Gambling on US equities is becoming more difficult

Deglobalisation should make investors think twice about betting on index tracker funds

Rana Foroohar

Investment Bet
© Matt Kenyon

At the recent Berkshire Hathaway annual meeting it sometimes felt like Warren Buffett was trying to square words with actions.

The Oracle of Omaha insisted, as he always has, that the best place for retail investors to be is in an S&P500 index fund.

But he also told shareholders that his company had sold 16 times as much stock as it had purchased in the last month, including dumping the entire airline asset class.

And he admitted that while you could still “bet on America, you are going to have to be careful how you bet”.

When you look closely at his actions, he is still following the same strategy that he has employed throughout his career.

It is an approach built on two things: first, value investing, which basically involves the forensic examination of corporate balance sheets; and, second, a belief not so much in America as in American companies and their ability to export their particular brand of capitalism abroad.

Both of those pillars still hold much wisdom for investors who want to understand where markets — and the real economy — are heading.

Mr Buffett learnt the skill of value investing from his former Columbia Business School professors David Dodd and Benjamin Graham, whose book, The Intelligent Investor, he memorised. They argued that investors should buy companies that have steady profits, low price-to-earnings ratios and very little debt.

Following that logic, it is no wonder that Mr Buffett isn’t buying much stock. Corporate debt doubled between Mr Buffett’s bullish buying spree after the 2008 financial crisis and the end of 2019.Meanwhile, P/E ratios are not providing a true market signal when asset prices are being driven mainly by US Federal Reserve interventions.

Many companies have stopped giving earnings guidance amid this historic downturn. Some people might respond that the Fed’s actions are the market signal. By that they mean that share prices will from now on be driven by the supply of money that central banks pump into the economy, rather than by the relationship of stock prices to corporate earnings.

But as Gavekal Research co-founder Charles Gave wrote last week, everyone in Japan in the 1980s thought the correlation between the Topix and the country’s supply of cash and cash equivalents would last forever, too. But the value of equities there stopped tracking the money supply in 1990.

We will continue to see plenty of companies and stocks flourish in the post-Covid-19 era, even after the Fed turns off the spigots of its recent interventions. But investors will need to conduct a new kind of forensic study to discover who the winners will be.

Mr Buffett’s second pillar of betting on US blue-chips, as a way to wager on global growth, no longer works as well in an era of localisation. The US, China and parts of Europe are all developing national champions in sectors such as technology, which holds a disproportionate weight within the S&P 500.

It is impossible to know yet how deglobalisation will play out in the long term. But in the short term, the increased competition will surely dampen US share prices.Some industries will be safer investments than others.

Travel — and anything related to it — is unlikely to rebound soon. As bond investor Jeffrey Gundlach noted last week, Mr Buffett bailing out of airlines was the negative equivalent of his doubling down on banking stocks in the wake of 2008.

He was making a bet that the long-term fortunes of an entire sector will change. In retail, it is hard to imagine that many big brands won’t follow J Crew into bankruptcy.

Banking faces increased risk as corporate insolvencies rise, so the sector’s share prices will probably stay depressed.

So, too, for small and midsized companies that don’t have teams of lawyers to push them to the front of the bailout queue. Many will surely be gobbled up by larger competitors as they flounder.

Even within seemingly Teflon-like sectors, such as technology, there will be divergence by company. Microsoft is booming amid coronavirus, while Apple chief executive Tim Cook says the company is in “the most challenging environment” it has ever seen.

All US companies will have to live with a new level of political risk that will make it difficult to predict returns — or their regulatory future. Not only is there growing tech nationalism among both Republicans and Democrats.

There is also rising concern about corporate concentration, which Democrat Joe Biden is making a central issue of his presidential campaign. Amazon is the perfect case in point here.

The company has become totally essential during the lockdown. Yet it is under more attack than ever from labour and antitrust activists. It is possible that Big Tech behemoths will come out of the current crisis stronger, only to have their wings clipped in the end via regulation and higher taxes.

They could be very much in the crosshairs as the politics of unequal wealth distribution and nationalism play out.In this environment, buying the S&P 500 as a whole only makes sense if investors believe that the Fed can continue to lift all boats indefinitely.

I believe the US is moving from a consumer liquidity crisis to a corporate solvency crisis. When that happens, it is unclear whether the central bank can continue to save everyone.

For a generation brought up to buy and hold US blue-chips, betting on America has become a lot trickier.

Markets should beware this morally hazardous approach to policymaking

Central banks repeatedly set the stage for the next boom and bust cycle, fuelled by growing debt

John Plender

The equity market recovery has been substantially driven by Microsoft, Apple, Amazon, Alphabet and Facebook © Getty Images

So much uncertainty surrounds the future path of coronavirus that it seems perverse that US equities in April staged their biggest monthly gain since 1987.

In part the bounce back after the rout in March is an acknowledgment that central banks and policymakers will continue to throw everything at this crisis that can be thrown. There are no political constraints in addressing a pandemic that affects everyone in society equally.

Yet this endorsement is strictly qualified. The equity market recovery has been substantially driven by Microsoft, Apple, Amazon, Alphabet and Facebook, which together account for more than one-fifth of the S&P 500 market capitalisation.

In other words, share prices are not pointing to a broad-based recovery.

Nor are wider markets, with 10-year Treasury yields at record lows, oil prices severely depressed — even after a big rise this week — and emerging market currencies plunging against the US dollar since early this year. Also striking is how halfhearted the relief rally in global bank shares has been.

Nervousness in equities at the start of this week also served as a reminder that we are still in a world of intense trade friction. It is clear, too, that China, whose fiscal and monetary response to the 2007-08 financial crisis helped drive the global recovery, will not be offering similar help this time.

While speculation continues as to which letter of the alphabet will describe the shape of the post-coronavirus recovery, the letter V can safely be ruled out. The huge accumulation of corporate sector debt since the financial crisis means that those companies that manage to pull through will be restoring their balance sheets by paying down debt rather than investing.

The retreat from globalisation and a switch from just-in-time supply chain management to just-in-case inventories will not be good for corporate profits. And with unemployment at levels not seen since the 1930s households will be averse to risk and anxious to increase savings.

In the short term the environment will be hugely deflationary. Fiscal and monetary policy will have to bear all the burden of driving aggregate demand.

Even as the virus appears to retreat and economic recovery picks up, there is a big risk of policy error, argues Harvard University’s Jeffrey Frankel. He points out that President Roosevelt’s premature removal of fiscal stimulus after the 1930s depression inflicted severe recession in 1937-38. Much the same was true after the great financial crisis in the UK and elsewhere.

A more fundamental question about the recovery relates to the central banks’ asset-purchasing programmes. William White, former head of the monetary and economic department at the Bank for International Settlements, points out that repeated monetary easing to stimulate demand brings forward private spending in time, with purchases being financed by debt accumulation. As the weight of the debt burden increases, the effectiveness of monetary easing declines.

In short, the continuation of ultra-low interest rates procures less and less growth.On a longer run perspective, the problem is one of asymmetric monetary policy. Since 1987 the Fed has put a safety net under markets when confronting systemic threats, while choosing not to restrain prices when they are in bubble territory.

This morally hazardous approach to monetary policymaking means central banks repeatedly set the stage for the next boom and bust cycle, fuelled by ever declining credit standards and ever expanding debt accumulation.

The Institute of International Finance, a trade body, estimates that global debt, both public and private, topped $255tn at the end of 2019. That is $87tn higher than at the onset of the 2008 crisis and it is undoubtedly going to be very much higher as a result of the pandemic.

The question, then, is how to break out of the asymmetric policy bind. In due course, potential measures could range from equalising the tax treatment of debt and equity; changing boardroom incentive structures that encourage debt-financed stock buybacks that weaken corporate balance sheets; and tougher competition policy to curb debt-financed takeovers that create near-monopolistic corporate giants.

The current debt overhang will never be repaid in full. With central banks directly monetising government deficits, much of the debt will ultimately be inflated away — which is something that fixed-income markets resolutely refuse to believe.

Since the turn of the millennium, markets have been plagued by widespread mispricings of risk. Here, almost certainly, is another case in point.

When — and How — Should the U.S. Economy Reopen?

As states across the U.S. experiment with lifting lockdowns in varying degrees, economists, policymakers and many others are struggling to find the right approaches to reopen the economy while putting safeguards in place to avoid a spike in new COVID-19 cases. How exactly things will play out remains largely uncertain – and the stakes couldn’t be higher.

Of the many challenges the pandemic has raised, “the most fundamental one is how much we are willing to pay, or more accurately lose, by shutting down the economy in order to save lives,” Wharton management professor Peter Cappelli wrote in an April 30 column in Human Resource Executive.

“This sounds like a policy question, but it is also a practical management problem because employers are gearing up for the challenge of bringing employees back to work when we know that doing so and ending social isolation will increase the risk that more people will get sick and die.”

An analysis by the Penn Wharton Budget Model released on May 1 (and updated most recently on May 11) shows that as states relax their policies and residents reduce social distancing, jobs and GDP grow, but so does the number of COVID-19 cases and deaths — to alarming levels.

Using a simulator, the PWBM analysis shows that if states don’t reopen and social distancing behavior remains in place, total coronavirus-related deaths in the U.S. would be nearly 151,000 by July 15 (including deaths before the simulation began).

Partial reopening would claim another 33,000 lives, while an additional 212,000 lives would be lost with full reopening, bringing total deaths to 363,000 by July 15.

Further, if people see full reopening as a “return to normal” and ignore social distancing — going back to how they behaved, say, on February 1 — there would be nearly 715,000 deaths cumulatively by July 15. PWBM updates the simulator once a week and presents rolling two-month forecasts.

Not surprisingly, the economic outcomes in those scenarios run conversely, and the PWBM analysis narrows them down to specifics. Without states reopening, 6.1 million jobs would be lost between May 15 and July 15, but full reopening (with social distancing still in place) could bring a net gain of 11.5 million jobs. Between those two scenarios, GDP would change from minus 12.5% to minus 10.3%.

As of May 7, nearly 33 million Americans had filed claims for unemployment benefits in the seven weeks since the virus outbreak. The unemployment report the following day showed 20.5 million jobs lost in April, taking the unemployment rate to 14.7%, which The New York Times described as “literally off the charts.”

Beyond staggering unemployment, the pandemic promises to have other long-range consequences for those who keep their jobs. “Many employers that used to offer retirement plans (e.g., 401(k) plans) have cut their matches, thus making it less beneficial for workers to contribute,” said Olivia S. Mitchell, Wharton professor of business economics and public policy, and executive director of the Pension Research Council. “While this does conserve on cash, a major concern now, it also prejudices workers saving for old age.”

Another concern she pointed to was that coronavirus stimulus package approved by Congress allows employees to withdraw money from their retirement accounts due to COVID-19 stresses.

“This too will erode retirement security in the future,” she said.

How to Reopen

In terms of the number of new cases — a key indicator — the outbreak in the U.S. is yet to peak and diminish, while it seems to be on a decline in Italy, Spain and Germany, according to Johns Hopkins University’s dashboard that tracks the spread of the virus.

“The tortuous path that society and politicians have to consider walking is the fine line between allowing people to return to society — whether it’s to work or whether it’s to consume or whether it’s just to fraternize — versus the inevitable fact that the more people intermingle, the higher the chances that the virus will spread and the more deaths there will be,” said Wharton professor of health care management Mark Pauly. “That is the trade-off.”

A measure of caution for states before reopening is to achieve a “sustained reduction” over 14 days or so in the rate of new cases, according to Kevin Volpp, professor of medicine at the Perelman School of Medicine and professor of health care management at Wharton. That scenario assumes that there’s ample availability of testing, he said. Next, the new cases have to be reliably identified and isolated.

The challenge, though, is that as many as half or more of people are asymptomatic but infectious, he noted. (Volpp talked about the challenges in reopening the U.S. economy with Wharton finance professor Jeremy Siegel on the Behind the Markets radio show on Sirius XM; you can listen to a podcast of the discussion here.)

Reopening needs to be staggered, avoiding high-risk settings such as movies and sporting events, said Pauly. It could begin with low-risk businesses, such as “a small neighborhood restaurant where we know the owners, and the chairs and tables are already widely separated.”

A “market-based solution” could also emerge, where people patronize establishments by the degree of risk they perceive in them, said Pauly. “More customers would come to a low-risk business than a high-risk business. More customers will come to a business that has successfully mitigated the risk compared to one that either didn’t or couldn’t successfully mitigate the risk.”

State-level relaxations on lockdowns could, of course, have unintended effects. “People may take that as a cue that maybe things are OK,” said Kent Smetters, Wharton professor of business economics and public policy and faculty director at PWBM, during a virtual presentation of its analysis last week.

But the evidence here is mixed, he noted. “In Hong Kong, for example, when the government started to relax, there was a lot of reduced social distancing at the personal level. [However], we saw in other countries where even when the governments did not have a lot of relaxations or policy restrictions in the first place, people maintained their personal social distancing.”

Frustrated by the lockdowns, some people are willing to take more risks than others, and in the process they could endanger others. There are ways to mitigate those risks, either through insurance plans or by societal pressure, according to Pauly. “There should be some conditions under which you would be allowed to reenter society,” he said. “One is obvious. You should get a test and test negative. We shouldn’t let people enter into a normal course of life without a negative test.”

Still, a negative test is “not bulletproof,” Pauly said, adding that a person could have picked up the virus 20 minutes earlier and not show symptoms. As a backstop, he said, individuals could also be required to pay for a permit, or something similar, to reenter society.

“Usually when people do things that impose risks on others, we make them pay for the privilege,” Pauly explained. The permit fees would also help “to raise funds to compensate people if you happened to infect them,” he added. Such a system would “be a way to confront people with the undeniable fact that if you reenter normal life, you’re going to potentially impose harm on your fellow human beings.”

Beyond Testing

With no vaccine on the immediate horizon, authorities can only rely on the three-pronged approach of testing, isolating and contact tracing to stem the pandemic. While testing is already taking place in varying degrees, the traditional public health approach of human contact tracing has “inherent limitations,” said Volpp.

With the enormous number of cases and the amounts of interaction between people, there is a need for a new type of “technology and human-based solution” for contact tracing that would work, Volpp said. However, obstacles to developing such a solution include “strong privacy laws and cultural beliefs around not wanting to share data,” he added. “How do we create a system that’s going to be both palatable to the American public and effective?

It would also be hard to obtain all the requisite data for such contact tracing, Volpp noted. After lockdowns are lifted, it would be “very difficult” to track the number of contacts made by those who use public transportation, walk through a crowded subway station, and then walk down a crowded street before they get to their office and interact with other people. If a public health authority were to ask such a person who may have developed symptoms to recall the contacts they had over the previous seven days, “it would be impossible,” he said.

Volpp noted that South Korea and Taiwan have successfully controlled the spread of the disease by systematically using cellphone data for contact tracing and requiring phone companies to provide that information to the government. In the U.S., though, privacy concerns will mean that participation by people who have been tested will be voluntary on an opt-in basis, he said.

“When you look at the rates of enrollment in various opt-in programs, typically it’s less than 10%,” Volpp continued. “If we have a technology-based tracking system which has 5% of the population enroll, it won’t be all that useful. We have to figure out how we’re going to set this up in such a way that we’re going to have a high proportion of people participating.”

Once a consensus is achieved on a technology platform for contact tracing, city and state governments, employers and other organizations have to find ways “to strongly encourage, incent, compel people to participate,” he said. “Those discussions haven’t quite happened yet, but that’s a very important consideration as we think about trying to reopen the economy.”

As for testing, setting realistic goals is a good starting point. True, the spread of the pandemic might be tamed if people are tested in large volumes. “[But] we don’t have the human or material capacity to test everyone at once,” said Wharton management professor Mauro Guillen.

Guillen identified three types of testing priorities: (1) healthcare personnel and first responders; (2) randomized testing of representative samples of the population to understand the overall pandemic dynamic; and (3) high-risk groups. He stressed that first-responders need to be prioritized for testing and for the necessary protective equipment.

Guillen also advised a staggered reopening of businesses with periodic checks before proceeding. He suggested an “incremental reopening,” with proper planning for transportation of people from home to work and back to the home. Alongside, there would have to be protocols in place for contact tracing if a worker falls ill, he said. In reopening schools, he recommended that children be taken to school in groups of 20% and step that up gradually while ensuring that the requisite testing and contact tracing capabilities are in place.

Social distancing must continue during transportation, at the workplace or in schools, and in residential areas, he said.

It is too early to identify a single country with the best model for reopening the economy, said Guillen. “[But] Germany and South Korea come to mind,” he said. “They are testing, testing, testing, and then gradually reopening.”

On the Work Front

In his column in Human Resource Executive, Cappelli noted that people in the U.S. and across the globe have been willing to isolate themselves, losing their income as well as their social contacts and interactions, in order to slow down the COVID-19 infection. He didn’t expect them to rush back to life as it was before the pandemic began. “The idea that after all this buy-in and social pressure to self-isolate, employees will happily return to their offices and workplaces is quite probably a mistake.”

How could the workplace be made safe for employees who return to work? “Making employees feel as though they are still doing social isolation probably helps – staying six feet apart, no big meetings (yay!), lots of sanitation, and so forth,” Cappelli wrote.

Many businesses are preparing to reopen with safeguards, such as temperature checks and social distancing restrictions, including Apple and Boeing. Apple is approaching the reopening cautiously, selecting only four of its 271 stores nationwide. Boeing has announced site monitoring and other measures such as voluntary checking of workers’ temperatures and staggered work schedules at its facilities.

“The first question is who will be required to return to work and whether logistically they can,” said Wharton management professor Iwan Barankay. People who have to take care of others or need to quarantine can get paid sick leave in most states from larger employers, but only for a week or so and only if they have accumulated enough eligibilities through their tenure at the firm, he pointed out. Smaller companies are typically not required to provide paid sick leave, he added.

“For most professionals with children, the big reality that has not quite sunk in yet is that summer camps might not be available at all and even if they are, they might abruptly come to an end in case there are confirmed COVID-19 cases at such camps,” Barankay said. “So, the usual routine of being able to ship of the kids to camp and then dedicate yourself to work is not an option for most people this summer.”

According to Barankay, companies and their employees could find creative solutions, such as remote daycare and other programs to keep children engaged while adults are working. Firms might also be able to use grants from the Small Business Administration to fund paid sick leave for employees, he added. He pointed to Italy and Germany, where funds are made available for employers to provide additional paid sick leave and for childcare subsidies.

The ground realities may offer suboptimal solutions. Employees are legally entitled to a safe working environment, “but what if a company does not have the space and supplies to ensure it?” Barankay asked. “Some might prefer to not reopen for fear of legal consequences, and others might reopen in the hope that it will work somehow.”

According to Barankay, individual states need to provide clear guidelines on reopening businesses and not wait for federal guidelines to be announced. Such clarity is important also to ensure that employers can protect themselves legally, he said. “Just imagine the legal nightmare when someone can document that they were infected in the workplace or in case of death, and the claims that dependents will file.”

Given the considerable hurdles both employers and workers face, “it is easy to predict a decline in workforce productivity, which suggests that a sudden return to economic growth is not in the cards,” Barankay said.

“Instead, it will be a slow and steady recovery with possible pauses when states experience sudden spikes in infection rates with an intermittent return to shelter-in-place orders….
Companies and states should take clear leadership here so that America can safely get back to work to avoid a prolonged economic depression.”

Taking the German Constitutional Court Seriously

Given the many flaws in the controversial ruling by Germany's Federal Constitutional Court against the European Central Bank, it is tempting to dismiss the decision as yet another instance of German obstructionism. But either through persuasion or reform, Germany's longstanding complaints will have to be addressed.

Marcel Fratzscher

fratzscher16_Uli Deckpicture alliance via Getty Images_germanfederalconstitutionalcourt

BERLIN – The German Federal Constitutional Court’s (GCC) ruling against the European Central Bank’s pre-pandemic asset-purchase program has stunned policymakers and other observers outside of Germany. Many will be tempted either to ignore the ruling altogether, or to escalate the legal battle with the GCC.

But both approaches would be counterproductive. The situation calls for an earnest debate about the ECB’s mandate and existing European treaties.

Specifically, the GCC has accused the ECB of breaching the Treaty on the Functioning of the European Union by not conducting a proper “proportionality assessment” for its Public Sector Purchase Program. The court regards the PSPP as more than a monetary-policy tool.

It is a broader economic policy that has imposed undue costs on small savers, taxpayers, and individual sectors. As such, the GCC believes that the ECB has approached or already crossed the line of extending prohibited monetary financing to member-state governments.

While this is not the first time that the GCC has gone after the ECB, the latest ruling certainly constitutes an intensification of the conflict. In the absence of a proportionality assessment from the ECB, the Bundesbank will be prohibited from participating in the PSPP, with potentially far-reaching implications for Europe’s Economic and Monetary Union (EMU).

There is much to criticize about the ruling, not least its failure to understand the economics of monetary policy. The ECB does, in fact, conduct a regular, broad assessment of the implications of its policies each time it publishes quarterly projections. Moreover, price stability is not attainable in an economy where savers have been disowned, zombie firms are flourishing, and the banking system has collapsed.

By demanding that the ECB offer the kind of assessments that it requires, the GCC is provoking a dangerous clash between European and German law. It is not surprising that many economists and legal scholars have described the GCC’s arguments as utter nonsense.

Nonetheless, European institutions must take the GCC’s challenge seriously, or catastrophic consequences could follow. Given that the GCC has long been on a mission to challenge the ECB’s policies, there is no reason to assume that it will stop with this latest ruling. More important, one cannot ignore the fact that the court’s arguments resonate with many German economists, politicians, and voters.

Across the German mainstream, there is a deep conviction that the ECB does not act in Germany’s best interest. Especially since the 2008 global financial crisis, a growing chorus has criticized not just the ECB’s bond-purchase programs, but also its interest-rate and collateral policies, and even its TARGET2 payment system.

This intensifying public sentiment has steadily eroded the ECB’s credibility in Germany. That is not a problem that can be brushed aside. Trust and credibility are a central bank’s most important assets, without which it cannot fulfill its mandate. The EU and other member-state governments therefore can no longer ignore the GCC and the constituency it speaks for.
As a first step, the ECB needs to understand what the GCC (and the German public) expects from it. The court’s complaint that existing monetary policies impose costs on specific groups implies that it doesn’t think price stability should be the ECB’s primary objective. The GCC is essentially demanding that the ECB pursue a different mandate.

To be sure, the GCC has no authority to demand such a change. But, to avert a deeper crisis, the ECB needs to convince the German public that price stability is its primary objective for a reason, and that it cannot simply decide to discipline certain governments or favor policies that would benefit German savers and banks. This issue will not be resolved through the ECB’s standard strategy review process.

The GCC also objects to the risk-sharing element that is inherent in all ECB policy decisions. Monetary policy always will have distributional consequences within societies, and, in the eurozone, across countries.

But the German mainstream view is that ECB policies since 2008 have been designed to benefit weaker southern European countries at Germany’s expense. Again, it may be tempting to dismiss this argument as nonsense (which it is), and to point out that Germany has benefited as much as others from ECB policies over the past decade. But that will not resolve the conflict.

After all, the ECB has assumed an extraordinary degree of responsibility for maintaining economic and financial stability – first during the 2008 crisis, then during the subsequent European debt crisis, and now in response to COVID-19.

With a proper fiscal and capital-market union to strengthen risk sharing, divergences within the eurozone could be reduced, allowing the ECB to step back from sovereign bond purchases and other interventions. But this probably won’t happen any time soon, which means that the ECB would do well to adjust its strategy.

The ECB should revise its definition of price stability and its method of analyzing the implications of monetary policy, not to please the German court, but to enhance transparency.

For now, at least, that could help protect its operational, institutional, and legal independence.

But in the long term, the EU and member-state governments cannot ignore the German position. Despite several serious weaknesses and contradictions in its reasoning, the GCC raises legitimate and important issues concerning the ECB’s monetary-policy mandate and its role within the EMU.

In the best-case scenario, the EU will take the GCC’s ruling as a wake-up call to work toward a viable fiscal and capital-market union, and to clarify the ECB’s role therein. That will require a maddeningly difficult EU treaty change. But the alternative would be far worse.

Marcel Fratzscher, a former senior manager at the European Central Bank, is President of the think tank DIW Berlin and Professor of Macroeconomics and Finance at Humboldt University of Berlin.