The Fed vs Fundamentals: Who Wins?

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by Tyler Durden
Friday, Apr 24, 2020 - 06:40 AM

Submitted by The Chicago Economist

The thing about market fundamentals is that they’re like gravity. They never relent. And that means if you’re not lighter than gravity it requires continuous energy to overcome it or succumb to it. In markets, productivity is the equivalent of being lighter than gravity, that is, productivity makes markets rise naturally in line with the laws of economics.

Without productivity markets require energy (liquidity) to counter the fundamentals. In order to move markets higher naturally it is important then to understand the laws of fundamentals so we know how much productivity we need or alternatively how much energy we need to counter them.

The foundation of market fundamentals are cash flows. Cash flows are ultimately driven through sales. Sales are the only common tenet of all businesses without which it is not a business. So all business must have a customer that will exchange money for some value a business is offering. However, that means customers must have an ability to pay.

There are three means from which customers can pay and it is incredibly important to understand them - Money on hand, Credit, and Transfers (gov subsidy such as EBT, SNAP, etc.) So as a CEO it is required that I predict my customer’s ability to pay as much as my customer’s desire to pay in order to accurately predict cash flows. And as a market analyst I must do the same.

This is where things have gotten interesting over the past 4 decades and in particular over the last decade.

While personal expenditures (PCE) have continued to climb…

...the following chart shows that since the early 1960s we’ve had a steady decline of Money on Hand (i.e. wages and salaries) as a percent of consumer expenditures and a steady increase of Credit and Transfers as percentages of consumer expenditures. Note the summation of the three always equates to 1.

This indicates that corporate revenue growth for the past six decades has been increasingly subsidized by Credit and Transfers.

The problem is that Credit and Transfers are forms of private and public debt and their limits are a function of the ability to pay them back. Some may argue that public debt can be rolled over forever and that may be true while we hold “world reserve” status, although that status will be tested within the next 12 months. And so perhaps Universal Basic Income such as the $1,200 “stimulus check” can subsidize corporate cash flows forever but this too will be tested. Credit is rigidly a function of our ability to pay it back and so rigidly a function of wages and salaries.

This latest event has decimated wages and salaries with tens of millions of workers displaced and that figure is only going to grow. A historically large percentage will never find their way back to work at least not for many years. This means that both Money on Hand and Credit will decline materially placing a huge weight onto Transfers. Overall it means the customer’s ability to pay has just gapped down quasi-permanently.

And so cash flows, the foundation of market fundamentals, too has gapped down quasi-permanently.

I explained this on March 4 as Chinese factories were shutting down.

Now in addition to the collapsing consumer, the virus has acted like Luminol in that it has exposed the dirty secrets of financial engineering. Things like the US shale industry that was being artificially kept alive by inflated oil prices above competitive global supply/demand functions. That is, global producers can produce and profit at half the market price that was inflated to allow American producers to participate in the market.

Chinese macroeconomics (due to the virus) and Russian policy put a very abrupt end to that game. Also, corporations artificially inflating market cap via borrowed funds being allocated to dividends and stock buybacks are now facing bankruptcy.

All of sudden gravity just got heavier. And that means the energy to counter it must increase. Enter the Fed.

Between February 11 and March 12, the Fed decided it would need to inject $5.4 trillion to keep the repo market from imploding. That opened the spigot of easy money, which has already led to trillions more, and it will never close again. For some perspective, and remember this is just the beginning, let’s have a look at the easy money train…

We bent the laws of economics for a long time and got away with it. But something finally snapped. Production differentials have never seen a move quite like what is taking place now on a global scale. The amount of leverage and engineering that was maintaining the house of cards meant that any significant hiccup was going to require exponentially more energy (liquidity) than in the past. What we didn’t count on was a historically epic disruption to production. And so the battle between the Fed and the Fundamentals is just beginning and it’s going to get bloody.

Who wins is truly anyone’s guess because nowhere have we designed models that apply to this scenario. My bet is on gravity and it will be a helluva a fall when the (value of ) money runs out.