Suspicions and a Market Review

Note: I was meant to do a nightmare review of what the Fed could do, but I thought my positions were pretty obvious. Also been a bit sick, so this is a bit rushed

Market Participants are all interested in two ideas

1. The possibility of a market crash
2. Earnings per Share are down/Debt is up

This effectively suggests that the stock market has become disconnected from its fundamentals. However, as can be clearly seen from the chart, earnings don’t seem to be down much, but this doesn’t take into account the massive printing that’s been done in recent months and the massive stimulus checks. Still, I don’t think this argument holds much water (although the dollar has lost a lot of value compared to a commodities peg). In dollar terms, stocks shouldn’t fall, and most investors believe that the dollar will fall anyway. A similar argument applies to corporate debt from the Fed.

1. Margin debt is incredibly high

1. Debt is rising, so are interest rates

As investors attempt to roll over debt, higher interest rates will make credit more expensive to obtain, preventing them from successfully rolling it over. The effects of rising interest rates are compounded by leverage (ie a 1% change in yield per annum leveraged 100x is a 100% loss)

1. Unemployment is higher from pre-pandemic

This means less demand for consumer goods and also a systemic loss of production for Americans. Ultimately, this will lead to economic stagnation, which can appear as demand-driven deflation (less likely given how the Fed has promised to support the economy) or cost-push inflation from decreased supply. While Powell has claimed that the economy has rapidly recovered, he’s also claimed that jobless numbers underestimate the problem (to justify continued monetary support). While he’s largely right on both counts, this contradictory messaging misses that the economy has not recovered and likely cannot recover its productive capacity. If those jobless people cannot find work, the US’s economy has structural weakness that will lead to an end downturn in productive capacity. Nevertheless, should an economic contraction occur, because companies will lose economies of scale (due to less supply and demand), costs will increase.

1. Government plans to raise taxes

Biden has already announced he plans to look at raising taxes, which will cut into corporate profits and possibly cause a capital outflow. While corporations have done this to great success in the past, Americans may no longer have access to easy credit to be the main consumer of American goods. In effect, with weakening demand (consumers), and raised taxes, American corporations are likely to see profits fall.

1. SLR Ratios
2. As suggested in my previous medium article, the Fed had little reason to not enact the SLR ratio since it would go against policy makers, show a complete unwillingness to allow interest rates to increase, and allow short term treasuries to increase supply.
3. However, given the short time constraints on the SLR ratio, the Fed will likely loosen restrictions somewhat to assure credit supply remains expanded as this is easier to change on-the-go. I could see the Fed lowering SLR ratios over the short term if any liquidity constraints do occur. Although bank stocks dropped on this news, possibly due to effective loss of spread upon selling of treasuries, this is likely overblown as banks tend to make more during higher interest rates (which is what the re-enactment of the SLR is expected to cause). The effect is also likely to be small due to point c. Furthermore, as a previous article mentioned, banks have hedged many of their riskiest loans through other funds and carry less risk compared to other institutions.
4. Banks are unlikely to be affected as even when SLR ratio comes back since they are anyway slightly underleveraged. This means that their claims that they would be forced to refuse deposits are likely overblown. Powell alluded to this, saying in December that banks were found to be well capitalized. However, if interest rates do rise with this, we could see systemic risk in debt held by other institutions.

Outlook

Powell has suggested we will see 7% growth in GDP, which is astounding. It suggests that during Covid19, the US somehow increased productive capacity for three years worth of growth. If this were truly the case, why has Powell promised to continue supporting the economy? It’s much more likely that Powell plans to pump up this GDP growth figure by increasing the monetary supply. Examining 2010, the closest example we have in modern history of economic recovery following QE, we see that real GDP growth was somewhere around 2.56% (slightly higher than the average for the past decade). This implies that the US (which will likely still have some form of quarantine from continued Covid/see a fall in demand as consumers recognize they don’t need a lot of goods) will experience real growth around 3% max, leaving 4% as inflation. Here, we assume that Powell was referring to nominal GDP growth, which is not inflation adjusted. Even the Fed’s own predictions seem to factor in rampant inflation from the increased monetary supply. However, this does suggest that Powell is committed to keeping interest rates low until 2023, but he will likely start looking toward different initiatives (reenacting SLR ratio/fiscal policy?) to help control inflation until then.

With inflation expected to increase and continued easy credit, cryptocurrencies seem like a decent hedge, especially with a crypto-friendly SEC chair in Gary Gensler.