A Full Deflationary Panic: What’s Next For Coronavirus And The Fed
In our capitalist economy, the decisions of hundreds of millions of actors create an inexhaustible trove of indicators and data upon which to review the past, examine the present, and with certain uncertainty, predict the future of this $20+ trillion enterprise. And we in the macro asset allocation business peruse that data each day. What do I look for? I think of the economic direction as a windowpane with four squares. The upper two panes represent a growing economy (nominal GDP); the lower two a slowing or receding economy. The two panes on the left are an economy not creating inflation (perhaps even deflation) while the two on the right indicate increasing inflation. In sum, is the economy growing and with or without inflation?
This week, due to the coronavirus and perhaps a little Democrat politics, the financial markets see only the lower left pane clearly – a slowing economy with deflation. And, the markets are panicked about it.
The markets are showing this obsession with deflationary panic in several ways (according to Bloomberg LP data):
1. Ten to thirty-year government bonds are at their lowest levels ever, piercing the prior lows with ease.
2. Ten-year inflation expectations have dropped to 1.4%. This is not as low as they dropped in 2016. This is hopeful, but the chart looks ominous.
3. The major commodity indexes have broken to lows not seen since 2011. Again, hopeful that we are not at all time lows, but still scary.
4. The yield curve is inverted again with Fed funds at 1.6% and 10-year bonds at 1.1%.
5. The one-year correlation between stocks and bond yields is near all time highs. Stock buyers show up when government bond yields rise, indicating some inflation is returning.
But why the full out panic manifested by one of the fastest 15% drops ever and a volatility index that hit 50 intraday (this was at 11 in mid-January)? The answer is debt. The reason to panic about deflation, has been, is today, and likely always will be the ability to service debt. China, where the virus started, is one of the most highly levered large economies ever. Of course, the data is opaque, and it is not an open society, but the laws of leverage work there and in both directions.
Here in the US, our non-financial corporate interest coverage ratios have been falling steadily since 2014. Small caps are already at interest coverage ratios that signal caution. Especially vulnerable is the energy sector. Individuals, while no longer over levered with mortgages, have piled into credit cards and student debt. So, is it game over?
It is not game over if the lower interest rates continue to work their magic on the super strong housing market and also the corporate cap ex spending markets. Moreover, if you want higher stock prices, you want lower rates year over year, and we’ve got them. Many central banks around the world are easing, including China. Stimulus is in the air.
But there are caveats – one is medical. If the coronavirus skips from country to country we may not be at the end. Right now, it looks like China and Singapore have had some containment success. If it skips from country to country and lingers for months, the effects will be more substantial. And, two, does the Federal Reserve cut interest rates to assuage the financial markets? I’m betting they do cut interest rates and so is the market. Right now, the effective fed funds rate is 1.6% and the market thinks it will be 0.9% by June. The Fed has talked about inflation symmetry for some time now, the market believes that means fighting a deflationary panic with lower rates.
The path back to an upper pane growing economy with some inflation will now be pushed out, more volatile, and will need to bring investors back from the ledge. I recommend that portfolios hold 5-10% gold in case the Federal Reserve overshoots its stimulus and because there are negative real rates. Don’t abandon stocks; it’s too late. Wait for volatility to calm, assess the economy, and stay invested. Finally, my homework should be everyone’s homework: With a 1.1% ten-year bond, what place do government bonds have in an asset allocation portfolio? And, what’s the replacement? More on this soon!