In his latest ad hoc investing note "Where Is The Folder", the legendary creator of the MOVE bond volatility index and the iconic Merrill Lynch RateLab, Harley Bassman, opines on the coronavirus pandemic and wonders how the United States could have been so unprepared for its arrival:
We manage the Global financial system, which transacts in the currency we print. We control the oceans to ensure the safety of the Global supply chain. Our legal system is an aspiration, and our military keeps hot spots localized to mitigate nuclear annihilation.
So WTF happened?
The Chinese lied - of course they did ! But that's why we have some version of SkyNet watching. And let's not forget Google, Facebook, and Apple that make The Matrix look benevolent.
Whatever. Since the Government will not think two moves ahead, we shall be forced do it ourselves; thus let's consider the next Black Swan.
With that skeptical background in mind, Bassman looks at the opaque future in a time of corona, and contemplates how three key variables - the velocity of money, demographics (Labor Force growth rate inflects up sometime between 2023 and 2027 as the increase in Millennials (1980 – 1996) overtakes the decline in Boomers (1946 – 1964)) ...
.... and supply chains interact, and concludes that "ultimately, a combination of these forces will increase the demand for money; the result being higher interest rates and inflation between 2023 - 2027."
Yes but... before we get there, here are the known unknowns as Bassman lays them out:
- We are fairly confident that an increase in Government debt relative to GDP will hamper growth.
- We know that a massively expanding the money supply will alter the relationship between real assets and fiat assets, but we do not know when or by how much.
- We know that Modern Monetary Theory (MMT) posits that politicians must turn off the money spigot once potential is reached, we do not know if they can do it.
- We know that residential real estate is a more secure asset than commercial real estate, and demographics favor the latter over the former.
- We know that Gold is effectively an alternate currency, but we do not know to what degree it will be valued relative to fiat currency.
Addressing the stock market, the bond trading legend admits that he is "clueless as to where the SPX will close out the year; and that I can make a compelling case for a Fed-juiced 3400, or a COVID-related 2350." He does however not that he would not short the S&P 500 vs single name assets, because - as we wrote in the entire market is now just five stocks - "the primary reason is that the construction of this capitalization weighted index is no longer a measure of the value of the overall equity market, but rather of the top five stocks, who presently make up a -martin line- of 21%."
It is for this reason that Bassman thinks it is unlikely the SPX can revisit the March low print of 2191, as the math is virtually impossible (absent a total collapse in ad spending revenue of course): "Holding the FAAMG at its current 7% decline, the other 495 constituents would need to decline by 45% to reach that level. More evidence of dispersion - last week the SPX was down 17% while the median stock was 28% below its peak."
Of course, the real reason for the recent market surge is the unprecedented liquidity
bazooka nuclear bomb launched by the Fed, which is "the third time the “Fed put” has been exercised in the past 15 months. First in December 2018 as the market just averted a clock stopping 20% draw down. Again, in September 2019 as the Treasury Repo market jammed which was occasioned by a 60bp drop in the T10yr rate in a month. And finally, last month after a Global “margin call” prompted even the safe haven of Gold to plunge by $250 (~15%) in six days."
Fed's massive injections aside, Bassman believes that “V”-shape recovery is absurd, and a “U”-shape may be wishful thinking, even as the FED has promised to do “whatever it takes”.
Fine, but surely at some point there comes a time when not even the Fed can print its way to prosperity, or otherwise as we have been asking for years, and then Jeff Gundlach chimed in overnight, why pay taxes?"
The U.S. Treasury Department today admitted to a $3 Trillion “borrowing” need in the next quarter. (I’ll take the “over”.) If endless borrowing is a viable solution, why did we have any taxation in the first place?— Jeffrey Gundlach (@TruthGundlach) May 5, 2020
AS it turns out, such a point does exist according to Bassman, who says a worst-case scenario, "has to include a situation where the FED can no longer hold back the tides; and I will volunteer this occurs if interest rates significantly increase, perhaps above 4.5%" as a result of the massive debt load carried by the system:
As he further explains, the massive leverage built up in the financial markets has been supported by the correlation between stocks and bonds. Since the start of the Great Financial Crisis (GFC), the prices of these two asset classes have generally moved in opposite directions, offering “hedge value” for a diversified portfolio.
Employing a strategy of Risk Parity, managers might use $100 of capital to buy $70 of equities and $130 of debt instruments. As long as this correlation holds, losses on one asset will be offset by gains in the other. If this relationship flips, risk manager MUST reduce leverage and sell both; which is precisely what occurred in March and prompted the FED execute an inter-meeting surprise.
Then in a fascinating observation, using a chart from Minack Advisors, Bassman shows that the correlation correlation flips when the inflation rate is above 2.5%.
What does that mean in yield terms? As Bassman notes, the old rule is that the T10yr rate should tend toward nominal GDP. As such, a real GDP at 2.0% plus an inflation of 2.5% should lead to a T10yr rate of 4.5%.
While a 400bps increase in rates presently seems unlikely, I can assure you that, at the time, a 400bps decline from 2007’s average yield of 4.63% would have been thought even more absurd.
But what about the deflationary impact of demographics and debt? Here Bassman's answer is that while demographics would keep rates under 3.5% until 2023, and MMT policies might not be fully engaged until after the election in 2028 when the entire Boomer generation reaches the age of 65, "this pandemic has accelerated the clock as (direct) fiscal Helicopter money has been added to (indirect) monetary expansion (QE)."
Which brings us to the obvious conclusion, which is what according to the bond trading guru, is the Fed's biggest fear. It will come as no surprise to anyone that the answer is not deflation but (hyper)inflation.
Prior to the pandemic, nattering financial pundits insisted the FED’s toolbox was depleted, this was clearly not the case. What was vacant was the imagination of the chattering class. For while the FED may be somewhat bothered by deflation, let me promise there is a tanager folder marked “secret”, locked in a glass box with a hammer, that contains the plan for how to manage the inflation on the horizon; this is the real ‘lights out’ scenario they fear.
Bassman concludes with his investing recommendations:
For an investment horizon greater than two years, one should have exposure to large cap equities. They have the resources to survive the shut-down and will gain market share as the economy recovers.
Buy quality intermediate term (4yr to 7yr) fixed income assets. As pandemic fears recede, the Boomer demographic will reach for yield to fund retirement; and they will continue to transition out of Equities and into Bonds as mandatory IRA withdrawals escalate.
Own positive Convexity (assets with much more upside than downside):
- Buy 7yr into 20yr payers (put options), K = 3.00% @ 225bps;
- Buy USD / JPY calls, 7-year expiry, K = 120 @ 1.75%;
- Own Gold, perhaps 5% of assets;
- Refinance your mortgage - you own the prepayment option;
- Be cautious of embedded leverage (this is why mREITs imploded).