What’s On Fire

March 10, 2020

“The fundamentals of the U.S. economy remain strong.”

That was the unfortunate opening line, provided by the Trump administration, of the statement by Federal Reserve Chairman Jerome Powell announcing the Fed’s between-meeting, “emergency” half-point rate cut Tuesday on account of the global spread of the coronavirus and the anticipated economic consequences therefrom. However, as the economist John Kenneth Galbraith reminded in his Introduction to The Great Crash, 1929:

“Always when markets are in trouble, the phrases are the same. ‘The economic situation is fundamentally sound’ or simply ‘The economic situation is fundamentally sound’ or simply ‘The fundamentals are good.’ All who hear these words should know that something is wrong.”


Something indeed is (at least potentially) wrong. Even so, the Fed is doing what it can, but its tools are limited: “a rate cut will not reduce the rate of infection — it won’t fix a broken supply chain,” Powell warned. Moreover, the Fed can’t “print a vaccine,” it can’t “help companies deal with delayed orders or an infected workforce,” and it can’t “get people to go out.” What’s needed is what Powell called a “multifaceted” response – first and foremost a competent and effective health policy (which there are very good reasons to doubt) and, secondarily, a carefully enacted fiscal policy, neither of which are in the Fed’s toolbox (although the president signed an $8 billion funding bill to deal with the coronavirus last week). Still, the projected economic problems seem largely temporary, empty hotel rooms notwithstanding.

Worse, at least for the markets, is that the Fed pulled the fire alarm without pointing out the fire.

It’s clear that problems – potentially big problems – are looming, but they don’t appear to be here yet. The G-7’s finance ministers and central bankers talked Tuesday morning and produced a statement that the market found disappointingly weak. The Fed’s precipitous action came shortly thereafter and despite still generally strong economic data. A between-meeting “emergency” rate cut suggests that another is likely at the next regular meeting…in a week-and-a-half.

What does the Fed know (or fear) that the market doesn’t? The Fed’s latest beige book suggests that U.S. firms could be in for a significant slowdown in March, but anecdotes are not data. Service businesses are seeing some lower demand, but not to a level that screams, “Emergency!” Without evidence of a real fire to this point and without any clear idea of what’s burning, the Fed’s abrupt action limits an already limited toolbox of responses and suggests that it has lost control or succumbed to political pressure.

Bond markets were on fire (rallied hard) in a flight-to-safety trade last week, and that mostly happens when some other big thing is on fire (but not in a good way). After falling sharply the previous week, the yield on the benchmark 10-year U.S. Treasury note tumbled further following the Fed’s rate cut, moving below 1 percent for the first time in history on Tuesday and then reaching a new record low of 0.66 percent on Friday before rising a bit into the close. Despite violent price action in stocks both up and down since the rate cut, bond markets have continued to push yields lower – into historic territory such that real yields are below zero – and haven’t taken a break from the unrelenting pressure.

That’s never happened before. On a risk-adjusted basis, the long-bond has outperformed every S&P 500 stock since its most recent peak yield (3.4647%) in November 2018. President Trump wants more. He wants negative interest rates. Already in record territory, there’s no way to know if rates will continue to go down or by how much.

What does the bond market know that we don’t? What’s on fire?

Nearly 100 years ago, Frank Knight made his famous distinction between risk and uncertainty. In neither instance do we know for sure what will happen? However, when we know the potential outcomes in advance, and perhaps even the probabilities thereof, we’re talking about risk. Think dice or poker.

On the other hand, when we don’t know the possible outcomes in advance, and thus their relative probabilities, we’re talking about uncertainty. Think complex systems like economies or the global spread of a dangerous virus.

When markets are volatile, you can count on the financial media to point to uncertainty as a cause. However, we all face uncertainty over and over every day. The uncertainty trope takes center stage when we recognize how uncertain life is – how little we know – as with the breadth, scope, and impact of a global pandemic. We don’t deal with uncertainty very well, especially at the extremes. That’s why we routinely overpay for insurance policies and lottery tickets.

Even when we know (or at least someone knows) about a specific fire, real or metaphorical, there will always be many, many more fires and potential fires “out there.” When we think uncertainty is somehow limited or contained, we delude ourselves.

Something is always on fire, somewhere. But we’re not usually as aware of it as we are right now.

If you hadn’t been paying attention last week, you might have thought the market was no big deal…mostly up a little. If you were paying attention, you had quite the ride.

Last week saw the second week of extraordinary volatility driven by COVID-19 fears. The large-cap benchmarks and the tech-heavy Nasdaq recorded gains, thanks to sharp rallies on Monday, Wednesday, and late Friday, but the smaller-cap indexes ended modestly lower. Monday-Thursday saw alternating moves of at least 2.5 percent, with Friday seeing moves of at least that size in both directions.

Within the S&P 500, the typically defensive utility sector performed best. Health care shares were also strong after the prospects of “Medicare for All” seemed to diminish following former Vice President Joe Biden’s excellent Super Tuesday performance. Energy shares again led the declines as U.S. oil prices plunged to multiyear lows on Friday following OPEC’s failure to convince non-OPEC member Russia to agree to production cuts.

Stocks seem more skittish than fragile, but that may be a distinction without a difference. When the market jumps, in either direction, lots of people are jumpy, too. Accordingly, the markets rode a rollercoaster last week, coming full circle to nowhere.

European shares resumed their decline last week, wiping out earlier gains triggered by hopes for coordinated stimulus efforts. The pan-European STOXX Europe 600 fell 2.21 percent. Germany’s DAX slipped 2.77 percent, France’s CAC-40 declined 3.18 percent, and Italy’s FTSE MIB dropped 5.25 percent. The UK’s FTSE 100 slid “only” 1.75 percent.

In Asia, Japan’s Nikkei 225 declined 1.86 percent while Chinese stocks – counterintuitively – continued to rise. The Chinese government continues to provide substantial policy support to bolster the flagging economy there. The Shanghai Composite closed 5.4 percent higher for the week, while the CSI 300 large-cap index gained 5.0 percent, despite sharp losses on Friday.

It is possible, perhaps likely, that in a few weeks or months COVID-19 will have been contained, with limited economic damage. However, to this point, that is far from certain.


In The News…

This would be an important point even without coronavirus. A 2019 survey found that, on average, people touch their phones 2,617 times per day. These devices generally host 10 times more bacteria than toilet seats, mostly because people don’t commonly clean them as often. Wash your hands. Then wash your phone. Here’s how. Hand sanitizer, an aloe vera concoction with 60 percent alcohol by volume, was projected to be a $5.5 billion product by 2024 before COVID-19. Why doesn’t somebody make one that doesn’t smell? Oh, and stop touching your face.

On Tuesday, a day in which the Fed cut short-term interest rates by 50bp, the yield on the benchmark 10-year U.S. Treasury note traded below 1 percent for the first time, and kept dropping throughout the week. Even so, President Trump wants negative interest ratesMight they be possible? As the week progressed, and as traders bought safe assets and mortgage paper owners bought Treasuries to try to hedge their shortening duration, bonds moved further into unprecedented territory, such that 10-year U.S. Treasury notes now yield less than many bond funds charge.

Fed rate cuts are most often followed by poor market performance and, although the sample size is extremely small, market performance after an emergency rate cut is even worse: the average one-year return for stocks following an emergency rate cut is -7.3 percent. However, that should be seen as more indicative of market conditions at the time than that rate cuts are ineffective.

Employers added 273,000 jobs in February and the jobless rate was 3.5 percent, signs of labor-market strength before COVID-19 spread widely in the U.S. Wages increased 3.0 percent from a year earlier in February, in line with recent months.

Monday, the OECD updated its economic forecast, cutting its expectation for global growth this year by half a percentage point, to 2.4 percent. But in the worst-case “domino scenario,” a widespread outbreak could push global growth down to 1.5 percent, the worst result since — you guessed it — the 2008 financial crisis.

The COVID-19 outbreak began weighing on U.S. businesses even before the virus had begun its spread in the U.S., the Fed’s latest beige book shows, suggesting that U.S. firms could be in for a significant slowdown in March. Concerns about the novel coronavirus epidemic also clouded the outlook for the U.S. service sector. The Institute for Supply Management’s U.S. manufacturing index barely held in expansionary territory last month.

Congress passed an $8 billion funding package to deal with the coronavirus with virtually unanimous support.

Does Warren Buffett sense a buying opportunity?

Record low mortgage rates.

Top 20 stocks of the last 20 years.

A slew of SEC risk alerts are on their way.