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Burgess COMMENTARY Peter Burgess | ||
Dystopia Now
Summary
I) 'Lifeline' On a blinding Saturday morning, while squinting unhappily at a too-big pile of mail through a pair of Helmut Lang aviators on the back deck, the cover of the April 13 edition of The New Yorker stuck out. It's a piece by Pascal Campion called 'Lifeline.' In it, a worker delivering something essential (food, probably) stands under a lighted awning amid towering high-rises and rings the buzzer. Just a few feet away, his bicycle rests precariously against a light pole. It's raining. It's dark. The streets are deserted. The visual is, to quote Françoise Mouly, who interviewed Campion, 'a nod' to the essential worker 'and to his place in a silenced metropolis.' Describing the cover, Campion told Mouly the following: I started not with the feel of the city but with my own emotions. I felt dark, lonely, a little scared, and I built a city—based on New York—out of that feeling. Instead of choosing shapes, I chose lights and shadows. I worked on textures first and added details later. Eventually, I got to a point where all I needed was a small visual anchor to make the image representative rather than abstract. In this case, the delivery man became the recipient (and embodiment) of my emotions. 
Staring at the cover I felt suddenly out of place in the world - even more detached from the rest of humanity than usual. My reality is the opposite of Campion's 'Lifeline,' and thereby the opposite of the reality experienced by the millions upon millions of people living through the most acute public health crisis in a century. My reality on Saturday is lonely, but certainly not dark. I'm wearing pastel knits that tend to get caught in the thorny arms of the airy wicker porch furniture. And it hasn't rained in what feels like weeks. One fixture of any good dystopian film or novel is the ubiquitous outsider. Sometimes (but not always) this person is the protagonist, and there's usually some manner of backstory that explains why he (or she) lives outside the main population centers, which are unfailingly overcrowded and usually run by cabals of criminals, elites, or both. Inequality is pervasive and life is typically some combination of treacherous and annoyingly cumbersome for everyday people. Technology's role is almost always antagonistic, and very often serves to perpetuate some system of social stratification. All of this varies from novel to novel, and from film to film, but if you're thinking of writing a dystopian book and selling the rights to a movie studio, those are some generic guidelines. I suppose I'm playing the role of the outsider in our real-life dystopian future, and while I'm no stranger to the outsider bit, the total economic and societal collapse is as new to me as it is to the rest of you. I'm fortunate to be observing it from outside the 'walls.' II) Surveying the collapse Early on in the world's ongoing waking nightmare, I suggested it might be best to close markets and suspend the release of economic data. Leaving aside the myriad good arguments for why closing markets is counterproductive, and taking as a given that if closures are to last for any length of time, you'd need to create a mechanism whereby investors could access some kind of liquidity based on the assets they own (but can't trade), the futility of investing in this environment becomes clear when you realize that virtually all of the most important questions for market participants are suddenly unanswerable. JPMorgan's Marko Kolanovic was out this week with a lengthy rationale for why US equities will ultimately reclaim record highs in the first half of next year. In it, he captures the current dilemma. To wit, from Marko: If the business is closed for 3 months, quarterly revenues will drop to zero. With the earnings near-term negative, if the business is to be worth anything (e.g., $1), P/E will effectively be infinite. Once the business opens, and earnings come back, the P/E will drop from infinity and normalize to some long-term sustainable level. Kolanovic is constructive on equities over the medium- to longer-term (contrary to what you may have read, his outlook is based on the suppression of rates and credit spreads by the Fed, not on 'sunshine'), but as I put it on Wednesday, the bit about buying stocks implicitly trading at a multiple of 'infinity' in the near-term is what has some market participants worried. Remember, corporate America was already in an earnings recession headed into the pandemic, albeit a shallow one. Expectations were for a 'hockey stick' rebound. Those dreams have been shattered. 
(Heisenberg) So far in earnings season, things aren't going particularly well. 'Of companies reporting, 28% have missed consensus EPS by more than a standard deviation of analyst estimates, a rate that would represent the largest share in the 22 years for which we have data,' Goldman's David Kostin wrote Friday. 'Only 36% of stocks have reported EPS beating analyst estimates, the smallest share since 2008.' That bodes poorly for the remainder of Q1 earnings and it goes without saying that barring some manner of miracle, profits in the second quarter are going to be severely impaired. Big bank earnings showed provisions for losses more than quadrupling over the first quarter. That's hardly surprising, but it gives you an idea of what's coming in terms of missed payments, credit events, and defaults. 
(Heisenberg, company filings) For what it's worth, Wall Street's traders saved the day for the banks in Q1 as volatility led to increased client activity, cushioning the blow from the reserve builds. But, as Morgan Stanley was keen to note in the color that accompanied their report, there is no guarantee that trading results will be similarly buoyant in the difficult quarters ahead. So, how do you value equities when earnings completely collapse due to an engineered shutdown? You can't. Or at least not in the very near-term. Goldman's full-year, top-down estimate for S&P 500 earnings is just $110. That means that if the S&P were to make it back to 3,000, the multiple would be in excess of 27 - in the middle of the worst economic downturn in a century. 
(Heisenberg, Goldman) We're in a broadly similar situation when it comes to economic data. How do you capture and quantify economic activity when that activity is forbidden by government decree? PMIs, for example, have been rendered almost entirely meaningless. In France, the flash read on the services PMI for April was 10.4. For the eurozone more broadly, it was 11.7. The composite gauge printed 13.5. 
(Heisenberg) Those figures are so bad – and so wide of consensus – that once this crisis is over, market participants may fairly reconsider whether these particular types of economic indicators are useless at the extremes (i.e., during obvious booms and outright busts). There is no informational value in a PMI that prints 11.3. In the US, the jobless claims figures have obviously grabbed all the headlines and for good reason. Assuming the recession began in Q1 of 2020 (i.e., taking December’s non-farm payrolls report as the last data point), the US created around 20.5 million jobs over the longest expansion in history which, going by the NBER’s official start date, began in June of 2009. Over the past five weeks, America has effectively seen the entirety of those gains wiped off the board. The red dot in the visual shows what is now a large net loss over the period. 
(Heisenberg, NBER, BLS) That is by no means a definitive assessment, and there’s quite a bit of implicit extrapolation, but it helps to put the last five weeks in perspective. The bottom line is as follows. There is no economy currently. Not in major, western nations anyway. The manufacturing sector hasn't completely rolled over yet, but the services sector simply ceased to exist starting late last month. To help illustrate the point, I’ve updated a visual I frequently use to help capture the scope of the malaise for America’s small businesses. For those who don't follow my work elsewhere, a quick explainer is in order. The data I tap into for this comes from Homebase, a scheduling and time tracking tool used by more than 100,000 local businesses covering 1 million hourly employees. According to numbers current through April 21, hourly employees working at local businesses are still down around 60% (and more, on weekends). Hours worked fell as much as 75% on April 12. 
(Heisenberg, Homebase) The data compares a given day to the median for that day of the week for the period January 4 to January 31. That’s how Homebase captures the effect of COVID-19. According to the company, Homebase’s customers in the US consist mostly of restaurant, food & beverage, retail and services and are largely individual owned/operator managed. That makes this data particularly well-suited to this situation, given the pain is concentrated in the services sector, and particularly in food & beverage. The message is clear: Main Street isn't just hurting, it is disappearing in a very literal sense. As Atlanta Fed boss Raphael Bostic warned earlier this month, 'May is going to loom large, in terms of the transition of concern from this being a liquidity issue… to this perhaps translating and transferring into a solvency issue, and whether companies can exist at all.' III) I'll need to scan your passport Following the latest claims release, ING delivered a somewhat depressing quick take on the numbers. Consider the following from a Thursday note: If we assume unemployment has risen 20 million in April, that would push the unemployment rate to around 16%. An additional 10 million unemployed in May and we are looking at an unemployment rate of around 22%. Thankfully this is below the 24.9% peak experienced in 1933, but we have to remember that one third of Americans aged 18-65 are not classified as employed or unemployed – they are students, early retirement, homemakers, carers or sick. This leads us to yet another sobering statistic – that less than half of working age Americans will be earning a wage next month. In an election year, this means that the call for politicians to re-open the economy is only going to get louder, irrespective of the health advice.Some states are, in fact, reopening their economies against the advice of health experts, with Georgia being the most prominent example. Leaving aside that state's rather cavalier decision to allow even high-contact businesses (e.g., salons, spas and tattoo parlors) to reopen, other states are pondering a more nuanced approach. In true dystopian fashion, it appears as though we may be moving towards the institution of 'immunity passports' or 'risk-free certificates,' based on antibody testing. Nearly 14% of 3,000 New Yorkers tested in a state program were positive for antibodies to the coronavirus, Andrew Cuomo revealed, on Thursday. More than a fifth of those tested in New York City (21.2%) had the marker. The implications are clear. Some 2.7 million New Yorkers may have been infected. That was 10X the official, confirmed total, as of Thursday. In a sign of vociferous debates to come, a prominent city health official cast doubt on whether these types of tests can be depended upon to project 'durable immunity,' and on Friday, the World Health Organization said the following: Some governments have suggested that the detection of antibodies to the SARS-CoV-2, the virus that causes COVID-19, could serve as the basis for an “immunity passport” or “risk-free certificate” that would enable individuals to travel or to return to work assuming that they are protected against re-infection. There is currently no evidence that people who have recovered from COVID-19 and have antibodies are protected from a second infection. I've read (at least) a half-dozen sell-side reports which mention the distinct possibility that, going forward, economic life in population centers will entail the scanning of these 'passports,' perhaps via bar codes on smartphones. 'Once an individual takes a test and determines that they either have already had COVID-19, or currently do not have it, then they can be cleared to resume normal life,' Deutsche Bank's Jim Reid mused, in an early April note. 'This proof could be managed through the use of smartphone-based technology (a bio-passport?) if privacy concerns can be addressed,' he added, noting that 'those who either have the virus, or who are in higher-risk groups, can continue to self-isolate.' Social stratification and the passing of smartphone, bar code tests as a prerequisite for leading a normal life sounds like science fiction – but here we are. Chile said earlier this month it will begin offering just these types of “immunity passports” to people with antibodies, the first such official program in the world. IV) Administered prices In order to stave off economic and financial oblivion and buy time for humanity to sketch out the contours of what our post-COVID future will look like, policy makers both monetary and fiscal have deployed aggressive stimulus. Deutsche Bank rolled up the fiscal and monetary support programs announced and implemented in the US and Europe into a single 'bailout' figure. The sheer size of the COVID-19 response necessitated a log scale (on the left axis) in order to help 'better identify the earlier bailouts and get a rough feel visually for the numbers,' as the bank put it. Here's that visual: 
(Deutsche Bank) It is, quite simply, the largest bailout in history. 'Obviously we won’t know how much will be used until much further down the road,' the bank cautioned, in the course of presenting the numbers and accompanying visuals. For their part, UBS has doubts as to whether the measures announced across all economies (both advanced and developing) will be sufficient. 'Whether the stimulus is remotely enough remains to be seen,' the bank said, in a note out last week, adding that 'the hit to global activity is severe.' By 'severe,' UBS means that if you compare their forecast for the contraction developed markets will likely suffer in the second quarter, that forecast is three times larger than even the worst quarter from the financial crisis. Part of the policy support entails central banks announcing unlimited buying of some assets and what might as well be unlimited buying of others. The Fed said Friday it will cut Treasury purchases to 'just' $10 billion per day next week under its open-ended program, but remember, that pace (which represents a marked slowdown from the furious accumulation seen during the weeks in and around the worst of the panic) would have been unthinkable during pre-COVID iterations of QE. The latest update shows the Fed's balance sheet has grown by more than $2.4 trillion since early March. It will likely hit $7 trillion within weeks. 
(Heisenberg) The annualized monthly purchase rate of ETFs by the Bank of Japan at one point hit nearly 18 trillion yen in March (the BoJ upped its commitment to ETF purchases last month, and is expected to announce new easing measures imminently). The ECB now has 'PEPP' (the pandemic QE program) in addition to 'regular' QE, and this week followed the Fed in announcing support for fallen angels (assets which met the criteria for ECB programs as of April 7 will be grandfathered in, even if they are downgraded). While everyone who understands what's going on (for lack of a more precise way to say it) recognizes the utility in the Fed's myriad liquidity facilities aimed at unfreezing crucial funding markets and ensuring the world has access to US dollars, some feign incredulity at the support for credit markets. Howard Marks, for example, lamented the credit backstop in one of six memos he published recently. Here are two representative excerpts: What’s the Fed’s purpose in buying non-investment grade debt? Does it want to make sure all companies are able to borrow, regardless of their fundamentals? Does it want to protect bondholders from losses, and even mark-to-market declines? Who’ll do the buying for the government and make sure the purchase prices aren’t too high and defaulting issuers are avoided (or doesn’t anyone care)? Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called 'moral hazard.' Normally, I'm as big a fan of Howard Marks as the next guy, but I've grown weary of generic 'moral hazard' arguments. They are a dime a dozen and frankly, don't apply in the current environment. In addition (and I'm going to recycle some language from a note I penned earlier this month), there is nothing new about the questions Marks asks in the passages above. They are good questions. But we’ve been asking them for years both directly and indirectly. Directly, vis-à-vis the ECB and BoJ’s sponsorship of corporate credit and equities, for instance. Indirectly, because is not what the Fed is doing simply making what was tacit, explicit? After all, what does engineering a “hunt for yield” mean if not, as Marks puts it, “ensuring that all companies are able to borrow regardless of their fundamentals”? My point isn’t to say that Marks is wrong. Rather, it’s simply to say that policymakers have been deliberately suppressing volatility, compressing risk premia, tamping down credit spreads and keeping the market wide-open for borrowers for the better part of a decade. To be fair, though, it does at least feel as though we've ventured into surreal territory. Is it possible that part of our new dystopian reality will be administered prices for all types of assets? Early this month, Deutsche Bank's George Saravelos addressed this prospect. 'There is no such thing as a free market anymore,' he began, in what I affectionately called 'a requiem dressed up as an FX strategy piece.' He continued as follows: In a matter of weeks, policymakers have become a backstop for private-sector credit markets. At the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks. With unlimited capacity to print money, central banks have unlimited capacity to intervene in asset markets too. Put simply, a central bank that pegs bond, credit and equity markets is highly likely to stabilize portfolio flows as well. Imagine our dreary dystopian metropolis - picture Pascal Campion's 'Lifeline' with a futuristic feel. There's a break in the rain. The sidewalks and streets are red-tinged glass as puddles reflect the city lights. You're looking out from an alley. A girl walks by holding her umbrella. Above, today's prices scroll across a ticker tape. 
(Heisenberg, Pexels, Pixabay, Unsplash) Videos of the daily price-setting press conferences play in a loop, as they do every night from 8 PM to 9 PM on every electronic billboard from New York to London to Tokyo. They say it promotes 'transparency.' It's important, they say, for the public to understand 'the process.' V) When abstraction collides with the tangible Economic data and asset prices ostensibly reflect something real, whether that means the production of goods, the provision of services, cash flows, operating income or even sentiment, which, while hard to measure, is real too. Although monetary accommodation in the post-GFC world impaired price discovery, we mostly spoke in terms of engineered disconnects between prices and fundamentals. In some cases, those disconnects became patently absurd. For example, some European corporates saw their entire curves go negative last summer, which effectively meant that for those companies, debt had become an asset. Sovereigns which had no business tapping the market at all based on fundamentals were able to borrow at what, just a decade ago, would have been low rates even for a developed economy. And on, and on. But, in all cases, there was still something there. The prices for fixed income may not have represented the risk associated with a given borrower, and equities were of course distorted by the very same dynamics (as the voracious appetite for corporate issuance allowed management teams to plow the proceeds from record bond sales into EPS-inflating buybacks), yet through it all, sovereign borrowers still had tax bases. There was still an economy to reference. Corporations, even unprofitable ones, still had operations. Now, there's a very real sense in which the underlying 'stuff' (so to speak) does not exist. Economies are shuttered. Tax payments have been delayed. Rather than take in revenue, governments are handing out cash. Businesses are idled. Corporate titan after corporate titan is withdrawing guidance. This is a temporary state of affairs, but the point is simply that some of the assets you own are, for the time being anyway, claims on things that don't exist. This raises (very) uncomfortable questions. Last Monday, as the May WTI contract was busy careening to a deeply negative settlement, a friend asked me about the right way to frame it for something he was writing about oil ETFs. I told him it barely makes sense to analyze the situation when there’s no storage capacity. I spent hours documenting every twist and turn in oil's historic week, but the most crucial point is that there was something existential about the situation. What happened last Monday in oil is another example of financialization bumping up against reality – a dramatic example of abstraction colliding with the tangible. 'There's nowhere to put the stuff and nobody needs it,' Nomura's Charlie McElligott said, before asking the following: And without storage – since you cannot take physical delivery – then what is the utility of the futures contract itself? I'll answer that: There is no utility. The chart below (which uses a continuation series running back nearly to World War II) doesn't make any sense. It is meaningless. And that is precisely the point. 
(Heisenberg) You may or may not have noticed this, but CME had to switch to Bachelier options pricing to cope with this situation. The Street will presumably have to do something similar. What do you do, for example, if your desk sold puts to a producer looking to hedge against falling prices and your model assumed oil was bounded at zero? If that assumption doesn't hold, your losses are theoretically unlimited. That position could blow up the entire firm. (That won't be allowed to happen, but you get the point.) That excerpted line from McElligott (above) resonates not merely as an assessment of current market dynamics, but as a broader comment on the extent to which, at times like these, we’re forced to confront a harsh reality – namely that the instruments we dabble in as market participants cease to have any real meaning beyond certain thresholds. We've hit that threshold on a number of fronts. These abstractions of ours - futures, bonds, equities or whatever else - have temporarily ceased to have any meaning by virtue of the fact that the underlying reality they represent now looks totally different than it did just four months ago. VI) A castle in the sky Over the last two months, many Americans were forced to begrudgingly come to terms with a rather grim reality. As businesses large and small closed their doors amid the engineered shutdown (an 'induced coma,' as JPMorgan puts it), it became readily apparent that the largest economy on the planet is something of a castle in the sky. That castle is built on what, at best, is the flimsy foundation of late stage capitalism. At worst, the entire system is inherently unstable, based as it is on massive negative convexity at every node. Believe it or not, there is a pseudonymous blogger whose musings on the intersection of economics, finance, and geopolitics are far more profound than my own. His social media following is sparse, and he posts only occasionally to his own Wordpress blog. I reached out to him last week to get his take on the state of things, and specifically on the negative convexity aspect. He got back to me and eventually summarized his thoughts in a comment posted elsewhere. On Saturday, I asked if he would mind my sharing it with readers on this platform. I could think of no better way to close this piece than with his brief thoughts, which I'll present below without further comment. With mortgages, the homeowner has an option to refinance. Therefore, the issuer or the owner of the mortgage bond is short an option. That is why MBS have higher yields than Treasuries. Similarly with credit. If a corporation issues a (defaultable) bond, they have a right to default (stop paying coupons or principal if their business doesn’t work out). The owner of a corporate bond has sold an option to the issuer and has a higher yield in return. So, both MBS and credit markets are negatively convex because they have an embedded short option. At the point of issuance, both refinancing options and default options are far out of the money, so that convexity is small. But if the market moves towards the strike, that negative convexity becomes substantial. This is a problem if the move is systemic because everyone wants to exercise their option at the same time. This is really not much different than selling insurance and then everyone who owns the policy comes to collect simultaneously. That is clearly an unstable point of the market. Now let's look at the same dynamic from the perspective of the broader economy and our current circumstances. For a consumer in question, if they have a job, they will continue to pay their obligations. But in principle, they can decide not to - they are always long that option, but are unlikely to use it. Or at least not all of them, all at once. But if a large number of them loses their job, their option not to pay will be forced. That triggers the chain reaction which exposes the collective insolvency of the entire underlying system. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
The Heisenberg ... The Heisenberg Report (28,959 followers)
| Apr. 26, 2020 11:49 AM ET The text being discussed is available at | https://seekingalpha.com/article/4340027-dystopia-now and |