By Lyn Alden Schwartzer:
This has been a historic month for global markets across almost all asset classes, representing the conclusion of a bull market in U.S. equities that lasted for more than a decade. It might also be at or near the conclusion of a 40-year bull market in U.S. Treasuries that began in the early 1980's.
The U.S. stock market crashed into bear market territory in the fastest time on record starting in late February. There have been faster and bigger crashes before, such as the single-day 22% drop in 1987, but not directly from all-time highs into bear market territory like this. The market is down about 30% from its all-time highs in less than a month.
Most foreign markets, which were already having a bad decade, crashed at least as hard as U.S. markets.
But even more spectacular than the crash in stocks, was the Armageddon that happened in the oil market.
When global economic activity decreases, oil prices generally drop because demand slows down versus supply. This time, however, the Russians and the Saudis, as large low-cost producers, decided to increase oil supply at a time when oil demand was weak in order to drive down oil prices to unfathomable lows and take back market share from growing U.S. shale oil production.
For years, Saudi Arabia and Russia had been cutting production or holding it flat while higher-cost U.S. shale production kept growing and taking their market share, and now they struck back at a moment of weakness. Lower oil prices hurt them severely as well, but they're taking a longer-term view that they can run some higher-cost producers out of business and take back market share.
As a result, oil fell by over 20% in one day, the biggest daily decline since the Gulf War, and has recently traded roughly between $20 and $30 per barrel of WTI crude compared to over $60 at the start of the year. This situation will persist until either Russia or Saudi Arabia backs off with production, or until U.S. shale producers reduce production and halt capital expenditures. Oil producers across the globe are already slashing capex plans and a significant portion of the U.S. shale industry is vulnerable to bankruptcy at these low oil prices.
Here is the year-to-date performance of various regions and asset classes:
So far, asset classes crashed in price roughly in the order of Exter’s Pyramid.
First, commodities fell sharply early this year when China quarantined itself and sharply cut down its need for commodities. Oil and copper in particular began a terrible drawdown early on.
Second, the U.S. stock market pushed to new highs and then crashed, along with corporate bonds a little later.
Third, investor money flooded into nominally safe U.S. Treasury bonds and they spiked to new all-time highs during the initial stock market crash, but then even they started to fall back down from their highs as well, which hurt many risk parity hedge funds that use leverage to hold both stocks and bonds.
Fourth, we’re at the phase where liquidity shortages have become a key problem in the global financial system and cash dollars have surged in value.
Here is the asset class drawdowns from their highs this year:
Commodities fell first, then stocks and corporate debt, then long-dated treasuries. Cash is at highs now.
John Exter, the late American economist born in 1910, was a member of the U.S. Federal Reserve, a vice president to a predecessor of Citigroup, and the founder of the Central Bank of Sri Lanka. Today he’s most well-known for creating Exter’s pyramid, which is an upside-down pyramid that ranks the various asset classes in order of size and risk. The shape of the pyramid (upside down rather than right-side up) highlights the fragility that our financial system inherently has, with the safer asset classes also being the smallest in size.
There are several slightly different versions of it that have been adapted as times change, and here’s my simple one:
At the bottom is gold, the small foundation, because dollars and other currencies were still backed by gold in Exter’s day. Most currencies around the world have historically been based on gold or silver, with occasional exceptions. The 1971-present period has been a novel exception, because it's the only time in history where all currencies in the world are fiat; unbacked by any tangible thing. The official U.S. gold reserves are worth about $400 billion, depending on gold price fluctuations.
The next layer up is paper cash or in today’s more common form, digital money. It used to be partially backed by gold, meaning that you could exchange it for gold, but not everyone at once or else there wouldn't be enough gold. The paper money supply was always larger than a country’s gold supply, and since 1971, cash isn’t backed by anything in particular and gradually loses its value each year due to inflation. Currently, the U.S. has about $1.8 trillion in currency in circulation and $16 trillion in broad money supply (which also includes checking accounts, savings accounts, CDs, all sorts of digital cash and cash-like assets).
Then up from there is the layer of sovereign bills, notes, and bonds. For the United States, this is debt issued by the U.S. Treasury. The United States has about $23 trillion in public Treasury debt outstanding. Short-term treasury bills are very cash-like, while the longer-dated bonds are a riskier proposition, because they promise to pay dollars back one or more decades from now. Since they can print dollars to fund their debts, the chance of nominal default is exceedingly low, but there is risk of loss of purchasing power.
Up from there is the universe of private and local government assets, ranging from stocks to corporate bonds to municipal bonds to private equity and real estate. The U.S. stock market and U.S. real estate market are each worth tens of trillions of dollars (over $30 trillion each before this crash), and then there are trillions more in corporate and municipal debt. Corporate and municipal debt are like Treasuries, but at a higher credit risk than the federal government. Stocks and real estate are assets that can produce dollar cash flows over an indefinite period of time but with substantial operational risk, and are valued based on their perceived future ability to generate those cash flows. So, these are all promises to pay dollars in the future, but with credit and operational risk that they may fail to deliver.
At the top of the inverse pyramid is the derivatives market, e.g. options and futures. They are promises to deliver assets from lower levels in the pyramid at a future date. This layer of the pyramid is also sometimes thought to include unfunded liabilities, like future pension payouts or government medical coverage that they have not yet allocated sufficient funding for but are on the "future books" based on existing laws and demographics. This total market is several times larger than the rest of the pyramid combined.
The Gold and Silver Disconnect
Over the past few weeks, the price of precious metals in the futures market (the top derivatives layer of Exter's pyramid) disconnected from the price of precious metals in the physical world (the bottom layer of Exter's pyramid).
The futures market is far larger than the physical market, with most participants never touching the metals, using a lot of leverage, and speculating on price movements in cash terms. The majority of futures contracts are not settled with physical delivery. Due to high leverage and relatively rare physical delivery, they can trade around a larger amount of gold and silver in paper form than they actually have access to. The physical market, held in coins and bars privately or in allocated accounts, is the actual metal, generally without leverage attached.
In the futures market, gold and silver responded similarly to U.S. treasury bonds during this crash. They held strong initially, but then fell. Silver took a big hit to lows not seen in over a decade, while gold held up reasonably well and has greatly outperformed equities, but is still more than 10% down from its recent highs and down nearly 2% year-to-date.
Interestingly though, this negative price action does not hold in the physical market.
Bullion dealers across the world went out of stock on many gold, silver, and platinum coins and even large bars over the past few weeks. This is true in the United States, Canada, Europe, Singapore, and many other places. Whatever inventory left is marked up at big premiums. Even the U.S. Mint ran out of silver eagle coins to ship to their core authorized dealers, citing an extreme surge in demand.
As of this writing, gold is at $1,498 and silver is at $12.59 per ounce in the futures market.
However, most major vendors don’t have any stock of core items, like sovereign precious metal coinage or bars from premium refineries.
Want American gold eagle coins from APMEX? Sorry, out of stock:
Image Source: APMEX, March 22
Or silver bars from JM Bullion? Nope:
Image Source: JM Bullion, March 22
Platinum from Kitco? No such luck on either coins or bars, from any country:
Image Source: Kitco, March 22
BullionStar over in Singapore has plenty of stock, but at high premiums and big international shipping costs. In fact, they have a notice on their homepage saying that they're willing to buy silver coins from you at 28% over spot, or gold from you at 2.5% over spot:
Image Source: BullionStar, March 22
Normally, in addition to getting stock from whole-sellers, bullion dealers are willing to buy from folks a bit below the spot price and resell it at a bit above the spot price to make a market and turn a profit. BullionStar is in a position where they're willing to buy above spot and then sell for way above spot.
So, all the stuff at the very bottom of the pyramid, metal that retail investors can actually get in their hands in a few days or weeks, is currently harder to obtain and/or at a big mark-up. The metal in the futures market, that is normally not physically delivered and if it is, usually comes with a multi-month delay and with a logistics hassle, is cheap.
Normally, silver coins sell for maybe a 4-8% premium over spot. A couple weeks ago, as physical demand outpaced supply, the premium stretched to 20%, then 50%, and rising. Silver coins went up to $20-$25 per ounce or more on all major bullion websites, compared to $16-$17 this past summer. Now it’s simply out of stock at many places, or still at $20+ an ounce of silver for non-standard products, while the official price in the futures market is below $13.
So, gold and silver coins now, for places where you can even get them, are at higher prices than what individuals could buy them for months ago despite the price decline in the futures market.
It’ll be interesting to see in the coming months how the two markets resolve. Last time this physical/derivatives market divergence happened was in 2008, with the futures prices of silver and gold selling off while the physical metal was harder to get and at sizable premiums. Prices resolved to the upside back then. Maybe this time will be different and it’ll resolve down to the futures price as retail interest drifts lower, but we'll see.
I think precious metals are a great place for diversification over the next several years as a hedge against zero interest rates and the sheer scale of the expansion of the monetary base that's about to happen. By most valuation metrics, gold is reasonably-priced and silver is quite cheap.
I like the Sprott funds for gold (PHYS) and silver (PSLV) here. They still trade at the lower futures price but have fully-allocated and redeemable metals. Similarly, private fully-allocated vaults are pretty cost effective at the moment. And the futures market still works currently; investors can take delivery of the metal in large quantities if they're willing to wait and go through the logistics of official delivery.
The Liquidity CrisisMost folks are looking at stock market prices each day, but the most troublesome things are under the surface. Global liquidity has sharply dried up.
The world as a whole has never had a higher debt-to-GDP ratio than it has right now. The U.S. corporate sector has record high debt-to-GDP levels, while U.S. government debt-to-GDP is at highs only surpassed in World War II. Foreign markets as a whole are in similar shape, and according to the Bank for International Settlements there is over $12 trillion in dollar-denominated debt held by foreigners, and a lot of that debt suddenly became distressed (higher default risk; higher yields) due to the global shutdown.
In the United States, corporations all around the country are pulling money from their revolving credit facilities with banks, meaning they are extracting money from bank balance sheets onto their own balance sheets to ensure they have as much cash on hand as possible. Companies like Boeing, Hyatt, and Micron are doing this; basically every restaurant, hotel, transporter, and more broadly a large portion of the corporate sector are trying to maximize cash on their balance sheets.
Just like how banks are not designed to be able to give out cash to every depositor at once (a retail bank run), they are not designed to have half of their corporate clients request funds from their revolving credit facilities all at once (a corporate bank run). So, there's a liquidity problem.
The U.S. Federal Reserve, as the lender of last resort, has launched a number of programs to try to backstop everything. They started buying Treasury bonds and mortgage-backed securities at a faster rate than ever before, as those markets started to break down with wide bid/ask spreads and Treasury auctions became troubled. They dramatically increased the size at which they would offer overnight repo lending to banks for collateral. They're also funding money markets, corporate paper, and municipal bonds to keep them stable. Congress is currently working on legislation to possibly let the U.S. Federal Reserve buy longer-dated corporate bonds.
This image aptly sums up what's happening. Here is the U.S. Federal Reserve's balance sheet over the past five years, as of this past Wednesday when the latest data came out:
Data Source: U.S. Federal Reserve
After a period of flat holding, and then quantitative tightening (reducing the balance sheet), the U.S. Federal Reserve had to start rapidly growing their balance sheet in September 2019 in order to regain control of the price of money in overnight repo markets. They then leveled off for a few months as things stabilized, and this recent crisis suddenly caused a parabolic move to new all-time highs. In other words, they are aggressively expanding the monetary base to buy several types of debts.
The U.S. Federal Reserve added over $500 billion to their balance sheet in the past three weeks, including $356 billion last week alone through Wednesday, and are only getting started. Since then, they have added another $150-$200 billion on Thursday and Friday, which is not yet reflected in the chart above and would bring it nearly to $4.9 trillion as of this weekend. They're on track to comfortably pass through $5 trillion by early next week, and I'd be surprised to see the balance sheet end the year at under $7-$8 trillion. That might prove conservative. Debt, everywhere, is being monetized.
The U.S. federal government went into this crisis with structural fiscal deficits of $1 trillion per year and rising, or about 5% of U.S. GDP. Congressional and White House discussions for a fiscal relief package, including sending direct checks to most U.S. residents and providing industry bailouts, have risen from initial discussions of $800 billion to $1.2 trillion to $2+ trillion. Who knows where they will ultimately end up this year. We're looking at U.S. fiscal deficits that are likely to reach at least $3 trillion this year, or about 15% of U.S. GDP. If so, this would be the biggest deficit year as a percentage of GDP since World War II.
The dollar initially fell vs the euro and yen during the stock market crash, but when this liquidity problem started to form, the dollar suddenly spiked up due to its global shortage:
Chart Source: Koyfin
The TED spread, or the difference in rates between offshore dollars and the 3-month T-bill, began sharply increasing over the past two weeks:
This is indicative of a severe shortage in dollars outside of the United States to pay for dollar-denominated debts. In my article from last month, The Global Bottleneck, I discussed this dollar shortage/liquidity problem in detail. I suggest reading it because this is going to be a key factor as the global financial system re-aligns.
Due to the suddenness and severeness of this global shutdown, we're unfortunately now on the more dangerous and disorderly orange path for the dollar that I mentioned in that article. The "Bad for Everyone" scenario:
The overvalued dollar makes U.S. exports less competitive, and due to $12 trillion in foreign dollar-denominated debt, it acts like quantitative tightening on several foreign markets during a severe recession.
If it persists long enough, foreigners may need to begin liquidating some of their $7 trillion in U.S. Treasury bonds, which would be a disorderly sale into a market that already has liquidity problems. In fact, foreigners have $39 trillion in total U.S. assets according to the U.S. BEA, so they may also liquidate some of their stocks and other assets if the U.S. Federal Reserve doesn't provide enough liquidity for dollars to function as the world reserve currency.
It may seem like the United States has the upper hand here, as dollar strength is the heart of the problem as the world reserve currency during a time of global dollar shortage. Our country alone holds the "print" button for dollars.
However, we are a debtor nation, and are reliant on external funding from our foreign creditors. Foreigners, especially creditor nations like Japan and China, own more American assets than Americans own of foreign assets, and they own a lot of our debt while we do not own much of their debt. So, when foreigners are financially distressed, they can liquidate assets in our country, including U.S. Treasury bonds, U.S. corporate bonds, U.S. stocks, and U.S. real estate. That's a key reason why the U.S. Federal Reserve has such a large interest in ensuring that there is adequate liquidity in both domestic and foreign dollar markets, as described below.
The U.S. Federal Reserve's Increasingly Large Bazookas
To combat this liquidity shortage and regain control of dollar liquidity and restore a smooth Treasury market, the U.S. Federal Reserve keeps amplifying the actions it is taking to restore liquidity. Every day that liquidity continues to tighten, they pull out a bigger gun.
Prior to this past week, the U.S. Federal Reserve was performing about $20 billion in Treasury purchases per week, meaning they were expanding the monetary base to buy Treasuries and hold them on their balance sheet by an average of around $4 billion per business day. Suddenly, last Friday, March 13th, they bought $37 billion in one single day. Then, they increased it to $40 billion per day starting this past Monday, and then quickly up to $75 billion per day from there, which is a $1.5 trillion monthly rate if sustained. Here is the chart of recent Treasury debt purchases by the U.S. Federal Reserve:
Data Source: N.Y. Federal Reserve
In addition, the U.S. Federal Reserve recently opened currency swap lines with several major central banks, such as the Bank of Japan and the European Central Bank. The last time they did this was in 2008, for the same dollar shortage reasons. In this agreement, they temporarily swap dollars for other currencies as a loan in order to make sure those markets have dollars to service dollar-denominated debts. However, this time a few days after opening those swap lines, they also added nine more countries including several emerging market central banks to the list of swap lines (Mexico, Brazil, South Korea, etc.), which was not the case in 2008.
Pretty much every day, including at odd late night hours and on weekends, the Fed has announced yet another set of tools to buy things, provide funding, and restore liquidity. Every day that the dollar strengthens and the TED spread increases, the Fed will be amplifying their tactics to break it.
Back during the crisis in 2008, the TED spread spiked as well (blue line below), along with the dollar relative to other currencies (red line below):
Chart Source: St. Louis Fed
The Fed expanded their balance sheet massively at the same time (red line below), and opened their currency swap lines. It took about 6-8 weeks to resolve the TED spread spike (blue line below again) by flooding everything with well over $1 trillion in dollar liquidity:
Chart Source: St. Louis Fed
We'll see how long it takes them to break the liquidity problem this time. The stakes are bigger now and it'll likely take more than $1 trillion to do it. The spike in dollar strength is starting from a stronger base (it was quite weak in 2008 vs now), and the ratio of debt to dollars in the world is much greater now. Combating that, the Fed is doing very large-scale asset purchases, and is opening up more currency swap lines than ever before.
While a technical bounce is perhaps likely, it's hard for risk assets to have a sustained rise while liquidity remains this tight. It's particularly bad for emerging markets, but also bad for foreign developed market stocks, U.S. stocks, bonds, precious metals, and almost everything other than cash dollars.
This is because, for foreign markets, a rising dollar means that their dollar-denominated debts (mainly for corporations and governments) are increasing relative to their local-currency revenues (which just took a big hit from the virus quarantines). If foreign markets get crushed, it means that the 40%+ of revenue that the S&P 500 gets from ex-USA sources dries up, and so U.S. stocks get hurt as well. If foreign markets and domestic tax revenues get crushed, it means the U.S. Treasury has a problem finding buyers for its debt, and struggling foreign markets begin outright selling their U.S. Treasury bonds and other U.S. assets to get dollars.
So, while many people are looking at prices of the S&P 500 every day, the first thing I look at is the TED spread and the dollar index. The ocean of credit market problems is the far larger issue at hand, like the bulk of the iceberg that is under the surface while stocks are just the smaller and more visible part above the surface. The key battle going on right now is between the U.S. Federal Reserve and the shortage of global dollar liquidity due to an unprecedented amount of U.S. and global debt.
This next chart basically summarizes the point of this whole liquidity section.
If we look at the price action back in 2008 and 2009, the top in the dollar strength spike (blue line below) coincided perfectly with the bottom in the U.S. equities market (red line below, as the Wilshire total stock market index). Even the fake top in the dollar coincided with the fake bottom in the market. I highlighted those fake and final tops & bottoms with green dots below:
Chart Source: St. Louis Fed
In other words, not until global liquidity was restored with a weaker dollar were risk assets able to find footing and move permanently back up.
I'm not saying it'll be so perfectly timed in this sell-off, but until liquidity improves and the dollar turns lower via liquidity from the U.S. Federal Reserve, there is significant downward pressure on most risk assets due to an abundance of forced sellers and squeezed foreign markets.
For that reason, my main investment focus these days is on liquidity and the dollar.
Summary ThoughtsInitial indicators are that several million initial jobless claims are being filed this week. Data from initial states as well as in Canada show us that the baseline number of new claims could be 10-20x or more a typical week. Since a typical week lately is 250,000 or so claims, we're looking at several million claims, which will be by far the worst week of jobless claims in U.S. history.
Even the worst week in the 2008-2009 Great Recession was less than 800,000, because the sheer speed at which this shutdown occurred is atypical of a normal recession.
Service workers in the United States and elsewhere are generally among the lower income brackets, with little savings. This will be a very challenging time, with an unprecedented reliance on government support, which is a very fragile state of affairs.
The coming year will put to the test our ability to work together, whether in Congress, or between nations, or just out in the streets among ourselves.
From an investment perspective, what works well during the next decade will likely be quite different than what worked last decade, but the general approach of prudence and patience pays off in all market conditions. In the meantime, the key thing I'm watching is global dollar liquidity, and the eventual reversal of the rising dollar relative to other currencies.
As this situation drags on, there are more and more deep values out there.
Russian equities, for example, were crushed year to date. The best time to buy Russian equities during the past decade was in early 2016 when oil reached a major low and the dollar reached a major high. Investors doubled their money in two years if they bought then, but how many investors were fearless or foolhardy enough to do so? Today, things like beaten-down Russian equities are the last thing on most investors' radar for things they want to buy during a global recession and oil price war, but will we be looking back at this five years from now and able to say that it was an incredible buying opportunity again, or will it be different?
Some of the lowest cost oil producers and copper producers around the world are at major lows. Emerging markets like India and Mexico broadly are cheap and under pressure from the strengthening dollar, similar to 2014-2016 and 2008-2019. Silver in the futures market is at the lowest price of the decade.
In the United States, many restaurant stocks, financial stocks, industrial stocks, and others are deep in the red. Some premium growth stocks are still pricey, but a lot less pricey than they used to be. Investors that sort out the ones with the strongest balance sheets, with the highest probability of surviving this type of massive slowdown, may be rewarded in the coming years. Nothing is guaranteed, but over the coming months, bargains will be everywhere, along with plenty of value traps along the way.
See also VGLT: 2 Graphs That Support A Buy (And 1 That Doesn't) on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
