It is time to take down risk and plan for a long stretch of deflation, poor returns on assets, and general stagnation. The immediate but temporary threat of Coronavirus is obscuring clear and obvious signs of a much uglier, longer-term slump.
I’m actually grateful for the noise and smoke of Coronavirus because it’ll hopefully allow me to shuffle out of some positions at higher prices. A decent number of people will “look through” Coronavirus and price in a return to normalcy by year end. Maybe price in a recession and some tough times, but basically mean reversion as we get into 2021. Because people usually (and reasonably) tend to assume a return to the status quo.
That forecast should drive a decent market rally. “Look through the dip” buyers will come back in. The forced selling will have already happened. We won’t be back to go-go times, but we should bounce.
But the market is bigger and smarter than those people (or me). The market sees something darker than just a temporary dip. Coronavirus is obscuring increasingly obvious signs of an increasingly stagnant, deflationary economic outlook.
How obvious? They are in the paper every day. Below is a table of US treasury yields going out 30 years. They are barely positive. They are negative until 10 years out once you account for market-based inflation expectations (which have also cratered – see below or this link).
|Rate||Real rate (Subtract 1% Inflation)|
Remember the 10-30 year bond is a “rule of thumb” forecast of real economic growth (treasury rate = future real growth minus future inflation). Per the chart above, the market is pricing in around zero real growth 10-30 years out.
You might shrug and say yields are low because of the Coronavirus crisis. But as we get closer to 0%, the danger embedded in those yields goes up exponentially. Policy error. Pushing on a string. Lack of political will for fiscal stimulus. Those risks get a whole lot more real and dangerous as we get near 0%. Professionals should know to know this, but yields have been headed down for so long everyone has kind’ve gotten used to it.
The other obvious sign was the market reaction to the Fed’s 50 basis point cut in rates. Instead of rallying, the market tanked. Because the market is seeing that exponential increase in risk The IOER rate (what the Fed pays to banks on reserves) is now 1.10%. That makes overnight deposits at the Fed a better investment than anything but the 30 year Treasury. Which makes it highly likely the Fed cuts rates again as they keep chasing (not leading) the market down. Arguably they need to get their overnight rate somewhere closer to the 0.44% 1 month treasury.
Maybe that rate cut spurs a rally. But the market’s current message is pretty clear from here until somewhere past 10 years out. Economic growth is gonna suck. Not because of Coronavirus, but because of all sorts of chronic problems (mostly demographics).
Maybe the market is wrong. I’ve made pretty decent money betting on exactly that with individual stocks. But I’m going to believe the market on this one. It is usually smarter than us.
I’ll wrap up with this quote from John Authers at Bloomberg.
“As people spot the logical fallacy in American exceptionalism, they also begin to spot the fallacy in TINA (“there is no alternative”) — the notion that low yields make bonds such bad value that it is justified to pay high multiples for stocks. The problem with this, rather as with the “long oil/short banks” trade back in 2008, is that at a certain point the rationale no longer works. Bond yields of less than 1% only make sense if the economy is bound for a long drawn-out deflationary recession. And if that is the fate of the economy, the effect on stocks will be horrible. This little item of logic also appears now to have clarified itself in the mind of investors, helped by the twin shocks of oil and the virus. “