weekly relative value · but as powell tried to normalize rates, the corporate high yield bond...

Weekly Relative Value

www.alloyacorp.org/invest

WEEK OF JULY 27, 2020

Tom Slefinger SVP, Director of

Institutional Fixed Income Sales

La La Land

We all quickly realized the emperor had no clothes in late 2018 when Fed Chair Jerome Powell had the audacity to try to hike the federal funds rate to that oh-so lofty level of 2.5%. But as Powell tried to normalize rates, the corporate high yield bond market dried up and the S&P 500 plunged almost 20%. Then Powell did his now famous “pivot,” indicating that the rake hike cycle was over. Amazing, this latest hiking cycle ended with the fed funds rate at the lowest peak since the 1930s!

Thus, the inability to “normalize” interest rates speaks to the vulnerability of the markets and economy long before the pandemic hit. Prior to COVID-19, the economic recovery was the longest ever. Despite zero rates and massive quantitative easing (QE), it was also the weakest ever economic recovery cycle. And to be clear, by no means was this the best economy ever!

Then the virus arrived, and a health crisis became an economic crisis, which morphed into a financial crisis. The Fed quickly slashed rates to zero-bound and restarted its QE money printing machine.

Source: Cagle

As I have discussed time and time again, the predominant reasons why economic growth had been so underwhelming over the past decade was a function of excessive debt combined with unfavorable demographics.

Thus, the biggest challenge coming out of this crisis will be debt levels at, or above, where they were following World War II (WWII) in the context of much more challenging

THIS WEEK • FED POLICY EXPLAINED:

LOWER FOR LONGER

• HOW LOW?

• U.S. STILL THE HIGHEST IN THE WORLD!

• SHADES OF 2000

• IS THE JOBS RECOVERY OVER… ALREADY?

• LESSONS FROM THE PANDEMIC

PORTFOLIO STRATEGY

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demographics. In fact, all debt across all sectors of the economy, especially the government and corporate sectors, will be at totally unparalleled heights.

Let’s look at the government sector. In just 11 months of the current interest rate cycle, federal debt has already risen by $4.4 trillion (more than any entire cycle prior to 2007) to $26.5 trillion. I assume by inauguration day in January 2021, federal debt will be sitting at or above $30 trillion. As shown below, the federal government gross debt-to-GDP ratio is already at 107% of GDP and set to challenge the WWII peak of 119% in 1946.

Source: Bloomberg

But what makes this debt albatross so much worse is the demographic backdrop. Life expectancy in the U.S. has risen to 79. For historical perspective, in 1945 the average life expectancy was 66 years old. People died before they could collect their social security/Medicare benefits. Today, as boomers head into their golden years, they are expected to live longer than the social welfare system was designed for.

Making matters worse, the median age of the U.S. population is nearly 40 years, a record high. Coming out of the Great Depression and WWI, it was closer to 30. So, in the decade following WWII, the debt could get repaid because we had a young and expanding labor force as the working-age population rose at nearly a 2% average annual rate. We have not seen a pace that strong in 40 years as the boomers chased their careers instead of replacing themselves. In a nutshell, we have a growing population of older Americans who no longer have the support of a younger and growing labor force. Thus, decades of negative fertility coupled with fast declining immigration, hitting zero in 2020, has and will continue to reduce the labor force and lower tax revenue necessary to fund the expanding social welfare state.

It all adds up to more debt per full time employee. The chart below shows the parabolic rise in the growth in federal debt per the net growth per full time employee (15 to 64-year-olds).

Source: Economica

Yes indeed, demographics are destiny.



If anyone thinks we simply “grow out of this” mess, think again.

In the decade following the war, real GDP growth topped a 4% annual rate and nominal growth approached 7%. It’s been three decades since we have seen anything remotely close to this. As a matter of fact, over the past decade the U.S. economy has not once reached 3% real growth for any one year.

Today, life appears to be one giant “la la land” of borrow and spend and borrow and spend with impunity. But could it be that today’s extreme level of complacency will come back to haunt us all. The things I worry about the most are the soundness of our money. You can’t continue to run deficits, sell debt or print money, rather than be productive, and sustain that over a period of time. If anything, today’s debt binge is tomorrow’s liability, a tourniquet on economic growth even more ruinous. Even if interest rates stay low, some investor somewhere (e.g., insurance company, pension fund) is still expecting to see the principal repaid. One person’s asset is another person’s liability.

Source: Bloomberg

So, to avoid a debt crisis of historic proportions, nominal bond yields will remain lower for longer and remain close to zero, or even negative, for years to come as this prolonged era of financial repression develops even more legs.

But what we can almost assure is the tax bite will become bigger. Either that, or “damn the torpedoes,” the Fed will monetize these massive debts. But as Newton once said, “for every action, there is an equal and opposite reaction.” Fiat currencies will weaken, and inflation will soar since there is no such thing as a free lunch. The result will be years of declining real incomes as this inflation (which the Fed craves) eats away at consumer purchasing power. As shown below, goldbugs have already begun pricing in that scenario. This morning, gold has reached a new all-time high!

Source: Bloomberg



Summing it up: the demographic and fiscal time bomb is ticking, and no one cares! Imagine what happens when inflation does rise out of the ashes? If spending is not reduced (likely will never happen), then taxes have to go up. The question is who bears the brunt (duh, I think I know).

FED POLICY EXPLAINED: LOWER FOR LONGER

The graph below shows fed funds interest rate cycles from 1981 through 2020 and note they grow progressively longer, starting and ending lower, and with less interest rate recovery. Based on this pattern and the fundamentals of debt and demographics driving this, the current cycle is likely to be decades at zero (or more likely moving to Negative Interest Rate Policy (NIRP)) with no rate hikes.

Also, one can glean from the graph that the depth of cuts moves progressively greater (essentially 100% for last two cycles), and have lasted longer (the number of months from initial rate cut to initial rate cut of the next cycle) stretching from less than a year to over a decade. During hiking cycles (how much rates are hiked in the hiking phase from the cycle low rate) the fed funds rate has risen to less than 50% recovery of previous cuts. Since 1980, interest rates have seen lower highs and lower lows. Again, in the current cycle, we already have 100% cuts. I would not be at all surprised to see rates remaining at zero bound for years to come. Japan has already set the stage.

Source: Bloomberg

HOW LOW?

Last week, the real 10-year Treasury yield (the nominal yield minus the inflation breakeven) dropped below -0.9% and briefly dipped under the previous all-time low set in December 2012. Meanwhile, the nominal 10-year yield fell below 0.6%. Such low rates are awful for savers and credit unions with excess cash.

Source: Bloomberg



On the face of it, real bond yields at 0.9% per year may seem an aberration. And it is tempting to think that they will soon rise again. But then again, maybe not. It is possible that Jerome Powell will soon start talking about tapering off QE (QE4Ever), but there is far less of a case for him to do so than there was for former Fed Chair Ben Bernanke seven years ago. Back then, the economy was growing steadily if rather anemically; that is not the case now.

The Cleveland Fed offers an online tool that allows the user to plug in different projections for inflation and unemployment and see what various monetary policy would spit out for future interest rates. With unemployment expected to stay high for a couple of years yet, and nobody seeing much inflation for a while, the results are grim. Even the public projections of the Federal Open Market Committee (FOMC) imply an effective fed funds rate of -5%, and there appears to be more downside than upside.

Source: Cleveland Fed, DB Research

In practice, there is no way nominal interest rates will be set that low, and the likelihood is instead that we will receive ever larger doses of QE and possibly yield curve control (YCC). For each $100 billion in QE, analysts estimate that it is equivalent to a rate cut of about three basis points. So that yields a ballpark estimate that another $12 trillion in asset purchases will be needed, just to keep the economy ticking. If this analysis is anything close to reality, there will be no Taper Tantrum II any time soon.

And yes, yields could go yet lower.

U.S. STILL THE HIGHEST IN THE WORLD!

The bond markets are signaling weak growth for an extended period. It’s not just that the yield on the 10-year Treasury note has dipped back below 0.60% but look at U.K. gilts. The 10-year yield is now just 11 basis points away from joining Switzerland, Germany, the Netherlands, Denmark, Finland, Norway, Ireland, Austria, Belgium, Slovakia, Sweden and France into negative territory.

Source: Bloomberg



And take a gander further out the curve. Many may not be aware, but the long (30-year) bond yields in Germany (seven basis points), the Netherlands (six basis points), and Switzerland (38 basis points) are already sub-zero. So, in actuality, the 1.28% yield on the U.S. long bond is an outright bargain within its own global asset class. It is more than double the comparable yield in the U.K. gilt market.

SHADES OF 2000

Bonds continue to price in an elongated recession as stocks price in an extended phase of massive central bank liquidity injections and asset-buying.

• The S&P 500 forward (earnings projections) P/E is back at 2000 bubble levels.

• The Nasdaq 100 trades at a 15-year high of 34x.

• Tesla trades at a 658x multiple and has become a darling of the retail investor crowd even though its market cap pretty well exceeds all of its global competitors combined.

• The market cap of the Nasdaq has now topped the entire GDP of the European Union. Amazon, Apple, Google and Microsoft collectively have a larger market cap than the entire Japanese equity market (the TOPIX)! Their combined valuations are more than twice the size of the Canadian economy.

• Apple, Amazon and Microsoft together are now valued at nearly $5 trillion. That’s larger than the entire economy of Germany and nearly the size of the Japanese economy.

These aren’t companies —they’ve become countries!

“About all you can say is ‘Wow.’ These three stocks, larger than Germany, have separated from their free cash flow more than any time other than an outright bear market. If the concept of reversion to the mean holds, either their sales are

getting ready to explode, or their stock prices are going to fall. Or some combination. These three stocks, in terms of free cash flow, are well more than three standard deviations above their average, and significantly more than even during

the tech bubble.” – Jesse Felder, The Felder Report



Felder goes on to say:

The bulls will tell you to ignore history. Dangerous.

Also consider what is really driving the markets. Since March, most of the gains of the S&P have come from just 10 companies: Microsoft, Apple, Amazon, Google, Facebook, Visa, Mastercard, Nvidia, Netflix and Adobe. As a group, they are up 35% since the beginning of the year. As a group, the other 490 are down more than 10%.

Finally, we have large numbers of small, inexperienced investors with spare cash from the government and a Robinhood app on their phone. Speaking of which, retail trading volumes have taken up an eye-popping 18.5% share this year, almost doubling from five years ago. And these neophytes have emerged as a dominant source of support for this mania. And then we have Dave Portnoy, internet celebrity, blogger, and founder of the sports and pop culture blog Barstool Sports, who posits stocks can only go up and urges his audience (which includes many idled sports bettors) to throw more money into the market. What could go wrong?

“What is really most astounding, though, is the aggregate valuation of these three behemoths relative to their free cash flow. Only at the peak of the Dotcom Mania did we see anything like it. The difference today is that these companies

are growing free cash flow at a tiny fraction of the rate they grew it back then. If that was a bubble, then what is this?”



And I am being told that there’s no equity bubble. Sure thing.

For the moment, the all-in stock strategy seems to be working. Yet history shows fundamentals eventually matter, and many of today’s buyers probably won’t like what happens.

IS THE JOBS RECOVERY OVER… ALREADY?

It just doesn’t let up. An astounding number of newly laid-off workers keeps filing for unemployment benefits week after week and pile on top of the people already unemployed. Initial claims rose from 1.307 million to 1.416 million, an increase of 109,000. This was the first rise in 16 weeks, a signal that the jobs recovery may be over.

Source: Hedgeye

And as discussed last week, state claims do not provide a complete picture because many people are not eligible for unemployment insurance. For example, self-employed are not eligible for state unemployment insurance even though they pay into the system. But the self-employed are eligible for 13 weeks of Pandemic Emergency Unemployment Compensation (PEUC) but that may have expired.

All continued claims are the sum of state continued claims plus Pandemic Unemployment Assistance (PUA) claims and all other federal programs. In the week ended July 18, the total number of people who continued to claim unemployment compensation, including gig workers and contract workers, edged down to 31.8 million. It was the third highest level ever and just a tad off the peak So nearly 32 million people are collecting some form of unemployment insurance and I expect the number to rise.

“If those folks do not have continuing support, we’re going to see a spike in delinquencies and defaults in consumer credit…That will have some contagion effects across the banking system and a variety of financial institutions.”

– Jim Millstein, the co-chairman of Guggenheim Securities



Source: Bloomberg

There are 160 million people in the civilian labor force. Of them, 31.8 million receive unemployment compensation under state and federal programs. This means that 20% of the labor force receives unemployment compensation, which forms the most realistic estimate of the actual unemployment rate: 20%.

Everyone in any unemployment program gets a monthly check of $600. Unless Congress acts soon, these $600 supplemental checks end, and persons only receive state unemployment benefits, which average $378 per week or primary PUA coverage which is even less, especially for those working part-time. This is why it is referred to as an “income cliff,” as it would mean consumption would crater, and the recovery would quickly reverse.

Already, the U.S. government has doled out, in the first five months of the year, more than $2 trillion in monetary gifts to the personal sector. The economy remains on life support!

LESSONS FROM THE PANDEMIC

In the National Post there was an article, titled Lessons from the Pandemic, and here were the sections of that piece:

1. “Stocks can be volatile” 2. “Debt is dangerous” 3. “Emergency funds have a purpose” 4. “Don’t lose sight of spending” 5. “Prepare for the Worst”

Wise advice indeed!

MARKET OUTLOOK AND PORTFOLIO STRATEGY

U.S. high frequency indicators have continued to flash red since late June. As just discussed, leading jobless claims data flashed a huge warning sign about jobs. Over nine million Americans are working part-time because the economy is still

“’The fiscal response to the Covid-19 recession is running out of steam just as the rising virus case count impinges on the recovery. The most critical near-term deadline is for enhanced jobless benefits, set to run out at the end of July. A

range of other programs will also need to be expanded and extended if policy is to avoid swinging from recovery driver to recessionary drag.’” – Andrew Husby, Bloomberg Economics



so moribund and the outlook so uncertain. We have only five million job openings for an economy with an official unemployment count of 20 million; and an unofficial estimate of closer to 30 million.

A Yelp study finds that 55% of business closures are closed for good. And sadly, permanent closures will continue to rise. Many small businesses already on the ropes will not survive the reopening reversal. Don’t confuse the stock market with the real economy. This is a deflationary event.

And the slowdown is apparent in mobility data, to restaurant bookings, to credit and debit card usage, to store traffic to airline activity. Things have seriously cooled off in the past month. American Airlines’ net bookings, or the difference between new reservations and cancellations, are down 75% to 80% — a huge difference from May and June, when the Sun Belt states were opening up and even some business travelers were staging a return (at one brief point, net bookings in those states were down just 35% to 40%).

In addition to all the checks Uncle Sam has been sending out, there has been a four-month moratorium on evictions. There are an estimated 12+ million renters at risk and a Census Bureau survey shows that 22% of American households think they may be forced to skip next month’s rental or mortgage payment. This is a crisis. A payroll tax cut for people who already have a job is not the solution.

Or consider the number of people on the Supplemental Nutrition Assistance Program (SNAP), which has soared 20% since the pandemic started (the fastest pace ever) to 43 million, only surpassed by the 2008/09 Great Recession.

The graph below shows the yield of the five-year Treasury drifting ever so slowly to an all-time low of 25 basis points. That would not be happening if the U.S. economy has truly turned the corner. For those subscribing to a V-shaped recovery narrative, I just don’t see it.

Source: Bloomberg

“As everyone focuses on eroding U.S.-China relations, the start of baseball and the fiscal shenanigans in Washington, a crisis begins today. It's called the eviction crisis as the 4-mth moratorium ends and the nation's landlords unite! Over 12m renters/mortgage borrowers at risk.” – David Rosenberg, Chief Economist & Strategist of Rosenberg Research &

Associates Inc., July 24, 2020

“I still think a V-shaped recovery is in place,” – White House Economic Advisor Larry Kudlow



The Fed has three options to further bolster the U.S. economy, whether at this week’s meeting or at September’s, or even later this year:

1. Tying future rate increases explicitly to actual inflation reaching or overshooting 2. Yield curve control out to three or five years 3. Adjusting Treasury purchases to mainly buy longer maturities.

Any one of these would support negative real yields – all three would guarantee them. Call it the next frontier in financial repression if you want, Powell and his Fed colleagues don’t mind.

Bottom Line: Given that the Fed has stated they expect to remain at zero-bound for years, we view “excess cash” as the least attractive investment. Thus, unless credit unions can make risk-appropriate loans in the current environment, we continue to favor high-quality, risk-appropriate, longer-dated investments.

Source: Bloomberg

PREMIER PORTFOLIO

Alloya Investment Services’ online trading platform, Premier Portfolio, has been making a positive impact at credit unions across the corporate’s membership since its launch in 2018.

“Premier Portfolio is user-friendly and modern. It allows us to browse current offerings and make immediate purchases at any point throughout the day. The tracking mechanism in Premier Portfolio is very hand. Since the system knows what dollar amount is currently owned in a financial institution, there is no room for error. We love the ability to check term and rate on a single summary. Premier Portfolio takes the guessing out of the equation. It is a highly useful tool and would recommend to anyone using Balance Sheet Solutions (now Alloya Investment Services).” – Darin Higgins, President of Western Illinois Credit Union

“While it is always great to connect with our Balance Sheet Solutions, (now Alloya Investment Services), Account Executive one-on-one, Premier Portfolio is an amazing and easy tool to use in purchasing investments. We have access to statements, online trading and the ability to look at all of the offering in one place. I highly recommend trying this out!” – Shawn Nikkel, Finance Director of Denver Fire Department FCU



Visit www.alloyacorp.org/premierportfolio to learn more about Premier Portfolio and how it can benefit your credit union!

MORE INFORMATION

For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at [email protected] or (800) 782-2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments.

At Alloya Investment Services, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alloya Corporate Federal Credit Union, Alloya Investment Services (a division of Alloya Solutions, LLC), its affiliates, or its employees. The information set forth herein has been obtained or derived from sources believed by the author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.

Information is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding prospects might not be realized. Please contact Alloya Investment Services* to discuss your specific situation and objectives.

*Alloya Investment Services is division of Alloya Solutions, LLC.

“Premier Portfolio’s online services allows me to access statements and overall market analyses, review a list of available security offerings, as well as purchase SimpliCD’s and Alloya’s certificates. Premier Portfolio is convenient, easy, secure, and has become my go-to place for investing!” – Rhonda Schroeder, CEO of Blackhawk Area Credit Union

http://www.alloyacorp.org/premierportfolio

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weekly relative value · but as powell tried to normalize rates, the corporate high yield bond...

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