopped working, as business was encouraged to be cut back or stopped altogether in the interest of public health and safety. That reduction in labor was not brought on by a tightening in monetary policy and a drop in credit creation as it usually is. There was also no deleveraging that caused it, which is what caused the shocks in 2008 when lowering short-term rates to zero was not sufficient to get enough money and credit into the system as it normally is.
The reality is that income simply dropped. And when income fell, spending fell in conjunction, feeding off itself and making it unusual.
Role of fiscal and monetary policy
We’ve covered the sources and uses of funds, but it’s also important to cover the main two levers of how to jumpstart the process (monetary and fiscal policy). Even though the drop in economic activity was deeper than the 2008 financial crisis and the fall in markets was steeper than previous drops like 1929 and 2008 (see Appendix at the end of this article).
But the depth of the fall in risk assets was shallower because of the faster policy response.
If enough money is created and distributed (doesn’t necessarily have to be perfect) in excess of the amount of credit being destroyed, some of it will inevitably get into the purchases of financial assets.
Below we cover a couple of the overarching risks.
Risk number one
Fiscal policy’s primary role is to replace lost income through programs like unemployment benefits and direct transfers. That’s the most important thing. The spending isn’t getting replaced directly. Instead it’s going into the income category.
The government is replacing the income directly but trying to get indirect effects by hoping or expecting that it gets into spending.
In step one, the government borrows money from the Treasury to give to people in the form of income. This also increases credit because the government doesn’t have the money so it increases borrowing.
But on the efficiency front, you don’t necessarily know whether it’s getting to the right places. Is it getting to the entities that need it and how are they using it and in what proportions? Is it going into spending? Cash reserves? Purchases of financial assets?
In terms of the sources and uses equation, you have the following:
M + C (goes to income) + I (higher) = S (?) + R (?) + F (?)
The government is borrowing in the hope that it replaces income. The amount they’ve sent out has been roughly the amount that has been lost in aggregate.
What they want to happen is for this income to be spent instead of saved (or using it for debt reduction). Spending helps it circulate and create credit to bring up the entire economy.
In terms of the equation, this is really the goal:
M + C + I (higher) = S (higher) + R + F
The risk is that the spending doesn’t happen. In other words, the government sends out the checks to get the income up but instead it mostly gets saved, put into financial assets, or goes into paying off debt (reducing credit, C). Financial assets can boost income a little bit because they throw off cash, but only by a fraction because financial assets have longer durations. Some of that cash goes back into reserves and new purchases of financial assets and not into spending.
The income comes up but the government doesn’t get the type of spending that it would like. In terms of the money people receive, usually a little bit less than half actually goes into spending. The rest goes into debt reduction, savings/cash reserves, and purchases of financial assets.
The government can tote up how much income and spending was lost. But if they simply replace income and only 40-50 percent of that gets into spending, that means they need to send $2.00-$2.50 for every $1 in lost income.
There’s also the risk that once the economy recovers, this extra liquidity could stoke inflation in the real economy, lowering real interest rates further and getting into the sticky situation of having to choose between price stability and output. The deflationary forces from the credit contraction are massive and might overwhelm the inflationary forces from the money creation, but it’s still a risk. When inflation does manifest in reserve currency countries recovering from a deleveraging process, it typically comes late through the overuse of stimulant.
But overall, that’s the main risk in fiscal policy.
Risk number two
The second matter is that monetary policy is supporting fiscal policy and the financial markets by providing liquidity. Central banks always want to create the money to save the system if they have that luxury. That’s a long-term risk for the value of the currency, but a divergent topic for now.
Money creation itself doesn’t produce income or spending directly.
In traditional quantitative easing (QE), the secondary form of monetary policy after short-term interest rates can’t be reduced, the central bank creates money and then buy government bonds.
If they need to, if there’s a lack of depth to their sovereign debt markets, they can buy other assets as well, going down the quality ladder to investment-grade corporate bonds or diversified equity products like ETFs.
But they don’t buy all assets. For example, usually they don’t buy stocks. This is because it usually doesn’t do enough to increase income and spending. Moreover, there are the distributional effects. Wealthier people own financial assets while the less well-off don’t, at least not in anywhere near the same quantity.
Accordingly, the targeting is not very well optimized to simply progressively move QE programs into riskier assets.
So, the government creates money and moves it into the purchases of financial assets, especially bonds.
M + C (higher) + I = S + R + F (higher)
When the government buys bonds, it puts money directly in the hands of sellers – i.e., the people who own the bonds, who are predominantly private sector participants.
Now how much of that cash is going to back into spending, which is somebody else’s income, and is able to get that spending to income cycle set into motion.
The reality is that it’s a pretty small fraction of QE money that gets into spending.
Thinking in terms of people’s motivations, if they own a bond and just sold it because it’s price went up, what are they going to do with the money?
They’re going to want to buy something similar to it. So they take the bulk of that cash and invest it into something a bit riskier. That could mean longer-duration government bonds. It could mean government-backed agency bonds that provide a little bit more yield. It could get into corporate bonds.
Those who sell the corporate bonds could get into corporate bonds of higher duration or lower quality, or move into equities. That process goes on all the way down the chain.
As the prices of those assets get higher and their forward yields drop, that causes the whole “asset yield curve” to shift down, as people move out over the risk curve into higher-risk assets.
That means the government actually has to create multiple amounts of the money and buy multiple amounts of bonds to get the desired amount of money flowing over into spending and income. It’s also a highly uncertain amount because they don’t know exactly what will happen and the shape of the elasticity curves involved.
You don’t know how much of the government’s money that the central bank is putting into bonds will go into the stock market.
They end up having to create a lot of money – way more than what’s needed to fill in income gaps – only to see a fraction of it end up in the desired places.
As second- and third-order consequences, going through the financial markets predominantly benefits financial asset owners, which increases wealth gaps and that can flow through into social conflict, more partisan political movements, ideological polarization, wider policy outcomes, greater geopolitical risk, and those types of issues.
Some of it ends up in cash reserves. So, going indirect with policy such as more aggressive QE creates uncertainties with respect to how much gets reinvested into other assets and how much “leakage” occurs as it goes into cash reserves.
Policymakers have to weigh the costs and benefits. Indirect policy measures like QE are more politically palatable and can be done independently by the central bank, but tend to have less direct benefit.
An alternative path could be something like a public sector jobs program. You saw this in the 1930s Great Depression era in the US under President Franklin Roosevelt through the Works Progress Administration (WPA).
In the case of the WPA, the government can borrow the money and hire people to do productive tasks (such as public infrastructure building) that the government is effectively buying. So, the government spends, which produces income and gets the type of fiscal stimulation that produces fewer dependencies than the type of policy we’re working with currently.
But there are pros and cons. Policy approaches that more directly try to rectify the spending issue is a harder path to actually implement successfully.
How the virus hits different players in the market in different ways
The income shock from the Covid-19 pandemic has different impacts on different entities. The distribution of outcomes is very different.
What you can do is take variations in the employment rate as a proxy for income drops and look at how that impacts spending in different types of sectors in the economy.
Then you can look at how that flows through into earnings.
Sectors that were very hard hit like airlines, travel, or restaurants see very large impacts.
If unemployment is set to ten percent, then you see huge declines in earnings in these sectors down to zero or very close to it. Things like durable goods sales are somewhere in the middle of the pack. Staples like food, basic medicines, and personal care products are a lot less.
This can be sensitized to unemployment rates of 5-20 percent in increments to see the impacts.
For a ten percent unemployment rate, you see up to 85 percent declines in earnings in some sectors, but only around 10 percent declines in others. If going beyond that, sectors like airlines and auto parts see their earnings dry up almost completely. Food, beverages, personal care, and healthcare are much less affected.
If that’s overlaid onto things that matter a lot about a company, such as indebtedness, cash reserves, cash flow positions, you see some companies getting into insolvency and others are not as affected.
That’s a simple approach that gives a general understanding of the sector disparities.
Another approach is to go through every public company and examine their cost structures and vulnerability in their revenue mix in this environment. Then you can look at debt and debt service payments and simulate the impact on earnings, cash flow, and then aggregate up to the country level.
In the US, this comes to around a $5 trillion revenue shortfall and a $21 trillion revenue shortfall globally. On the earnings front, it’s about $1.4 trillion in the US and close to $5 trillion globally.
That’s the size of the deficit that needs to be replaced by the policies. In reserve currency countries, it’s easier, as they borrow in their own currency and can control them in the usual ways; in emerging market countries without reserve currencies, it’s more difficult.
Distributional effects and building a better portfolio
Just as some industry groups will be affected a lot, some won’t be nearly as impacted to the same extent.
In a world of zero interest rates, where you have the continuous policy asymmetry to economies and markets, that makes safer, predictable cash flows more important than normal.
Bonds are no longer that attractive (though viable as a source of liquidity and diversification). But forming a bond proxy through a well-diversified basket of equities whose underlying businesses are things that will always get bought could be a reasonable alternative.
You know that certain everyday products like food and all the basics are always going to be in demand no matter what. The list above bears out which sectors are more reliable than others.
The companies selling the everyday basics have a very steady path of spending associated with them. Accordingly, the companies that provide these goods and services tend to have pretty steady earnings streams. They’re not going to be the most exciting investments. But they do tend to grow their earnings over time and provide a little bit more than bonds.
There will be volatility being equities’ cash flows are theoretically perpetual, giving them a longer duration. But you can get something close to a bond-like stream of income over time by strategically choosing which companies or sector baskets (i.e., ETFs) to include in your portfolio over time that fit the general bill.
Bond proxy portfolio
So, if you’re designing a portfolio that could give you an earnings stream from equities that could look something like the coupon on a bond over time, how would you go about it?
You know that the most stable earnings streams in the market are in three main sectors:
– consumer staples
With utilities, people always have to pay water, electric, heat, and so on. With staples, consumers always need to buy food, personal care items, and basic medicine. Healthcare is an elastic good; people will always have the demand to keep themselves functional and in good health.
All three sectors have similar levels of volatility. And all have popular ETFs assigned to them with a track record dating back more than two decades.
That means we don’t necessarily have to pick securities and can get broad exposure through the ETF. The companies that exist at any given point in time changes regularly, so it can be helpful to look at them as a whole and the type of cash flow streams and performances from those types of companies.
It also means we can pretty easily backtest a “stable earnings” basket through three recessions and major market downturns to see how it held up versus the broader market.
For simplicity reasons, and for reasons related to similarities in volatilities, we can split the “stable earnings” basket into three equal pieces and allocate utilities, consumer staples, and healthcare to each.
Then we can compare this to the S&P 500, the broad market benchmark.
Portfolios and comparison
“Portfolio 1” = Stable earnings basket
|XLU||Utilities Select Sector SPDR ETF||33.34%|
|XLP||Consumer Staples Select Sector SPDR ETF||33.33%|
|XLV||Health Care Select Sector SPDR ETF||33.33%|
“Portfolio 2” = Broad market
|SPY||SPDR S&P 500 ETF Trust||100.00%|
Portfolio performance over time
We can see better overall returns over time and shallower drawdowns. We touched in previous articles on the value of defensive stocks and their ability to provide similar returns and lower risk to more volatile forms of equities over time.
Portfolio performance by year
|Portfolio||Initial Balance||Final Balance||CAGR||Stdev||Best Year||Worst Year||Max. Drawdown||Sharpe Ratio|
Drawdowns for Historical Market Stress Periods
|Stress Period||Start||End||Stable Earnings Basket||Broad Market|
|Dotcom Crash||Mar 2000||Oct 2002||-25.82%||-44.71%|
|Subprime Crisis||Nov 2007||Mar 2009||-33.82%||-50.80%|
Drawdowns for Stable Earnings Portfolio
Drawdowns for Broad Market
Metrics and deeper comparisons
In a variety of ways, we can see that the stable earnings basket outperforms the broader market with better returns at lower risk.
It might not be the fanciest portfolio construction that’ll provide an action-packed ride. The chances for “exciting” 10- or 100-bagger investments is low.
But getting fairly steady rising accumulations of cash flows can certainly work over time. This is particularly true in a period where companies with cyclical cash flows may struggle when central banks have limited ability to ease policy when they need to going forward.
This portfolio construction could help create a bond-like alternative or at least a hybrid bond-equity type of asset class if engineered well.
This is another investment product to potentially build out as part of a well-balanced portfolio.
In this article we covered the macroeconomic environment before the Covid-19 pandemic, the new backdrop after, and how the mechanics of the downturn and fiscal and monetary policy choices are impacting investment outcomes.
Adjustment of short-term interest rates have run their course (monetary policy 1). Asset buying/QE has run its course (monetary policy 2). We’re now on monetary policy 3 (monetary and fiscal coordination), but all the normal ways that risk assets have had tailwinds historically aren’t there.
With corporate margins likely to fall a bit with more emphasis on self-sufficiency (rather than locating production wherever is cheapest), that’s another constraint on valuations going forward.
Policymakers won’t want asset returns to be bad in nominal terms, so I don’t think you’ll get huge drops if they’re adept at identifying risks and are capable of employing liquidity to where it needs to go. But real returns for foreseeable future will be low.
The performance gap currently between the markets and economy is the main issue. Over the long-run, financial assets can’t be reasonably valued more than the income they throw off. After the output gap is filled within the next two years or so in the US (somewhat later in most other economies), after that you’ve got 1.5-2.0 percent y/y productivity growth and not much in the way of labor market growth due to aging populations.
In terms of public market equities, owning utilities, consumer staples, and mature healthcare can provide stability in cash flows. Of course, companies in more cyclical industries (e.g., energy, materials, industrials, consumer discretionary) with strong cash yields and clean balance sheets can be viable as well. Engineered well, such a portfolio can provide the same effect as a bond proxy now that safe bonds are no longer that viable as sources of income.
Public markets, in general, are expensive and their real returns this decade aren’t likely to be much. The pattern of good returns in one asset class for a period followed by a “lost decade” in the next period is common over time. Past performance should never be extrapolated. To get better yields, you might increasingly make the case for private markets.
The global recession due to the Covid-19 pandemic is the deepest since the post-World War II (1945-46) period.
The global economy has experienced 14 global recessions since 1870. The global recession associated with the Covid-19 pandemic is expected to be more than twice as deep as the 2008 financial crisis.
Deepest global economic contraction since World War II
(Source: World Bank)
There is also the highest synchronization of recessions since 1870.
In 2020, the economies experiencing contractions in annual per capita gross domestic product (GDP) since 1870 will be the highest ever recorded. The share will be more than 90 percent.
This is higher than the proportion at the height of the Great Depression period running from 1930-32.
Economies with contractions in per capita GDP
2020 has had the sharpest economic contraction in multiple measures of activity
In 2020, many indicators of global activity are expected to show the sharpest contractions in more than six decades.
A large portion of the services economy has seen a near sudden stop in activity. This is due to both regulated and voluntary reductions in human interactions to decrease the threat of infection. Partially due to an unprecedented weakening in services activities, world trade and oil demand will see record declines in 2020. Moreover, the overall global rate of unemployment will likely rise to its highest level since 1965.
Retail sales volume during global recessions
Sharpest ever decline in oil demand
Oil demand typically declines during global downturns. The previous largest drop in oil demand occurred during the 1980-82 period.
Oil consumption fell by a cumulative 9 percent from its 1979 peak. The outbreak of Covid-19 and the far-ranging measures put in place to slow its advance have caused a collapse in oil demand that’s never been seen historically. At one point the supply-demand was so out of whack that oil prices went negative.
They also resulted in a surge in oil inventories, and, in March, the steepest one-month decline in oil prices on record.
Oil consumption during global recessions
Declines in per capita GDP in all emerging and frontier regions
Although the magnitude will vary across emerging and frontier regions, current projections indicate that five out of six are projected to fall into outright recession. The majority of emerging and frontier regions will experience the lowest growth in at least 60 years.
All of them will see declines in regional per capita output for the first time during a global recession since 1960.
East Asia and Pacific (EAP)
Europe and Central Asia (ECA)
Latin America and Caribbean (LAC)
Middle East and North Africa (MENA).
South Asia (SAR)
Sub-Saharan Africa (SSA)
The Covid-19 pandemic has led to a global recession that is unique in many ways. It will be the most severe since the post-World War II period and is expected to trigger per capita GDP contractions in the largest share of economies since 1870. It is also associated with weakening in multiple indicators of global activity that have seen a massive drop, such as services and oil demand, as well as declines in per capita income in all emerging and frontier economic regions.