Amid characteristically dour (some might even say “alarmist”) comments from the likes of Nouriel Roubini (who on Wednesday suggested New York may soon witness “mass looting” and “food riots”) and Jeff Gundlach (who is concerned about “mile long lines at Costco”), it’s always refreshing to hear from the handful of folks you can count on to, at the least, adopt a thoughtful, pensive tone.
One of those folks is Howard Marks, who, while striking a cautious chord in his latest memo, doesn’t fret too much about overtly dour outcomes like rampant pestilence and the possibility that large swaths of the populace will go Jack Torrance-style mad after being housebound for two months under virus protocol.
Oh, wait, actually he does.
“Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us”, Marks says, towards the end of his latest missive, which closes with two words: “Stay safe!”
So much for consoling everybody.
Marks has a section dedicated to the “positive case”, but I’m going to confine my summary and analysis to “the negative case” portion of his memo, not because I’m trying to spread anxiety, but rather because it’s just far more interesting.
First and foremost, Howard is concerned about America’s failings on multiple fronts in the fight to contain the spread of the infection. To wit, from Marks:
I’m very worried about the outlook for the disease, especially in the U.S. For a long time, the response consisted of suggestions or advice, not orders and rules. I was particularly troubled last weekend by pictures of college kids on the beach during spring break, from which they would return to their communities. The success of other countries in slowing the disease has been a function of widespread social distancing, testing and temperature-taking to identify those who are infected, and quarantining them from everyone else. The U.S. is behind in all these regards. Testing is rarely available, mass temperature-taking is non-existent, and people wonder whether large-scale quarantining is legal.
That captures the gist of his thoughts on the pathogen itself.
On the economy, he encourages you to think a bit further down the line in terms of what happens beyond the first or second missed paycheck(s).
“Many millions will be thrown out of work [and] people will be unable to patronize businesses’, he writes, adding that “not only will workers miss paychecks and businesses miss revenues, but businesses’ physical output will tail off, meaning essentials like food may run short”.
Maybe Roubini and Gundlach aren’t that far off with their “food riots” and “mile-long Costco lines” warnings after all.
Marks calls “some forecasters'” notion that S&P 500 earnings will fall just ~10% in Q2 “ridiculous”. He notes that some of the more dour projections see corporate America as a whole losing money in aggregate.
When it comes to the tradeoff between human life and economic activity, Marks simply writes that “the longer people remain at home, the more difficult it will be to bring the economy back to life, but the sooner they return to work and other activities, the harder it will be to get the disease under control”.
He also warns that “if we seize the opportunity provided by a decline in the number of new cases to resume economic activity, we risk a rebound in the rate of infection”.
The risk of that outcome seems to have diminished considerably this week as Donald Trump abruptly came around to the reality of the situation and how truly catastrophic it might be were he to make a rash decision not based on science.
We now know that, even if he’s merely looking out for his own political fortunes and trying to ensure that when the history books are written, his name won’t have yet another asterisk next to it, Trump does have a limit when it comes to taking risks – that limit is apparently the prospective loss of 2 million American lives, which he described as the worst-case scenario in a situation where proper protocols are not in place.
Marks goes on to briefly recap why it is that this turning of the credit cycle is going to be particularly painful. Here’s Howard:
Many companies went into this episode highly leveraged. Managements took advantage of the low interest rates and generous capital market to issue debt, and some did stock buybacks, reducing their share count and increasing their earnings per share (and perhaps their executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times . . . but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead.
Then, on the oil shock, he lays it out in bullet points:
While many consumers, companies and countries benefit from lower oil prices, there are serious repercussions for others:
- Big losses for oil-producing companies and countries.
- Job losses: the oil and gas industry directly provides more than 5% of American jobs (and more indirectly), and it contributed greatly to the decline of unemployment since the GFC.
- A significant decline in the industry’s capital investment, which recently has accounted for a meaningful share of the U.S.’s total.
- Production cuts, since consumption is down and crude/product storage capacity is running out.
- The damage to oil reservoirs that results when production is reduced or halted.
- A reduction in American oil independence.
Marks next addresses a crucial point which, while very simple, has been lost in the debate – namely that while it’s true Treasury can replace everyone’s income, someone has to make at least the necessities, otherwise, we’ll starve.
I imagine [Treasury] can print enough checks to replace every American worker’s lost wages and every business’s lost revenues. In other words, it can “simulate” the effect of the economy on incomes. But… we actually need the output of workers and businesses. If all businesses shut down, we won’t have the things we need. These days, for example, people are counting on grocery deliveries and take-out food. But does anyone wonder where food comes from and how it reaches us? The Treasury can make up for people’s lost wages, but people need the things wages buy. So replacing lost wages and revenues will not be enough for long: the economy has to produce goods and services.
Admittedly, I haven’t given that enough attention in these pages, primarily because I’ve endeavored to spend much of my free time (i.e., time not dedicated to “necessary” posts), to explaining that, contrary to popular belief, the United States cannot “run out of money”, nor is any amount of stimulus currently being pondered likely to cause any inflation, let alone hyperinflation in an environment of severely depressed demand and oil that’s about one bad week away from being free.
Marks then addresses Modern Monetary Theory which, Howard correctly says, is here. As in: We’re living it.
“It’s no longer just a theory; we have to deal with its implications now”, he says, before posing the following set of questions which, as ever, will resonate with most readers, if not so much with me:
- What would be the effect… on the value of the dollar, and thus on the dollar’s status as the world’s reserve currency? (Of course, in this environment, other countries are likely to behave much the same as we do, meaning the dollar may not be debased relative to other currencies.)
- Might a reduction of the dollar’s reserve-currency status make it harder for us to finance our deficits and raise the interest rates we have to pay to do so?
- Might money-printing to that degree bring on an increase in inflation?
- Might a supply shock stemming from reduced global output of raw materials and finished goods add to the increase in inflation?
Taking those one at a time, the dollar’s status as the world’s premier reserve currency is threatened more by US foreign policy than it is by any deficit, no matter how large.
For instance, the constant weaponization of the USD and the US financial system through draconian sanctions aimed at punishing perceived “foes” (sometimes for not very good reasons) along with the 2018 experience (when the rest of the world was again reminded that financial stability outside the US depends almost entirely on the Fed not erring by overtightening during a hiking cycle), are likely to be the key drivers of continued de-dollarization. Not deficits and not “money printing”.
Further, something has to replace all that USD-denominated debt for reserve managers. What would that replacement be, at the current juncture? Debt issued by the EU, a fractious monetary union with nothing that even approximates fiscal solidarity? Not likely. JGBs, issued by a country that’s been running a version of MMT for as long as anyone can remember? Maybe, but I doubt it, and if so, then why not just stick with US Treasurys? It’s MMT either way. Ironically, the best candidate is probably the Chinese RMB, but the idea that anyone is going to re-denominate the majority of their reserves in yuan is laughable right now, even if it might be a reality in 100 years. Gold isn’t an option. Historical precedent tells us that an international system of trade and commerce based on physical gold is prone to disaster for a laundry list of obvious reasons.
For what it’s worth, here’s the latest breakdown from the IMF:
- US Dollar Fell to 60.89% of known 4Q global reserves
- Euro’s global reserves share rose to 20.54% in 4Q
- Renminbi’s global reserves share fell to 1.96% in 4Q
- Sterling global reserves share rose to 4.62% in 4Q
- Yens’ global reserves share rose to 5.7% in 4Q
- Loonie’s global reserves share unchanged at 1.88% in 4Q
- Aussie’s global reserves share rose to 1.69% in 4Q
- Unknown or unallocated reserves rises to 6.35% in of total
Turning to Marks’s second question, it’s contingent on answering the first question in the affirmative. But I’m going to ignore that logical fallacy, and entertain it anyway. The answer is “no” or, at least, “probably not”, because where else are nations that need to recycle inflows going to do it outside of the UST market?
The answer to the third question is, for now, a simple “no”. And the implicit notion that MMT doesn’t address this is a straw man.
The answer to Marks’s fourth question is “yes”, and from my perspective, that question is by far the most interesting and therefore the most deserving of your attention going forward.
He concludes that section with this bit:
Possibly without serious vetting and a conscious decision to adopt it, Modern Monetary Theory is here. Whether we like it or not, we’ll get to see its impact much quicker than I had thought.
Finally, below is Howard’s conclusion, which I’ll present without further comment.
In the Global Financial Crisis, I worried about a downward cascade of financial news, and about the implications for the economy of serial bankruptcies among financial institutions. But everyday life was unchanged from what it had been, and there was no obvious threat to life and limb.
Today the range of negative outcomes seems much wider, as described above. Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go.
Nevertheless, the market prices of assets have responded to the events and outlook (in a very micro sense, I feel last week’s bounce reflected too much optimism, but that’s me). I would say assets were priced fairly on Friday for the optimistic case but didn’t give enough scope for the possibility of worsening news. Thus my reaction to all the above is to expect asset prices to decline.