The Investor October 2020

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ShareFinder’s prediction for Wall Street for the next EIGHT months:


The State of Play

By Richard Cluver                  October 2020

Faced with one of the world’s highest unemployment rates, investors must be aware that the resultant growing social unrest in South Africa could lead to total economic collapse if it cannot be addressed soon. The crime wave engulfing our major cities is, in this respect, probably the portend of far worse to come.

Because, as an international borrower, our bonds are now listed as “Junk” by all the major ratings agencies, coupled with the fact that the Covid lock-down has decimated tax revenue, the Government now faces a stark probability that it will soon not be able to maintain both the public service wage bill and the now doubled unemployment and old-age benefits. The consequences of that in the light of our already existing social pressures, does not bear thinking about.

Never in our history has the imperative to unlock job-creating economic growth been greater but without a reliable electricity grid, growth must remain a pipe dream. Our key imperative, if we are to have any hope of a brighter future in our lifetimes, is to decisively deal with Eskom before it takes us all down with it.

In short, decades of ANC neglect have brought us to the end of the road and unless our power supply can be made reliable in the shortest possible time, disaster is probably inevitable. It is as stark as that!

Writing in the Financial Mail this month, Features Editor Shirley de Villiers quoted researcher Nic Spaull who neatly summarised the issue facing Government: “Now that the [grants] genie is out the bottle, it may be political suicide to try to put it back … Every month that someone does not go hungry because they receive R350 from the government is another month they move towards becoming single-issue voters: ‘Keep the grants’.” With elections looming next year, the ANC will be keenly aware of this.

But where is the money going to come from?

Economic growth is the only effective solution, in part because our ability to borrow is entirely governed by the extent of our national debt as a percentage of Gross Domestic Product. If we can increase our GDP growth rate our ability to comfortably borrow naturally increases. Simultaneously, of course, growth implies both increased tax income and fewer people on the dole and so it is the sole ‘win win’ factor that can get us out of the economic mess we are in.

It is clear that President Ramaphosa knows what needs to be done. What is not clear is how much support he enjoys within his executive to get things moving or, indeed, whether the majority understand the gravity of the problem we face. What is urgent is that the country get on and remove the imposts to growth. But what the public observes is a singular lack of momentum within Government circles.

Government has been very well briefed over some considerable time by acknowledged world experts and there is a broad consensus about most of what needs to be done. From Government the singular most important issue is the need to remove red tape which is making it difficult to achieve growth.

However, while periodic statements from official sources suggest that progress of a sort is being made towards resolving Government’s highly constrained political logjam, from the viewpoint of the ordinary investors, progress is painfully slow…if indeed there is progress at all. What is abundantly clear, even to the untutored view, however, is that the pace of reform has been grossly inadequate to date and it is equally clear to everyone that we no longer have the luxury of time on our side.

Should there be any doubt about the red tape hindering investment in this country one need only refer to the comment made by Anglo American CEO Mark Cutifani at the 2020 Joburg Indaba mining conference this month at which he noted that Anglo would like to explore for base metals across SA but the Mining Charter prevents that.“That’s something we’re interested in. We’re already in Zambia and other places. We want to do more in SA, so we are looking for some adjustments in the legislation, which we’ve made pretty clear to the SA minister,” Cutifani said as speakers at the conference bemoaned the lack of a regulatory environment and tax regime to encourage exploration.

Minerals Council SA CEO Roger Baxter pointed out SA attracted just 1% of global exploration expenditure of $10-bn a year. That foreign investors have run out of patience is made abundantly clear by the outflow of foreign capital. According to JSE data, foreigners have sold a net R54-billion of SA bonds this year taking the extent of foreign participation in our bond market at, 30.1 percent, to its lowest level in eight years. The steady decline of the JSE All Share Index at a compound annual rate of 4.7 percent since January 2018, in my graph, is further clear proof.

The red tape constraints to growth are well known to most readers, but to refresh your memory the most important are arguably the monster of the Bargaining Councils which lay down sector minimum wages and make it impossible for small business to compete with established big business because the small employer cannot achieve the required economies of scale. Ramaphosa talks of a new dawn of import substitution but if our labour costs are not competitive this initiative is dead before we start down that road.

BEE is another because it adds another layer of costs which make it impossible for local businesses to compete with the sweat shops of the Far East.

Freeing up the broadcast spectrum and revising the Mining Charter are other well-known imposts that Government is well aware of.

Overwhelmingly, however, it is the unreliability of our electricity supply and its high cost which poses the major constraint. The graph below courtesy of the Mail and Guardian, neatly illustrates why energy cost has become such a big problem. From an average of 14.98 cents per kilowatt hour in 2002 to 90.01 cents in 2019 and still rising rapidly, it is killing our economy.

https://bucket.mg.co.za/wp-media/2019/08/tiiJAiHORyFzLOXYtI9A_1etl.jpg

Our electricity costs more than twice that of most of the producer nations with which we compete. Standardised to the US Dollar, the average household cost of electricity in this country currently is 0.119 cents a unit compared with 0.08 cents in China, India, Vietnam, Argentina, Mexico and the UAR. Most African countries are far cheaper than SA ranging from Ethiopia’s, Zimbabwe and Libya at 0.01 cents, Angola at 0.02 cents, Zambia’s 0.03 cents, while at 0.06 cents there are Ghana, Malasia, Pakistan, Russia, Laos, Paraguay and Congo.

Worse, our system which allows municipalities to buy electricity as a wholesaler and then add on a varying profit margin is making it increasingly difficult for businesses to remain competitive within different regions of the country. Durban, for instance, at R1.8209 a unit which together with Vat represents a charge of R2.094 to the consumer is one of the highest electricity costs in the world. By contrast, Johannesburg has winter and summer power charges and applies a sliding scale which means that the lowest energy users can pay as little as R1.3545 per unit though it does rise to maximum of R2.1342 for heavy users who effectively subsidise the poor.

Just in passing then, it is worth noting that Portugal has just claimed the world record for lowest-cost solar generation in its latest solar auction which will deliver power at 1.31 US cents/kWh. That works out at just 22 South African cents a unit/kWh…..a tenth of what Durban consumers are paying!

On its own such costs are catastrophic if cities like Durban, which has the dubious distinction of also having the country’s highest rate of unemployment, wish to attract industrial development. Worse, however, has been the crippling rate of energy cost escalation which could almost single-handedly explain South Africa’s rapid rate of de-industrialisation and its escalation of unemployment.

Thanks to statistics by energy expert Sean Moolman, between 1988 and 2007, electricity tariffs increased by 223%, whilst inflation over this period was 335%. But, that was the good phase in our economic history, when our power utility was held up as a world leader. From the 2008 electricity crisis onwards, there is a clear and sharp inflection point for electricity tariffs in South Africa. From 2007 to 2019, electricity tariffs increased by 446%, whilst inflation over this period was 98%….a four-fold increase in 12 years.

https://www.poweroptimal.com/wp-content/uploads/2019/10/Eskom-tariff-vs-inflation-comparison-with-projections-2019-1024x670.pngFar worse, based on the currently approved increases for 2020 and 2021, the total increase in electricity tariffs from 2007 to 2021 will be 520%. By then, electricity tariffs would have increased more than 5-fold in 14 years. Moolman’s graph on the right tells the whole sorry story:

https://businesstech.co.za/news/wp-content/uploads/2018/11/Electricity.jpgInvestors hoping to see a long-term turnaround of the JSE downward trajectory need first of all to come to terms with this data and to use whatever leverage they might possess to impress upon the ANC that if it has any hope of returning to power in the 2021 municipal elections (some time before next November) it has only a few months left to demonstrate its intention to put action where its collective mouth is.

But it is not just about the cost of electricity. The key fundamental for economic growth is a reliable electricity supply. It follows that while load shedding remains a threat, we cannot hope to see any real prospect of attracting new industrial and mining development which, along with removing the Government red tape that has long strangled growth, are the most promising avenues of stimulating job-creation.

Eskom CEO André de Ruyter has repeatedly told Government that unless we can urgently build new generation capacity, load shedding will become an increasingly frequent fact of everyday South African life. A according to a CSIR report our energy availability factor ( that is the percentage of total generation capacity that is available at any given time from coal plants are that are old and creaky, and therefore increasingly unreliable) has fallen from 80% to 67% in just the past three years!

We need to get cracking to achieve the cheapest and most reliable sources of energy. The CSIR report makes it clear that if we do not act quickly we can expect load shedding by 2022 that is two to three times worse than we’re seeing today, and permanent load shedding by 2025 with as much as 20% of electricity cut off at any one time.

Coal, nuclear and gas plants take at least ten years to create, so that route is impossible. However, a number of commercial entities which currently have supply capacity could plug the gap if only Minerals and Energy Minister Gwede Mantashe would sign the necessary document! Thereafter wind and solar installations are the only solution because they can easily be can be built within the next two years when, the CSIR study suggests, our grid will go into terminal decline. It just requires the political will which, on currently available evidence, Ramaphosa’s executive seemingly lacks.

The best-reasoned report I have recently seen came from the Daily Maverick which argued that: “There is, however, a solution. But it will mean creating policy certainty for the first time and bringing to an end the political bickering about renewables. All this could be done at no cost to the state. The easiest way to avoid plunging South Africa into an energy-driven economic crisis that exacerbates the current “pancession” (and also potentially triggers a sovereign debt crisis) is to ensure that a handful of key decision-makers make the right decisions within the next three months. Millions will benefit.

“For the sake of the argument, let’s assume a stretch target of 25GW of new, reliable, fast-deployment generation over the next two to five years – that means solar, wind, storage and gas backup, because no other technology mix can be brought online this fast. This notional stretch target of 25GW is derived from the Meridian/CSIR report that envisages a ramp-up to a build rate of 5GW pa for the next 20 years, hence 25GW for the first five is not unreasonable.

Building out this low-cost generation infrastructure could become the most significant post-Covid-19 economic recovery boost.

It will trigger a huge jobs opportunity in the ongoing construction of more and more solar and wind sites (including self-generation), and in the upstream manufacturing and assembly of components (e.g. wind towers, panels, steel production).

On average, 10,000 jobs are created per GW of renewable energy (and this excludes the upstream jobs that will be created), plus 200 permanent operational jobs per TWh. But once you start building renewable energy, you cannot stop, because what you build this year (say 5GW), must get rebuilt in 20 years. To put this in perspective, there are 56,000 jobs in coal mines that supply Eskom – and they reduce over a long 20-year period as coal mines that service Eskom close (with most of these workers reaching retirement age during this time).

“To argue that the energy transition means fewer jobs is totally wrong. A just transition is a real, tangible, achievable reality that can be unlocked relatively easily. As far as the manufacturing plants and jobs are concerned, they could be concentrated in (the recently promulgated) Renewable Energy Development Zones to be located near coal mines coming offline where grid capacity is the most substantial (even though the wind and solar resource might not be optimal).

“Not only that, with South Africa’s ultracompetitive solar and wind resource, if we can tap into that, we can unlock globally competitive industries in South Africa, and start exporting goods produced on the back of this clean electricity around the world. We will be the preferred supplier compared with those still using dirty fuels to manufacture.

One example: fuels such as ammonia, which is what ships use, can be produced with “green hydrogen”. Green hydrogen is made from running renewable electricity through water using mature electrolysis technologies – a future that Sasol is seriously considering.

“Some of the 292 billion litres of water that Eskom used to run the coal-fired power stations in 2019 could be repurposed after the power stations close. According to Tobias Bischof-Niemz, one litre can make 9kg of hydrogen using mature well-known electrolysis technologies. This means 292 billion litres can make 33 billion kg of hydrogen. 

“The energy content of 33 billion kg of hydrogen is 1,287TWh of energy, or 4,633PJ of energy per annum. South Africa’s coal mines produce 6,100PJ of energy in the form of coal (which uses up two-thirds of this energy to make the final energy that comes out of a coal-fired power station). 

“The potential is enormous, which is why there are major new green hydrogen projects popping up around the world.”

Finally, the major argument against solar power is that it only operates in daylight. However, ever since Australia built a grid-scale battery storage system, that argument has gone out of the window. Utility-scale batteries have dropped dramatically in price: an 85% reduction since 2010. 

Perhaps I should end by noting that the greatest indication of the role these batteries have played in modern society is that the 2019 Nobel Prize in Chemistry was awarded to the three scientists who developed the lithium-ion battery, John B. GoodenoughM. Stanley Whittingham and Akira Yoshino. And of course, few readers cannot have heard of Pretoria born Elon Musk whose Tesla electric cars are beginning to take the world by storm. This month Musk announced the invention of a new battery cell, the “4680”, which provides five times more capacity and six times more energy than currently available – at a 14% lower price. Musk projected savings of 56% on the cost per kilowatt hour, which will bring the cost of running an electric vehicle to parity with internal combusion engines.

Last month Energy Gwede Minister Mantashe finally welcomed a Nersa determination that will enable his department to begin procurement of 11.8GW of power. But the matter dates all the way back to April 2015 which saw solar solar projects come in at 62 cents/kWh which even then would provide electricity generation 40 percent cheaper than a new coal plant. But such plants are far cheaper today. Remember the new Portugese installation at just 22 cents a unit.

Even though it has taken unacceptably long to reach this agreement, it is a welcome first step. But it does not go far enough. It will enable a good portion of “shovel-ready” renewable projects to be developed but relative to the 25GW gap, it will be insufficient to resolve load shedding by 2025. Mantashe wants to plug the gap with further coal plants which would compromise South Africa’s commitment by President Ramaphosa at the UN Climate Summit in September 2019, when he suggested a transaction that traded voluntary accelerated decarbonisation for $11-billion of concessional climate finance.

To understand what that means, South Africa is seeking to attract financial support to address Eskom’s financing issues and this support is premised on evolving South Africa’s power system to renewables. New construction of coal plants would compromise that potential large-scale investment.

In conclusion readers should note, however, that Gold Fields has been waiting for three years for approval for a 40MW solar project at its South Deep mine to reduce its reliance on unreliable Eskom. In August, Gold Fields CEO Nick Holland said the company was hoping to get regulatory approval for the project “in a month or two.” Don’t hold your breath!

Finally, recognising that the cost of servicing Eskom’s debt of R480-billion is such that even at our unaffordable power costs, the utility is unable to meet the interest costs, let alone fund further development, the good news about a solar programme is that the capital cost of new plants would come from the private sector, neatly solving the question of where the money is going to come from.

Nedlac’s social compact on Eskom sidesteps debt

BL PREMIUM

The social compact on Eskom, now finalised by stakeholders in the National Economic Development and Labour Council (Nedlac), contains a detailed set of measures aimed at improving the sustainability of the company but pointedly avoids solving the biggest problem: the utility’s R488bn debt burden.

Eskom is unable to service its debt from the revenue it generates and is dependent on bailouts from the state and the continual raising of more debt to pay debt service costs.

Its mounting obligations, most of which are guaranteed by the government, carry a high risk of default, which would have a knock-on effect on government debt obligations.

The idea of a social compact originated from a proposal by Cosatu in December 2019 to relieve Eskom of R100bn debt by selling an equivalent equity stake to the Public Investment Corporation (PIC). The proposal created alarm in business and investor circles and among pensioners whose savings in the Government Employees Pension Fund are managed by the PIC.

As well as the potential negative effect on returns on pension investments, business has argued that such a move would affect investor confidence and cast doubt on the integrity of SA’s financial system.

The compact outlines interventions in three main areas: “There is a need for a strategy to reduce Eskom’s debt level; to maximise Eskom revenue [and] to collect all outstanding debt; [and] to fundamentally change and reduce the cost structure and to ensure that all suppliers commit to integrity in negotiated prices for all goods and services supplied to Eskom.”

From these flow a variety of agreements and obligations, for instance: to install prepaid meters in all homes; for community organisations to mobilise and campaign against illegal connections; to review all Eskom contracts with a view to increasing efficiency and lowering costs; a review of the bloated management structure at Eskom, and other internal reforms to reduce costs.

But when it comes to what to do about the debt, the compact is vague, committing all social partners to “jointly mobilising adequate financial resources for Eskom. The precise financing mechanisms will be evaluated taking into account all options available,” it says.

Though not spelt out clearly, this does imply a joint commitment to mobilising private savings for investment in Eskom.

The compact says that “finance mobilised will provide investors with appropriate long-term, stable and reliable social and financial returns”.

The mobilisation of these resources must be done in a “financially sustainable manner to ensure the country’s fiscal resilience and in a way that does not compromise the integrity of the financial system”.

Investments made in Eskom must comply with the mandates of the financial institutions and their fiduciary duties and the principle of risk-adjusted returns, says the compact. Risk management processes must not be weakened.

A strategy to deal with Eskom’s debt problem was also a part of the brief of both the presidential panel of experts which reported to President Cyril Ramaphosa in the early part of 2019 and the Eskom roadmap produced by the department of public enterprises, also last year.

At the heart of these proposals was the question of whether or how a large portion of Eskom debt — R100bn or more — could be moved onto the government’s own balance sheet. This discussion has not advanced over the past 12 months, with Eskom instead receiving annual bailouts from the Treasury

Stocks Typically Climb, Regardless of Who’s in the White House

By Paul Vigna of the Wall Street Journal

http://i1.cmail19.com/ei/d/1A/84B/A1E/csimport/chart-b14eceb2a401aedbbc12c36c-8u.084305.png

For investors worried about how the stock market will fare in the event of a divided government or a sweep by either party in next month’s elections, history offers an important lesson.

Stocks tend to go up regardless of which party controls Washington.

From 1929 through 2019, one party controlled both chambers of Congress and the presidency in 45 of those years. The S&P 500 on average rose 7.45% during those years, according to Dow Jones Market Data. The index was up 30 times and down 15 times.

http://i2.cmail19.com/ei/d/1A/84B/A1E/csimport/chart-a404a5554d477e149fefe23b-8u.084801.png

In the other 46 years when there was a split government, the index climbed 7.26% on average, rising 29 times, falling 16 times and remaining unchanged once.

“We are not encouraging anyone to try and do anything heroic at this point,” said David Jilek, chief investment strategist at Gateway Investment Advisors, who still cautioned that anything can happen in financial markets.

Postelection selloffs have also been rare during much of modern history. The period between Election Day and Inauguration Day has been largely uneventful for the stock market. In 1968, 1976, 1980 and 1992—all elections that saw a new party win the White House—neither the S&P 500 nor the Dow Jones Industrial Average moved more than 3.2% in either direction.

For a longer version of this article online, follow this link.

Caught in a Debt Trap

By John Mauldin

John Mauldin
We’re caught in a trap
I can’t walk out
Because I love you too much baby

Elvis Presley’s rendition of Suspicious Minds topped the record charts in 1969. The lyrics portray a romance that couldn’t work, but was also impossible to escape. That’s also a good way to describe our relationship with government debt. We know it can’t last, but we can’t walk out. We love government spending and its benefits (like Medicare, Social Security, and unemployment insurance) too much.

In other words, we are in a debt trap. Our political process can’t reduce spending and/or raise taxes enough to balance the budget, so the debt grows and grows. As it does, paying the interest plus the accumulated debt load pulls more capital away from more productive uses. This depresses economic growth, thereby generating even more spending and debt.

This has to end, and I think it will do so in the event I’ve called The Great Reset. When I first started talking about The Great Reset, we weren’t in the debt trap. We were “merely” in a situation with only bad choices. I didn’t think we would make them. Thus the underlying presumption was that we would end up in a debt trap.

The Great Reset will be our escape from the debt trap. While there will be some winners and (probably more often) losers, it won’t be fun for anyone. And it all springs from the debt trap.

Today I’ll talk about how we got into this trap, why we can’t escape without completely resetting the taxation/spending structure, and what it is doing to the economy. Let me warn you: Some of this will get political—but not in the way you might expect.

Whatever your persuasion, you aren’t going to like this. Nor should you.

Diverted Capital

I have the great privilege of being able to talk to some of the finest economic minds in the country. Rarely a week goes by that I do not spend significant time on the phone with Dr. Lacy Hunt. He and Van Hoisington write in their most recent quarterly review, (a must-read) which I think is one of their most important about the economic environment we are in, including the debt trap. (Mauldin Economics VIP members and Over My Shoulder subscribers can read a highlighted version with key points summarized here.)

I’ll quote directly a few short points from the beginning of his letter (emphasis mine) and then we’ll do a deep dive into two of those points.

The conclusions of this analytical review are five-fold:

1) A very powerful secular downdraft has occurred in major measures of economic performance.

2) The US is caught in a debt trap, a term originated by the Bank for International Settlements: a condition where too much debt weakens growth, which elicits a policy response that creates more debt that results in even more disappointing business conditions.

3) The secular decline in economic conditions and the debt trap preclude the textbook conditions for powerful monetary policy measures to stimulate economic activity. Furthermore, debt-financed fiscal programs only boost the economy in the very short run, and ultimately reduce growth.

4) The secular deterioration in economic growth has created a condition of excess resources and disinflation.

5) The workings of the Fisher equation, which have brought Treasury bond yields lower, have been reinforced by a sharp decline in the marginal revenue product of debt.

They go on to amplify point 2:

The concept of the debt trap is consistent with scholarly research, from the 19th century to present, which indicates that high debt levels undermine economic growth. This causality is supported by the law of diminishing returns, derived from the universally applicable production function. Historical declines in economic growth rates have coincided with record levels of public and private debt. Total public and private debt jumped from 167.2% of GDP in 1980 to 364.0% in 2019, with an estimated record 405% at the end of this year. Gross government debt as a percent of GDP accelerated from 32.6% in 1980 to 106.9% in 2019 to an estimated 127% by the end of this calendar year.

As proof of this connection, each additional dollar of debt in 1980 generated a rise in GDP of 60 cents, up from 54 cents in 1940. The 1980s was the last decade for the productivity of debt to rise. Since then this ratio has dropped sharply, from 42 cents in 1989 to 27 cents in 2019.

[Sidebar: The usdebtclock.org with debt to GDP has 137.7%. I asked Lacy about this. Essentially, he uses the same convention Ken Rogoff uses, which doesn’t count some intergovernmental debt. He does this so that he can compare debt across nations without the distortion of different conventions of counting debt. Perfectly legitimate, as Lacy frequently compares international debt in his writing. By any measure, we are long past the point where debt negatively affects growth. We have entered the territory of Japan and Europe.]

Let’s unpack this. Debt, even government debt, isn’t necessarily bad. It can actually be positive depending on how it is used. Borrowing to build a productive asset can make sense, if its output is sufficient to repay the debt and then produce even more.

Like many other temptations, debt can be good in moderation but destructive if abused. Some infrastructure spending doesn’t have a direct payoff, but clearly helps the overall economy, like the US interstate highway system.

Let me offer a few illustrations. It seems that every congressional representative gives lip service to the concept of “infrastructure spending.” And they never really get around to doing it in any sufficient quantity. Airports are necessary infrastructure and are typically paid for by landing fees. That’s productive debt.

I have read that much of the US loses as much as 20% of the water our water systems produce due to leaky pipes. To rebuild the national water system would take hundreds of billions if not over $1 trillion. Congress can easily allow the formation of a public-private partnership and guarantee the bonds so the Federal Reserve could buy them. Cities could access those bonds and raise the cost of water by 1% or so to pay for the bonds. Consumer water bills should still drop since we would be saving 20% of the lost water.

Everyone knows this. Congress does nothing. The same could be done with electric power. A smart grid could pay for itself even with debt costs. And consumer power prices would likely go down. I could go on and on.

But the debt we are accumulating now is not productive in that way. We use it to finance current expenditures like Medicare and Social Security. Necessary? Absolutely. But not the economic definition of productive debt.

Problems arise when debt grows excessive, relative to the output it will produce. The costs of repaying it diverts capital from other uses, leaving less capital available for productive investment. You start needing more debt to generate the same amount of production. Or, said another way, each additional dollar of debt produces less GDP. Lacy calls this “debt productivity” and it dropped from 60 cents in 1980 to 27 cents in 2019.

Debt service comes from taxation and even more borrowing (which is the definition of a Ponzi scheme), which leaves businesses and families less money to spend on other things. This results in lower economic growth, inflation, and interest rates.

Why is it a trap? Here’s where I have to get political.

Fiscal Futility

To those on the conservative side, the problem is simple. We have excessively high taxes and debt because the government spends too much.

That’s easy to say but gets a lot more difficult when you talk specifics—particularly if you are a member of Congress who must answer to voters. Exactly which government spending would you like to cut? What programs, departments, and agencies would you eliminate? Every dollar the government spends has a constituency—people who benefit from it, and will fight to preserve it.

Large amounts of spending are essentially on autopilot: Social Security, Medicare, assorted social programs, interest on the debt. These “mandatory” expenditures happen automatically, no matter the amounts, without Congress acting at all. The simple fact is that this mandatory spending plus defense spending is now consuming all tax revenue before any other government services are paid for on the federal level.

The so-called “discretionary” budget that Congress votes on (defense and all the assorted departments and agencies) is relatively minor. You could cut it all in half and we would still have a serious problem.

When Trump entered office the US deficit as percentage of GDP was less than 5%. The deficit for fiscal 2020 will be about 16% of GDP, or $3.1 trillion. The CBO estimates $1.8 trillion for fiscal 2021 (plus the off-budget debt they never mention) but that doesn’t include a stimulus package of close to $2 trillion that will be passed at some point. That will raise the deficit to much more than 2020’s, no matter who wins the election in a few weeks.

Sad to say, government spending just keeps growing no matter which party is in power. We have crossed some form of a political Rubicon where past performance is not indicative of future results. The few serious fiscal conservatives are now gone after finding the Republican Party under Trump spends differently than Democrats would, but has no desire to spend less.

In 2018, 39 Republican House members didn’t run for reelection. Another 22 literally “left the House” in 2020. I know a few of them personally. They were deficit hawks. They were also in the senior Republican leadership. They know the constituency for controlling government spending is simply not there.

And that’s the real problem: Voters like all this spending. They differ on priorities but no one really wants to balance the budget. There is no desire to make the sacrifices and endure the pain it would take to change the course we are on. So, it won’t change, and debt will keep piling up.

Raising taxes, as a Biden administration would probably seek, would in fact help the budget deficit if they didn’t also plan to add even more spending than the new taxes would collect. So that’s not a solution, either.

To be clear, sometimes debt makes sense. Congress should have passed another economic relief package months ago instead of playing the present pre-election games. We are in a dire national emergency. Adding debt to address it would be less problematic if we hadn’t piled up so much non-emergency debt.

Jaws of the Trap

Debt, as I have said many times, is future consumption pulled forward in time. It lets us consume more today by consuming less in the future. There is a school of thought which says this doesn’t matter because we can always just keep pushing the due date further out. I disagree, and Lacy Hunt’s research explains why.

While debt can be a problem, debt is also critical to economic growth. It finances innovation and adds to the economy’s productive capacity. Excessive debt diverts resources away from investment, without which growth slows to a crawl. Lacy proves this mathematically but really, all you have to do is look at GDP growth around the world since 2008. Europe, Japan, and the US have all struggled to maintain positive growth. It was only a matter of time until something pushed us all underwater. The pandemic did it.

This is why interest rates are so persistently low. Our aggregate debt burden reduces growth, which reduces demand for credit while also increasing the supply of credit. Lower demand + higher supply = lower prices. Interest rates are the price of money.

Lacy explained his fourth point in a short section you should read several times until it sinks in.

Falling real yields and inflationary expectations, via the Fisher equation, force government (risk-free) bond yields lower. But full application of the law of diminishing returns is also at work. Diminishing returns occur when a factor of production, such as debt capital, is overused. This observation is confirmed by the decline in the marginal revenue product of debt.

Economic theory demonstrates than when the MRP [Marginal Revenue Product] of a factor declines, the price received for that factor also declines. If, for example, labor is overused to the extent that its MRP declines, so do wages, the price of labor.

Thus, the decrease in MRP of debt due to its overuse indicates that interest rates, the price of debt, should fall. This is exactly what is happening in all the major economies of the world that are suffering from a debt overhang.

[JM note: from conversation with Lacy. Wages can decline several ways. Either they can directly go down or businesses can hire fewer workers. The combined effect to the economy is the same.]

Thus, considering decreasing interest rates as an inducement for governments to spend more borrowed funds will add to the severity of the debt spiral. If policy makers are incentivized to borrow more because interest rates are low, then the MRP of debt will fall, leading to even weaker growth.

Moreover, interest rates are lowered indirectly by poorer growth and inflation, and by a further fall of the MRP of debt. Thus, the whole premise of Modern Monetary Theory is flawed at the core. The low interest rates are not a potential benefit for the economy, they are a result of the overuse of debt.

At some point, you would think interest rates will have to rise. And in a totally free market that would be the case. But you can bet (as the market does) that the Federal Reserve will step in and implement yield curve control, further distorting the market and hurting savers. This financial repression has severe negative consequences on retirees.

We are enduring this recession as well as we are because debt-financed spending programs sustained many (but not all) workers and businesses. That may not be an option next time.

All that being said, this can continue far longer than most people think. Japan is now at 260% of debt to GDP. Eurozone debt is about 86%, but that understates the true situation in most countries. Europe and Japan both have low or nonexistent GDP growth. The explosion of US debt means the US will soon join them. The answer from almost every economist of any stripe about how to fix the debt problem is to “grow our way out of it.” The problem is we have passed the point of no return.

We can’t stop growing debt. That would bring down the system in a true greater-than-the-Great Depression crash. What do you cut? Social Security? Medicare? Military pensions? Education? Interest payments on the debt? The State Department? The only way to maintain that spending is to keep adding debt, which sends us further into the debt trap.

At some point, this will simply stop working. That moment is when the world will face what I call The Great Reset. I am often asked exactly when it will happen. The simple fact is I don’t know. My best guess is toward the latter part of this decade. I simply believe/know we will reach a point where everything has to change, and so it will.

In the song I quoted above, Elvis sang,

We can’t go on together
With suspicious minds
And we can’t build our dreams
On suspicious minds

In a debt trap we’ve turned this around. We already built our dreams on excessive debt. Now we can’t go on together.

We’re caught in a trap. We can’t walk out.

Anomalies in Paradise

I never knew how much exercise I got simply traveling. Just walking around stretching my legs at conferences and airports, trying to get a little gym time, etc. Now that I sit reading and writing entirely too much, which ultimately makes me stiffer, I am having to spend more time in the gym and walking on the trails around here just to avoid becoming a chair potato.

But then, I do come across lots of good material and I get a lot of thinking time out on the trails. For instance, my friend Tony Sagami sent me this:

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_1_20201016_TFTF.png
Source: Investing.com

It makes sense when you think about it. A few tech stocks are basically driving a bull market even as we face the worst recession in 80 years.

I read a lot about how inflation is coming back. And my answer is, well, yes, but not the way you think. We’re going to get another stimulus package which, combined with supply chain destruction, will be inflationary. But when that wears off the general deflationary trend caused by massive debt will kick back in.

But in the meantime, we will get lots of hysteria about how 1970s-like inflation is returning. I suppose there is a nontrivial chance of that, but it’s not how I would bet. I think we will be stuck with deflation and low rates for a very long time. After the election, I intend to write on what tax-and-spend policy would actually help us out of the crisis we are approaching.

Spoiler alert: We will need to completely revamp our tax code, with a greater percentage of GDP going to taxes than any of us want. But we’ll have to collect it differently and not destroy incentives as Europe and Japan have done. Sadly, I don’t expect a willingness to do that, at least political willingness, until we are already in the middle of a deep crisis. The good news is we will get one, and maybe change some things.

And with that I will hit the send button, and schedule nine holes of golf with some good friends this afternoon just to get my body moving. You have a great week! And by the way, here are a few links if you’re interested in following up the whole debt trap concept.


Great Reset Update: $50 Trillion Debt Coming

By John Mauldin 

Amid all 2020’s new problems, it’s easy to overlook the old ones. Yet they are still there and, like a silently spreading virus, silently getting worse.

One such problem is debt, and specifically government debt. All debt shares one common characteristic. A bill comes due at some point and, if the borrower doesn’t pay, the lender either loses their money or finds someone else to pay. Governments often do this.

I’ve warned for several years now that our growing global debt load is unpayable and we will eventually “reorganize” it in what I call The Great Reset. I believe this event is still coming, likely later in this decade. Recent developments suggest it will be even bigger than I expected. You could even say I’ve been too optimistic.

The federal debt problem has grown considerably worse than my admittedly somewhat gloomy 2020 forecast said to expect. It will get even worse. But I’m still optimistic and you should be, too.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_1_20200925_TFTF.pngAbsurd Assumptions

Way back in June 2019, I wrote a series of letters responding to Ray Dalio on government debt and related issues. In one of them I showed a series of spending and revenue charts my associate Patrick Watson prepared from Congressional Budget Office projections. Here is the primary one, exactly as published in June 2019.

Again, the underlying spending and revenue numbers came straight from CBO. They make numerous unrealistic assumptions yet still show a bleak picture. I noted at the time:

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_2_20200925_TFTF.pngUnder these projections, total federal debt will rise to $25 trillion sometime in 2021. If there is a new president, he or she will not have enough time to change that. Total debt by the end of the decade will rise to the mid-$30-trillion range. Note that these projections do not include off-budget spending (more on that later) which is significant.

The CBO also assumes the bond market can and will absorb almost $35 trillion worth of US government debt. When combined with state and local debt it will easily exceed $35 trillion. (State and local debt is already over $3 trillion. It will certainly rise in the next 10 years.)

I also asked what would happen if we had a recession in 2022. I assumed revenue and spending numbers would look similar to the Great Recession in the following chart, demonstrating that the deficit would rise to over $2 trillion annually and pretty much stay that way for the rest of the decade. It turns out we had a much deeper recession this year in 2020. I was such an optimist… Anyway, this was my forecast in January 2020:

Now let’s fast-forward. The CBO just published its latest review. We updated the chart with CBO’s new numbers. It looks a little different now.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_3_20200925_TFTF.pngThe most obvious change is a big spike in the blue “Mandatory Spending” area. That’s the unemployment and other benefits triggered by the recession. Less obvious is a small dip in tax revenue, after which the line continues upward as before. Even with the optimistic V-shaped recovery assumption, revenues barely cover mandatory spending (basically entitlements and social programs), defence, and only a little of the actual interest costs.

Let’s dig into that a little more. Here is a table summarizing federal revenue. The 2019 line is actual, the rest are CBO projections.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_4_20200925_TFTF.pngWe see that in this severe recession year, CBO expects federal revenue will drop 4.8%, then fall another 1.2% in FY 2021, followed by a 14.8% surge in 2022. Definitely a rocket-fueled V-shape recovery. Realistic? I don’t think so.

In 2008 federal revenue fell 1.7% and then plunged 16.6% in 2009. It didn’t fully recover until 2013, three years after the recession ended. And that recession was mild compared to this one.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_5_20200925_TFTF.pngEven more absurdly, CBO projects payroll taxes will actually rise this year despite record-high unemployment. Now, it’s true that the unemployed population tends to be lower-income workers (so far) with smaller tax liabilities. And payrolls were normal until almost halfway through the fiscal year. But for revenue to actually rise seems unlikely. It stretches credulity to think total US worker income will be slightly larger in 2021 than in 2019. But that’s what CBO forecasts.

This matters because these revenue assumptions go into the deficit estimates, which tell us how much federal debt will grow. (Spending assumptions are also absurd but set them aside for now.) Note, also, the substantial and uninterrupted revenue growth they project from 2022 through 2030. The last remotely comparable period was the 1990s.

It projects this revenue growth because it projects uninterrupted GDP growth, and especially high GDP growth in the next few years. These assumptions will be important at the conclusion of this letter.

Is CBO all wet? I think not. I think the very smart wonks who make these forecasts try their best. CBO is mandated by law to make the projections under current law as written and forced to make (within guidelines) positive projections. They don’t have the luxury of assuming there might be a recession in the future.

You wouldn’t hire a financial planner who used software that was guaranteed to give you an unrealistic projection with nothing but positive assumptions. Yet that’s what we do with the CBO numbers.

Breaching $50 Trillion

In my 2020 forecast letters, published in January as the pandemic was just gaining attention, I revisited the charts above and noted this:

When we do have a recession, which again I point out is likely to be after the election (the only meaningful data point between now and the end of next year), the deficit will explode to over $2 trillion per year and, without meaningful reform, never look back. That puts US debt at $35 trillion+ by the end of 2029.

According to CBO, this deficit which I gloomily said would be over $2 trillion in a recession year will be more like $3.3 trillion. I was an optimist.

What does this do to the national debt? First, we have to define some terms. You’ll often see numbers for “debt held by the public” or something similar. These exclude amounts the government owes to internal entities like the Social Security trust funds, military pensions, and other “we owe it to ourselves”-type funds. Those trust funds are running down at some point and those bonds will have to be repaid or sold into the market just like any other form of government debt. There is no such thing as owing it to ourselves. Not in the real world. It sounds good if you’re a politician trying to ignore or minimize debt. This ostrich-like head in the sand approach courts disaster.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_6_20200925_TFTF.png“Total Public Debt” is more inclusive, and at the end of FY 2019 it was approximately $23.2 trillion. If the latest CBO estimate is correct, it will be well over $26 trillion when FY 2020 ends on September 30.

If we plug that into CBO’s revenue and spending estimates through 2030, we get something like this.

Note again, this is the official CBO data. You don’t often see it this way because they usually express it as a percentage of GDP instead of raw dollars. Their own numbers now show an almost $38 trillion debt at the end of 2029, far more than the also-alarming $35 trillion I estimated earlier this year. Again, I was an optimist.

But CBO is optimistic, too. Some very slight and quite reasonable adjustments show the debt will be trillions higher by 2030. Below is the same table again with these changes:

  • We reset revenue to change by the same annual percentages it did in 2008 and the following recession and post-recession years. That actually raises 2020 revenue a bit, after which it drops considerably lower than the CBO estimates.
  • We take CBO’s spending projections and add 2% to each year, which I think is a fair and maybe even conservative expectation.
  • We add $269 billion in yearly off-budget spending, which is the average since 2000. (You can take almost any 10-year period out of the last 20 and get close to that $269 billion average. Some years it has over $500 billion and some years it is negative. But the average is eerily consistent.)

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_7_20200925_TFTF.pngEverything other than the above three changes is the same. When I asked Patrick to make those assumptions for the next table, we both knew that it would increase the total debt. I still admit to being quite surprised when I saw the final number. Here is the result:

Under these (more likely) assumptions, the debt will breach $50 trillion in 2030. I bet it happens even sooner, because we probably won’t get through the 2020s without some other event blowing out the numbers—another recession or pandemic, an expensive war, who knows. But history suggests something will occur, with significant fiscal effect.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_8_20200925_TFTF.pngFor those who prefer cool graphs, here is that $50 trillion in a simple line graph:

“Turning Japanese, I think we’re turning Japanese, I really think so.”

But Wait, There’s More!

The CBO projections follow the government’s fiscal year, running from October 1 to the end of September. It is projecting a deficit of a little over $3.3 trillion for fiscal 2020.

Note that the CBO can only project current law. I expect House Speaker Nancy Pelosi and President Trump will agree to a “Phase IV” economic relief package well north of $2 trillion.

Without another relief package the economy will fall into a depression by the end of the year. Neither party wants that. But that means adding another $2 trillion to the 2021 deficit, pushing it over $4 trillion.

Here is where the wonderful www.USdebtclock.org says we are today:

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_9_20200925_TFTF.png

You can click on any of the numbers at that website for an explanation and sometimes deeper links. This is just a small section. It tracks almost everything. On the left-hand side of the visual above, the third set of boxes show actual US federal spending and the budget deficit. When you click on the box labelled “US Federal Budget Deficit (Actual)” the definition includes off-budget spending. They project over $1 trillion in off-budget spending this year. Ouch! And they are not including the $2 trillion Phase IV relief package either.

We are so going to blow through $30 trillion total debt sometime early next year, making my milder projections wildly wrong. Just a year ago, I naïvely expected it would be 2025 before we got to $30 trillion, and we would be short of $40 trillion by 2030.

Add an additional $2 trillion in Phase IV and the debt will easily be $40 trillion by 2025, and $50 trillion before the end of the decade.

MMT Coming

The next question is how will we finance all that debt. Americans and a shrinking group of foreign investors have been surprisingly willing to buy as much paper as Washington can print, even at near zero (or below zero, adjusted for inflation) interest rates. But there are limits, at least in theory, and they may draw closer if the global recession drags on.

The most obvious solution is for the Fed to buy whatever amount of bonds Treasury needs to sell using quantitative easing. Powell is definitely willing. Depending on how the Fed disposes of its bonds, it might be the practical equivalent of MMT. And the Fed’s willingness will not be lost on a future Congress, which could easily decide to test the limit. $50 trillion could just be the start.

The other question is what effect all this federal debt will have on private markets. Will it have a “crowding out” effect that reduces private lending? How will it affect legitimate business and investment activity? We’ll see the result in lower growth.

Remember, we aren’t just talking about federal debt. States and local governments owe over $3 trillion more, plus trillions more in unfunded state pension liabilities, some of which could easily end up at the Fed or Treasury. Then there are the wildly underfunded pensions (both government and corporate) that could easily default and force some kind of federal takeover. Plus corporate bonds, mortgages, student loans, auto loans, SBA loans…

I will probably be referring to this letter in five years when it becomes clear that the debt will be hitting $60 trillion or more as the US government takes on state and local liabilities and we find ourselves in another recession. I will be admitting that my $50 trillion projection was way too optimistic. Sigh. Double sigh.

You may be a debt-free, prudent investor but the fact remains, you are also a citizen and taxpayer. We are collectively in hock up to our ears. Some of this will end up on your shoulders and mine. Not a pleasant thought? Exactly. Which is why I expect a Great Reset. A real economist would probably call it Debt Rationalization. We will reach a point where it becomes the least-bad alternative.

The Consequences of $50 Trillion of US Debt

  1. Raising taxes will not solve the problem. Of course, it could help reduce the deficit some but it would be more of a token. That is just the reality. From the Tax Foundation here are the real numbers as of 2017.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_10_20200925_TFTF.png

If we double taxes on the top 25% it would only bring in another $1.3 trillion, assuming people didn’t change their behaviour. (A 75% marginal rate plus 4% Medicare for a 79% top rate certainly will change behaviour.) A less-shocking 20–25% increase would only bring in about $3-400 billion, and would have to raise rates on incomes above $83,000. Not exactly the rich. They already think they pay their fair share.

If we raise taxes next year in the teeth of a recession it will only make the recession worse. If we raise taxes but they don’t actually take effect until 2023 and then get phased in? That would probably avoid creating a double-dip recession.

One reason we cut corporate taxes was to make US companies more competitive. It worked. Do we really want to lose that? Not to mention what it will likely do to the stock market. Just saying…

  1. I know I keep saying this, but debt is future income brought forward. There is a point at which debt becomes a drag on US economic growth, and we have likely reached it. GDP growth in the US is going to increasingly look like Japan and/or Europe, i.e. almost nil. So, the CBO’s continued 2% average growth forecasts will simply get thrown out the window and the deficits will get worse. Ceteris paribus, ipso facto, QED and FUBAR. Don’t shoot me, I’m just the messenger.
  2. It is possible I’m being overly pessimistic about the need for a Great Reset which would include national debt. Japan reached 250% debt to GDP a few years ago, since which the Bank of Japan bought around half of total government debt (back of the napkin numbers) and Japan is doing just fine. The European Central Bank is buying anything not nailed down and is muddling through.
  3. Let me point out that while the practical results of quantitative easing look similar to MMT (modern monetary theory) the actual results and practice are completely different. I am not persuaded that the US Congress can understand the difference. Dear gods, I hope they can.

I was explaining this to a friend last night. He asked me what we should do, somehow believing that there has to be an answer. There isn’t one. We have no good choices left. It is as if we are on a trip through a desert and know for certain we don’t have enough water to go back. We don’t know where the desert ends, but we have to go forward.

That’s the reality. Unless you want to cut Social Security and Medicare, ignore military pensions, sell the national parks, abolish departments like State and Treasury, cut the defence budget in half along with Homeland Security, Education, Labour, the Justice Department and the FBI, etc. we are going to have to live with the $2 trillion deficits. In good years. There are no better choices.

We are going to learn how much the US can borrow before it all collapses around our ears. I have no idea where that point is. It’s probably a lot more than any of us currently believe. Japan is continuing to borrow, as is Italy and the rest of Europe. And China, etc. Sigh.

  1. While all of this is happening, we will continue to see accelerating technological transformation. I believe within five years we will have something that looks like the Fountain of Middle Age, and within 10 to 15 years actually make you younger, while at the same time beating cancer, heart disease, and so on. It will truly be the age of technological marvels.

There are going to be phenomenal investment opportunities. We will have to be very conscious of how we handle our portfolios, especially towards the latter half of this decade.

That being said, I am currently making the largest percentage-wise single investment that I’ve ever made in a company (which is private so I can’t mention it) that I believe will have phenomenal dominance in its market within 10 years. It is one of the biggest markets in the world. Things like that are going to be happening more and more and more.

So yes, I fully understand that $50 or $60 trillion of US debt is a problem, but I’m not going to ignore the opportunities in front of me. I fully believe that the 100,000+ entrepreneurs who have lost their businesses are not simply going to sit on their derrieres and do nothing. It is in their DNA to launch new ideas. They will keep creating opportunities and jobs.

I think of myself as a realistic, rational optimist. I can admit the problems that we have with our government, debt, and political partisanship and still want to be long humanity and believe in a powerful future. You should too.

The Stock Market Is Less Disconnected Than You Think

By Nathan Tankus

Its a tired cliche of economic commentary that the stock market is “disconnected from the real economy”. A few weeks ago the Financial Times adviser ran an article with the headline “investors look to bonds as equities ‘detach’ from reality”. 

It’s not just news articles though. Heather Boushey, “unofficially” one of Biden’s top economic advisers according to the New York Times, had an op-ed in the Washington Post ominously entitled “The stock market is detached from economic reality. A reckoning is coming.” A strange thing happens when you get towards the end of these articles, though. It turns out, the “stock market” isn’t as disconnected as it may seem at first blush. 

Boushey says in the seventh paragraph that: “It’s not just that indexes such as the S&P 500 — representing 500 of the largest — skew big. It’s also that a subset of truly giant corporations is driving market gains. The S&P 500’s increases have been led by five companies: Apple, Amazon, Microsoft, Facebook and Google’s parent, Alphabet.”

Yet, Boushey doesn’t follow up on this point. The dominance of a handful of huge firms gets lost in a series of claims about how the Federal Reserve is boosting the stock market by “speculation”. 

The key issue here is that people reference what is happening with the “stock market” all the time, but what they usually mean is “stock market indices”. In this vision, these indices “tell us” what’s going on with stocks. So if they are up that means “stocks are up,” and if they are down “stocks are down”. This may seem to offer a simple and reliable guide, but does it?

The trouble with this kind of thinking is that these indices self-perpetuate trends. Companies’ relative places in these indices are weighted by the total value of all their outstanding stocks, referred to as “market capitalization”. Thanks to this, trends in price indices are exaggerated relative to actual stock prices. Stocks that go up in value become a bigger part of the index, while stocks that fall in value inherently shrink. 

In this kind of structure, indices will only represent overall economic trends when stocks nearly uniformly rise or fall together.

In the Coronavirus Depression, this is inherently unlikely because social distancing and shutdowns radically change consumption patterns. These conditions boost sales for specific industries and collapse sales for others. This is what’s driving tech stocks: their sales have simply been greatly boosted. 

While it’s certainly the case that there has been momentum trading, and that these stocks may have gotten over-priced at specific points, it’s hard to tell a narrative about elevated speculation driving these trends. Why that, rather than the more typical process by which sudden changes in economic circumstances lead to adjustment, overshooting and readjustment? 

This means to really glean information about what’s happening with the stock market, we must disaggregate the indices.

Disaggregating the S&P 500

To start with, it’s worth pointing out just how many companies listed in the Standard and Poors stock index have seen negative returns on their outstanding stock. Our first chart of the S&P 500 index compares the distribution of returns as of 9/18/2020, compared to 2/19/20 (when the index hit a high prior to the crash). 57% of companies in the index saw negative returns since the beginning of the year as of 9/18, compared to just 38% back in February. 

In this graph, you can see in the data that companies have really gone wildly different directions as a result of the pandemic. Only 10% of S&P 500 companies had returns less than -25% in February, compared to 23% as of 9/18. At the top of distribution of returns, less than 2% of companies were up more than 25% in February, versus 11% now.

https://cdn.substack.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F92e02c78-c898-4de0-a47b-b8085e2f29d6_1350x900.png

There is one big area you can say that the stock market is disconnected from the economic outlook— size. By definition, it tends to be bigger companies which are on the stock market. So inevitably the stock market can’t capture the thousands of small businesses that are failing. Yet, even here, disaggregation of the S&P tells us a lot. Again, there is a wide and sharp dispersion right now, with average returns for large firms a lot higher than smaller firms. This wasn’t the case in February. More than half the companies in the index have less than $25 billion in market capitalization, and the average year-to-date return for all these companies (equally-weighted) is negative.  

https://cdn.substack.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2Fc49c338d-42d6-4b78-9622-dd1e62582d35_1350x900.png

The clearest indication that the stock market is being driven by economic fundamentals is that growth and declines in sales so easily explain stock market returns. If stock market returns and the “real economy” were very disconnected, we’d expect the sales factor to be submerged in a sea of speculation. Instead, the chart below shows us another story. Once returns are broken down by sales growth, we see dramatic differences based on sales growth and decline. Returns are in fact highest for companies with the strongest year-over-year sales growth. Among those with sales growth greater than 20% are familiar companies like Amazon and Netflix, but also much smaller companies like Nvidia and Paypal. In other words, tech stock returns are being driven by tech sales.

https://cdn.substack.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F5d6c9dcd-e724-4259-8cb4-a586113a98c7_1350x900.png

This seems to show much more matching between sales and returns than our stock market sceptics would have us believe. Companies that have seen sales collapse have seen hugely negative returns. Companies that have seen big jumps in sales, have seen big returns. Companies that are treading water in sales are also treading water in stock returns. It’s hard to see from this data any reason to think the stock market is particularly disconnected from the ‘real’ shape of things. 

This does not mean that stocks, especially the ones that have really run up in price, are avoiding overvaluation. However, that is a different question. If there are overvalued stocks, it is likely caused by companies that have seen the biggest sales growth leading to overoptimistic expectations of future sales growth. Overconfidence reflects the economy and beliefs about the economy, while none of us know the future. But this is a generic point, not an argument for setting aside consideration of the stock market. Stocks with the highest valuation, as measured by forward price to earnings ratio, have in fact gained the most year-to-date. 

https://cdn.substack.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F6b39decf-be26-4bd8-86e0-e6cd4d9dc1a5_1350x900.png

 Meanwhile, the momentum has flipped in the other direction over the course of September. Stocks that were up the most year-to-date, through 9/2/2020 fell the most on average as of 9/18/2020. If at some point this year Federal Reserve interventions propped up the stock market by “financing speculation”, it doesn’t seem to be now.

https://cdn.substack.com/image/fetch/w_1456,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F522dc671-38f2-4ecc-ae19-e16c879844bd_1200x900.png

Of course, if the stock market doesn’t do a great job of capturing the fortunes of small businesses, it really doesn’t do a good job of capturing how well workers are doing. But workers are not the economy. If people really mean that the stock market doesn’t reflect workers’ economic circumstances, they should say it. That mismatch is also something that’s obvious, and clearly true all the time. Even here, overall sales were supported by the now expired ‘stimulus’ checks and supplementary unemployment benefits. 

To the extent those elevated sales represented labour’s economic circumstances, the stock market reflected it. Without making any predictions, it’s likely the stock market will continue to reflect sales as they taper off. More generally, workers do tend to benefit from high sales growth. Those factors spill over into a tighter labour market, as J.W. Mason’s new paper points out. The lesson here is that to understand what’s going on, we have to peer past the price indices, and examine the stock market in far more detail.

I thank Sonu Varghese for the data and charts in this article. 

Blackouts and debt are top risks, Reserve Bank says

Growth is likely to return to pre-crisis levels only by 2023

BL PREMIUM

Electricity shortages and the country’s precarious fiscal position are likely to be the biggest obstacles to SA’s recovery from the Covid-19 crisis says the SA Reserve Bank.

Though monetary policy has provided substantial support to the economy — with the Bank cutting benchmark interest rates to a record low of 3.5% — the pace of the recovery will depend on factors outside the Bank’s control such as improved sovereign debt sustainability and structural reforms, the central bank said in its latest monetary policy review.

Load-shedding, which reached its worst levels in 2020 despite the collapse in activity under the lockdown, remained a binding constraint on the economy, said governor Lesetja Kganyago in a briefing after the review’s release. “If we do not sort out the issues of energy security, then we will be choking investment in this economy,” Kganyago said.

Alongside this the state’s dire debt levels, which could reach 140% of GDP by the end of the decade without steep spending cuts and reforms, are a second stand out risk to SA’s recovery, the Bank said.

The review’s release comes ahead of the much anticipated medium-term budget policy statement, which is due later this month. Finance minister Tito Mboweni will provide an update on the extent of the pandemic’s effects on the fiscus and will outline promised reforms to reboot growth.

The Bank expects the economy to contract 8.2% this year before averaging 3.9% and 2.6% in 2021 and 2022, respectively, but warned that growth will return to pre-crisis levels only by the second quarter of 2023.

Severe headwinds

The economy is, however, expected to rebound from the record 51% seasonally adjusted and annualised GDP contraction reported in the second quarter during the worst of the lockdown restrictions. The Bank is forecasting a 45.2% uptick in the third quarter off this low base.

“The most important question now is whether this recovery can be sustained,” it said, warning that the headwinds to growth are severe. Load-shedding is likely to interrupt activity for at least another year as Eskom’s ageing generation fleet produces less electricity while requiring more maintenance, and as new capacity remains behind schedule, said the Bank.

Meanwhile the state’s high debt levels are likely to affect the recovery through several channels, including “confidence effects and uncertainty” as well as crowding out private sector investment, a lower country credit rating and reduced access to foreign savings.

Though many sovereigns have seen debt climb to “uncomfortable levels” during the crisis, SA is an outlier “both for the scale of its borrowing and for its weak starting point”, the Bank said.

SA’s debt levels are likely to reach 81.8% in 2020, well above the broad emerging-market average of 63.1%, according to the Bank.

Despite SA’s R500bn fiscal stimulus package being the sixth largest among fellow developing countries and policy rate cuts being the second highest among emerging-market countries, SA’s expected GDP outcomes were among the worst.

Though the Bank has faced criticism for not taking more dramatic policy action, Kganyago again underscored that the Bank has acted with “scale and speed”, cutting the policy rate by 300 basis points this year to the lowest level implemented in about 47 years.

Low interest rates

At its last monetary policy committee meeting in September, the Bank put a pause on the aggressive cutting cycle maintained through the crisis, shifting to what it termed on Tuesday a wait-and-see strategy.

With domestic interest rates at record lows and inflation apparently having bottomed out, it is likely that the repo rate will move higher in future, the Bank said. But this normalisation “is likely to be gradual, with rates staying at low levels for an extended period”, it said.

Though the MPC has not committed to any specific path for interest rates, its modelling suggest that rates will still not be back to pre-crisis levels by the end of 2022.

Alongside the steep cuts, it has reduced regulatory requirements on commercial banks to promote lending through the crisis and has purchased government bonds in the secondary market to help inject liquidity into the financial system. The Bank has since eased up its purchases — slowing them dramatically in August as conditions have continued to normalise…

Govt spending restraint the only option

brian kantorBy Brian Kantor

Central Banks have more to offer a distressed economy than lower interest rates. They can supply their economy with much more of their money in the form of the deposits they supply to their private banks. They can add as much money to the economy as they deem necessary, by lending more to their governments, private banks and businesses.

If the banks and their borrowers respond favourably to these monetary injections, the supply of private bank deposits and of bank credit will increase by some multiple of any additional central bank money. The extra money and credit created will then be exchanged for goods and services, the labour to help produce them and exchanged for other assets.  Higher share prices, more valuable long dated debt, and real estate, translates into more private wealth, leading to less income saved and more spent. Helping to relieve distress.

Lockdowns have disrupted output and sacrificed the incomes of businesses and the households and governments on a large scale. Getting back to an economic normal requires a mixture of increasing freedom and willingness to supply goods services and labour. It also needs more spending to encourage firms to wish to produce more and hire more workers and managers. Money creation on a very large and urgent scale is helping to stimulate demand almost everywhere. M2 (that is bank deposits) in the US have grown by nearly 25% over the past twelve months. QE is working very rapidly this time round.

The SA Reserve Bank has adopted a very different strategy and rhetoric. It has decided that it has done all it can for the economy by cutting its repo rate by 3 percentage points to 3.5%. It has rejected any QE that might have reduced pressure on interest rates at the long end of the yield curve. It argues that a structural inability to supply over which it has limited influence, is the cause of our economic distress, not the weak state of demand.  Go figure as they would say in New York

Yet perhaps all is not lost on the SA monetary front. The deposit liabilities of the banks (M3) had grown by about 11% by August and the supply of Reserve Bank money is up by 12.5% p.a. in September compared to the year before. This represents a marked acceleration. Much less helpfully bank lending to the private sector was up by only 3.9% p.a. in August. The difference between the growth in bank deposit liabilities, up 11% and assets up by about 4%, is accounted for by a large increase in the free cash reserves of the banks, of about a net R60b in 2020. That is the cash on their books less all their repurchase agreements with the Reserve Bank and others have become less negative.

The banks have been provisioning against loan defaults on a large scale. These provisions reduce their reported earnings and therefore dividends. It therefore increases their cash and free reserves that are reflected as an increase in equity reserves. A process that is reversed should the bad debts materialize.

The banks invested a further and significant R110b in additional government debt between January and June 2020. Very helpful to a very hard pressed fiscus, but also crowding out lending to the private sector. The currently very steep slope of the yield curve adds to the attraction of borrowing short to lend long to the government. It also implies that short rates are expected to increase very dramatically over the next five years. Unless inflation or real growth picks up very surprisingly, the very much higher short rates implied by the yield curve seem unlikely. Borrowing short to lend long seems like a very good and profitable strategy for SA banks and others. Borrowing short and rolling over short term debt rather than borrowing long, at much higher rates seems like a good idea for the RSA.

This all leads to an undeniable conclusion. Any revival of the SA economy will depend on realizing lower real long-term interest rates and flattening the yield curve. It will bring lower real required returns for any business that might invest more in the SA economy, essential if the economy is to pick up any sustainable momentum.   Only a credible commitment to restraining government spending over the longer run can lead SA out of the stultifying burden of very expensive capital.


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