The financial markets seem disoriented. The mood on Wall Street changes daily, the S&P 500 keeps trading sideways. Rising counts of Covid-infections in Europe and in the US as well as political uncertainty keep investors on their toes.
Jim Bianco advises caution. When we last spoke to the internationally renowned macro strategist from Chicago in mid-March, panic was in the air. There were even fears that markets would have to close.
«Luckily we didn't get that far,» says Bianco. «But it was a lot closer than most people realize.»
Today, things seem calmer. Nevertheless, Mr. Bianco, founder and chief strategist of Bianco Research, sees no reason for complacency. According to his view, there are obvious signs of a full-blown retail mania in the stock market. He also warns that the Federal Reserve could lose control over the bond market if inflation picks up next year.
In this in-depth interview with The Market/NZZ, the outspoken investment specialist explains why he thinks the risk of renewed lockdown measures is significant, what kind of market reaction investors should expect with the respect to the US elections and how to position your portfolio for the current environment.
Mr. Bianco, trading has become quite choppy as investors cope with an uncertain outlook for the economy and political risk in Washington. What’s your take on the financial markets?
The stock market has a two-fold issue. On one hand, retail investors are dominating the market. There’s no doubt that we’re seeing a full-blown mania coming from the single-stock options market. What’s more, valuations are at or near the 2000 peaks. Whether you’re looking at forward P/E ratios, market capitalization to GDP or other metrics. If you take out the FANG stocks, valuations are even higher than in 2000. This all sounds really bearish: You’ve got mania, and you’ve got stretched valuations.
What’s the second aspect of this two-fold issue?
On the other side of the equation you have the Federal Reserve, and they have kitchen sinks which they can throw at the market. At least, that’s the feeling. This is more than traditional monetary policy. The Fed was always involved in the markets, but never to this degree. They maintain facilities to buy corporate bonds, ETFs, municipal securities, PPP loans and other things - and that’s in addition to quantitative easing on levels no one would have ever imagined.
Yet, over the past few months the Fed’s balance sheet basically stopped growing.
That’s correct, but today these facilities are in place, and the Fed can start buying ETFs again in ten minutes. When they made their announcements in March, it took them two months to put these facilities together. Now, they can turn it back on at any point. That’s the other side of the equation, and it was tempering the recent decline in stocks.
What’s going to happen next?
We had exactly a 10% correction on the S&P 500 on an intraday basis. I think that’s about the extent of it for now. Until a new narrative develops, we are probably going to trade sideways. It’s very possible that this new narrative can be negative, and there are two potential negatives hanging out there: The presidential election and a second Covid wave.
Let’s start with the election. You’ve recently talked about the race for the White House in your new Podcast, Talking Data.
I’m looking at two things. Number one, the gut reaction is that everything you think you should do is already in the market. But I don’t think it is. According to poll analyzers like Nate Silver, Charlie Cook or The Economist magazine, there is like a 85% chance Joe Biden is going to win. They’re basically announcing it’s over; we’re just quibbling how big Biden’s victory is going to be. But if you look at the betting markets, Donald Trump has almost a 40% chance to win. Also, there is a London based pollster called Survation. They recently polled 91 investment managers and 60% of them said Biden is going to win. That means investors line up with the betting markets, not with the polls. So if the polls are right, there is going to be a negative Biden discount in the market to come as Trump's betting odds fall. On the other hand, if betting markets are right and the polls eventually start to tighten, we’re not going to see a big move like a pro-Trump rally because the market is already there.
And what’s number two?
Here’s a rational argument for last week’s ridiculous debate: About 95% of the country - and this is no joke - already knows who they are going to vote for. Whatever people thought going into the debate, is what they think after the debate. That said, only 60% of the public votes. So this election is going to be determined by turnout. Biden and Trump were not on stage to convince somebody to vote for them. They were trying to get people to actually do it.
Shortly thereafter, we learn about the Covid-outbreak in the White House and the President needs to get treated in the hospital. What do you think is going to happen on election night after all that drama?
My biggest concern is a «red mirage» or a «blue shift»: The mail-in balloting is expected largely to be Democrat, whereas in-person voting at polling stations is expected to largely skew Republican. Because of that, it’s very possible that on election night, Trump has enough votes to win the election, and comes out to declare victory. But then, as we start counting the mail-in ballots over the following couple of weeks, one by one states flip from Republican to Democrat, and by Thanksgiving, the election is gone the other way. I’m not suggesting any impropriety or fraud, but if that’s the scenario that plays out, I have a feeling that a lot of people won’t accept the outcome. They’ll think it was rigged and that the election was illegitimate.
How would the markets react to that?
This is not 2000 when the contested election came completely out of the blue and lasted 36 days. During that period of the time, the S&P 500 declined 13%. I think we won’t know on election night who won, and certifying the election results will take several days. If it doesn’t result in a legitimacy question, it’s largely a non-event for the markets. But if it takes a longer period of time, and it results in a question of legitimacy, that’s a big negative for the market. Even worse: If it gets really acrimonious with lawyers and everything else, and we get into January 20th and we don’t know who won, it’s a disaster scenario for the markets.
How does Covid play into this? Leading up to the first wave, you’ve been one of the very few market observers who saw the pandemic coming and warned early about the dire consequences for the economy.
Right now, Europe has the highest case counts. The virus is spreading especially in the UK, in Spain and in France. True, this time the case counts are resulting in less hospitalizations and less deaths. That’s possibly because we have better treatments and a better understanding of the virus. It’s also possible that this mutation is more contagious but less lethal. But death and hospitalization charts don’t really matter.
People’s mobility - their economic activity - and government policy are going to be determined on the case count. If cases go up, older people won’t go out and interact with other people. Also, no politician is going to say: «Cases are booming, but no one is getting really sick, so we won’t change our policies and roll back some of the shutdown.» Let me be clear: We won’t go back to April, but there will be policy measures to slow down the spread. You are starting to see that in the UK, for instance. There will be some roll back pulling down economic activity.
What does this mean for the US economy?
The question is if Europe and the Northern Plains - states like Wisconsin, Minnesota, North and South Dakota, Idaho, Montana, Wyoming and Colorado - are leading indicators. The situation is especially bad in Wisconsin, where they are openly talking about hospitals getting overrun. In addition to that, Wisconsin is a swing state, and if it winds up having a full blown Covid crisis by November 3rd, that could play into the election. At this point, I bet that you are going to see some kind of second Covid wave in the US, and I suspect we will get some roll back of the lockdowns.
How would that impact the financial markets?
As mentioned, by most measures the market is probably overvalued. The hope is that despite the market being a little bit ahead of itself, the economy will eventually speed up and justify these valuation levels. But if we get a second Covid wave, even if it’s not as lethal as the first one, it will retard growth enough that the economy will not meet those valuation levels.
There are already signs that the recovery is slowing. What’s the current state of the US economy?
According to high frequency data such as initial claims, restaurant bookings and mobility indicators, the economy bottomed in late March/early April, just like the stock market did. But then, around mid-July to early August, the recovery stalled. It’s not reversing, but it stopped getting better. We know that real GDP growth in the second quarter was the worst ever recorded at -31.4%. And we know that Q3 should be the best ever recovered with estimates near +28%. So we’ve gotten back around two thirds of the loss during the shot down.
What should be expected next?
Now, the recovery has stalled. Back in June, the consensus was expecting a massive growth quarter for Q4 of more than 11%. This forecast has been falling hard and is now just 3.6%. While 3.6% is a decent quarter, there are no assurances this forecast is done falling. The quarter is only seven days old and some economists are openly talking about Q4 being another negative growth quarter.
But isn't there also a chance that the economy could pick up steam again.
The medical bailout is still hanging out there. By that I mean a vaccine or a treatment. Today, there are several vaccines in Phase III trials. Thanks to Operation Warp Speed, the US government has already awarded massive contracts to start producing doses of all these vaccines now, and the military is putting together ways to administer them ASAP. So as soon as a vaccine is approved, they already have hundreds of millions of doses ready. But according to leading companies like Moderna or Pfizer a vaccine will not be ready until spring or summer 2021. That means a second Covid wave can really slow down the economy.
That’s why the financial markets are laser focused on a new stimulus bill. How likely is it that Republicans and Democrats will agree to a deal?
I thought a deal would come already in August. If you had a PPP loan or any of the bailout money from the earlier stimulus packages, part of the deal was that you will get your PPP loan forgiven or get a better deal on your bailout money if you don’t lay off anybody until September 30th. But now, we have airlines and other companies like Disney furloughing tens of thousands of people. Therefore, I expect a renewed push by both, the Democrats and the US administration, to get a deal. Both sides are afraid to be blamed for a giant jump of unemployment. So I’m operating under the assumption that we are going to get see at least some kind of partial deal.
In stark contrast to stocks, the bond market has hardly been moving until recently. It this bond market now finally waking up?
The bond market has seen one of its quietest periods in history. The MOVE index, the VIX index for the bond market, hit an all-time low last week. A main reason for that is heavy central bank intervention. Since March 13th, when the Fed ramped up QE, it has purchased $3.3 trillion of bonds, and it’s still doing 10 or 11 billion dollars a day. That has a big dampening effect. Another reason is yield curve control. Basically, that’s just price fixing where the Fed announces it will buy or sell as much bonds as it needs in order to keep interest rates at its target level. Well, with all that bond buying going on today, we virtually have already yield curve control, and it’s killing volatility. It’s killing interest in the bond market, and it is keeping rates low and stable.
The Fed’s strategy seems to be working for now. But what about the unintended consequences of these war like policy measures?
The game changer will be inflation. The recovery has stalled, so we are producing less stuff. On the demand side, 9 million people have lost their job since the beginning of the pandemic. That's why we’re artificially stimulating demand with government intervention. Less supply and more demand equal higher prices, and it’s likely that we are going to see a rise in inflation in the next year when the year-over-year comparisons get through the worst of the pandemic. Today, the core PCE - the Fed’s favorite metric - is around 1.25%. For me, inflation would mean a reading of 2.5 or 2.75%. Essentially, the last time the core PCE was at that level was 1993. If we get that, it’s going to be a real problem.
Then again, a rise in inflation is exactly what the Fed wants.
One of the things that’s larger than central banks is the market itself. The Fed wants to let inflation run because they want unemployment to go down. They’re sincere about that, but when the bond market decides that inflation is a problem, the Fed is going to be forced to react. Think about it this way: The Fed is like a post, and the market is a horse tied to that post. If you tie a horse to a post, it just sits there, and it doesn’t do anything for a while. But a horse is a 1500-pound animal, and if inflation spooks the horse, it will tear the post right out of the ground and run away. So yes, the central banks can control the bond market for some time. But when you spook it, it will rip that post right out of the ground and go, no matter what the central banks try to do to tamp down rates. My bet is that’s what’s going to happen in the second half of 2021.
What does this mean for risk assets like stocks?
I don’t think we have much more in the cards for the S&P 500 because I see too many problems: Stretched valuations, the election and a second Covid-wave. For now, they’re offset by the Fed. But I still contend that the 39-year bull market in bonds has ended on March 9th at 33 basis points on the ten-year treasury note. The next big move is going to be higher in rates. If I’m right, higher rates are going to be a big problem for all risk markets: stocks, credit and the whole nine yards.
How should investors position themselves against this background?
If I’m wrong and the yield on the ten-year note goes down to 33 basis points again, or we make a new low, this would mean we have another bad economic contraction, probably another recession. So what’s the best scenario for risk markets? The bond market stays asleep. If it wakes up in either direction, it’s going to be problematic. Higher rates mean inflation which is a problem for the bond market and filters into everything else. If rates plunge on the other hand, that’s an economic contraction and a problem for earnings.
What’s a good way to prepare yourself for more volatile times ahead?
The big thing I would emphasize is that the traditional stock-bond relationship is changing. That’s a fancy way of saying a 60/40 portfolio is not going to work as well as people think. You don’t have a natural hedge anymore when you put 60% in equities and 40% in bonds. At this point, the stock market really has to stumble in a big way, and you are not going to get as much help from the bond market. That’s why portfolio construction between bonds and stocks needs to be rethought. Gold can be a part of the solution, but gold is still a very uncorrelated asset. The negatively correlated asset for stocks used to be bonds, and there really isn’t any other one.
What else besides gold do you want to own in such an environment?
One of the interesting things happening in the stock market this year is the unprecedented dispersion of returns. On a year-to-date basis, the technology information sector is up close to 30%, and the energy sector is down 50%. That is a 80% swing from the best to the worst sector. Also, financials are down 20%. These are unbelievable dispersions. If you get everything right, but you own a little bit too much energy, you have a really bad year. In contrast, if you have everything wrong, but you wound up with a lot of FANG stocks, you are having a really good year. So sector positioning is going to continue to be a big play.
So what’s the best strategy when it comes to sector positioning?
I am not a fan of the financial sector, but I’m interested in the energy sector because it has been so eviscerated. Although, it’s a very speculative play. Also, I do like consumer staples and healthcare. Count me as one of those thinking that we’ve completely played the tech sector out. Sure, we’re talking on Zoom for this interview. But the fact that the entire US airline sector has an $80 billion market cap, and Zoom has a $140 billion market cap tells me that Zoom has likely done its thing. At this stage, everybody knows what WFH means. I’m not extraordinarily bearish on technology stocks, and I don’t think they are a short. But they have kind of run their course at this level.
How about investments outside of the US?
I prefer the US over Europe right now. With the second Covid wave, Europe is going to really struggle until it looks like the economy is going to return to normal. If we do get a vaccine, and people want to take it, a good play would be emerging markets. Once we do get back to normal, they will benefit more than everybody else. They are producers of stuff for the developed world. Today, the developed world is hiding in their house. But as soon as the developed world goes back to buying stuff, emerging countries will prosper. It’s a little bit early, but next year I will be looking at emerging market investments as well. What’s more, if you want to buy inflation protected securities, things like TIPS will play, too.