Category: Economy

 

U.S. Debt as a Percentage of GDP Has Hit Levels Not Seen Since World War II

 

The federal budget deficit is projected to hit a record $3.3 trillion due, in part, to government expenditures to fight the coronavirus.  With the deficit, the U.S. national debt is now more than $26 trillion.  With the U.S. annual gross domestic product dropping to $19.5 billion in the second quarter, that means that debt as a percentage of GDP has skyrocketed to 133%, up from a level of 106% in 2019.  The table below shows that the debt/GDP number has grown steadily over the last forty years, with big jumps coming during periods when the government has stimulated the economy.  In 2009, for example, debt/GDP jumped from 68% to 83% when the government bailed out distressed financial institutions.  Increased government spending during times of economic weakness is an unfortunate necessity.  More alarming, however, is the fact that debt/GDP percentage is not reduced during times of prosperity.  

 

 

How much debt is too much debt?  Even before accounting for this year’s stimulus spending, the United States was responsible for 31% of the world’s debt.  Presumedly, that debt must be repaid at some point. At current levels, the U.S. debt represents approximately $80,000 for every man, woman, and child living in the United States. Is the current level of debt placing a burden on future generations? Or should debt be viewed as a cheap form of financing that should be used as long as it does not lead to higher inflation?  This article explores the pluses and minuses of higher government debt levels.

 

 

Rising debt is a big issue

• The government is saddling future generations
  with debt.  If one assumes that debt must be repaid, GDP is one measure of a country’s ability to repay its debt.  Think of debt to GDP as a measurement akin to debt to sales for corporations.  When debt was only 30% of GDP as recently as thirty years ago, it was reasonable to believe that the country could repay its debt in the foreseeable future.  With debt levels at 130% of GDP and approaching 150%, such repayment is harder to imagine without future generations taking severe austerity measures.
• High debt levels choke out savings needed to
  fund corporate borrowing.  The government must borrow the debt from someone.  In theory, that means that there are fewer dollars to purchase corporate bonds, and corporations must offer higher interest rates to bond investors.  This could affect corporate profitability and the ability to fund investments needed to fuel growth.
• Higher debt limits the government’s ability
  to stimulate the economy in the future.  No one questions whether governments should borrow to stimulate the economy during times of economic weakness.  However, it can not do so forever.  Debt cannot rise without limit.  Therefore, increasing debt levels means that the government will be less able to do so in the future should the need arise.
• On-balance-sheet debt does not include many
  other government obligations.  The national debt reflects the cumulation of annual federal budget deficits.  However, there are many other government obligations.  Social Security is an example of a government obligation not included in federal debt.  Economist Jim Hamilton estimates that off-balance-sheet liabilities could exceed $70 trillion, or roughly three times that of on-balance-sheet debt.
• Our debt is held by foreign governments and
  carries the risk of being used against us for political reasons. Foreign entities own $6 trillion, or 29%, of the debt issued by the U.S. government, including $1 trillion held by China.  Should a country make a sudden decision to sell U.S. Treasuries, it could have negative implications for treasury market and the U.S. economy.  The large ownership by foreign entities is the result of the fact that the United States has run a trade deficit for many decades.  If a foreign entity were to suddenly decide that it no longer wanted to hold U.S. dollars in the form of treasuries, it could cause the dollar to drop suddenly and weaken the nation’s purchasing power.
• A loss of confidence in the government’s
  ability to repay debt could be disastrous.  Treasury rates are low because the bonds are backed by the full faith and credit of the U.S. government.  But what if investors begin to doubt the country’s ability or willingness to pay back their debts?  Such doubt could lead to a wave of selling in the treasury markets, pushing interest rates higher and thus putting additional pressures on the government.

 

 

Rising debt is not a big issue

• Other countries have a higher debt to GDP
  rate.  The United States is not alone in reporting rising debt levels. Other countries such as Japan and Greece have spent their way towards economic growth and are doing well.  Japan’s debt, for example, is 235% of its GDP.
• The nation has had debt levels larger than
  GDP before and survived. As mentioned earlier, the U.S. debt as percentage of GDP rose above 100% during World War II due to increased government spending. When that spending stopped, debt levels decreased.  Government stimulus to combat the effects of the pandemic can be viewed as a temporary increase in spending.  There is no reason to believe debt spending will resume to more normal levels once the impacts of the virus subside.
• Not borrowing to stimulate the economy would
  mean lower GDP, so the rate would rise anyways. Federal deficits are the function of two things: government spending and the receipt of taxes.  Since taxes are directly correlated to GDP, government spending to stimulate GDP growth can be viewed as an investment that will result in higher tax collection.  Conversely, if the government were to not spend money to grow the economy, the debt-to-GDP ratio could rise anyway because of negative or limited GDP growth.
• Interest rates are low. The United States is engaging in a strategy of increasing debt while at the same time lowering interest rates through moral suasion.  The strategy of increasing debt while pushing interest rates lower is a key component of Modern Monetary Theory. The Fed has set the discount rate (the rate at which eligible financial institutions may borrow funds) at the low rate of 0.25%.  This directly affects the rate at which financial institutions lend to customers.  To date, there is no sign that government borrowing is affecting corporate borrowing.

 

Conclusion

The debate about government debt levels will probably continue for centuries.  To date, rising debt levels have not had an adverse effect on interest rates, inflation, or corporate lending.  On the other hand, the U.S is approaching debt levels never seen before in history.  In April, the Congressional Budget Office projected the deficit for Fiscal Year 2020 will be $3.7 trillion.  If another stimulus package is passed, the deficit could read $5 trillion. The CBO also projects fiscal 2021 government spending of $4.8 trillion.  That means that the government will borrow more in 2020 than it typically will spend in a given year.  Repaying the debt cannot be done by cutting government spending for a few years. It will take decades of austerity. 

 

Suggested Reading:

JOLTS Report Suggests More Risk Taking

Small-cap Stocks are Looking Better for Investors

Can One Do Well and Do Good in Tandem

 

Each event in our popular Virtual Road Shows Series has a maximum capacity of 100 online investors. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you 
here.

 

Sources:

https://www.cnbc.com/2020/09/02/budget-deficit-to-hit-record-3point3-trillion-due-to-virus-recession.html, CNBC, September 9, 2020

https://theconversation.com/why-the-22-trillion-national-debt-doesnt-matter-heres-what-you-should-worry-about-instead-111805, The Conversation, February 14, 2019

https://www.investopedia.com/articles/investing/080615/china-owns-us-debt-how-much.asp, Investopedia, January 15, 2020

 

 

Job Market Stats Suggest More Clarity, More Clarity Suggests More Economic Activity

 

Earlier this year, after both individuals and companies in the U.S. began to grasp that North America is not immune to the lockdowns and distancing experienced overseas, and both groups took steps to protect and prolong their financial positions. Companies that had infrastructure plans to enhance operations or production put those orders on hold. Many withdrew from signing agreements for services such as marketing, investor relations, hiring, and hiring. Some went as far as suspending existing agreements. Individuals acted in a similar fashion. Plans that included financial commitments like buying a car, starting a small business, or changing jobs were paused while households waited for greater clarity.

Small signs have been emerging recently that companies in many industries are now cautiously open to investing in their future. Spending includes new hires, infrastructure, and marketing. The consumer has been slower to enter into commitments. New car sales are down 20%, retail sales seem contingent on stimulus pay, and overall frugality remains the trend. However, there is a recent indication that individuals are willing to play it less than safe. The indication isn’t in consumption or other retail sales; it’s in a section of the Bureau of Labor Statistics (BLS) report on unemployment. A table that usually gets little attention.

 

JOLTS

The job openings and labor turnover survey (JOLTS) is conducted monthly by the BLS to help measure job vacancies. The labor department’s definition of vacancies is positions that have become available, the companies are looking for candidates to fill the openings that could start within 30 days. A section of this monthly survey is at a five-month high as of July. This could indicate that U.S. workers feel renewed optimism and understanding to a large enough extent that they are willing to take risks with their financial stability.

 

 

The Numbers

The report released on September 9 shows that nearly 3 million people quit their job in July. This is a large increase of 344,000 over June.  What’s most impressive is the number of job leavers as a share of total U.S. employees rose to 2.1%; this is close, but still below, the 2.3% that was prevalent previously while the unemployment rate was near historic lows.

The improvement in confidence demonstrated by people’s willingness to resign is not the same across industries or regions. Those holding positions in mining, real estate, and business services were most likely to quit their jobs.  Workers in positions in the fields of hospitality and manufacturing were less likely to resign compared to the prior month.

 

SOURCE: Bureau of Labor Statistics, Job Openings, and Labor Turnover Survey, September 9, 2020.

 

Devil’s Advocate

As with any set of economic statistics, a lot is impacting the number of quits each month. Certainly, there are many factors. During this year, when workers are perhaps more concerned about health risks in their work environments, or unrest in their towns, one would presume this would motivate and add to resignations. Digging into the data and reviewing the nature of the positions where resignations are highest, it suggests that health, civil unrest, and even childcare are not significant factors. Although an argument can be made that these concerns are motivators in retail quits, it doesn’t explain office professionals who are not likely to have higher childcare issues than they have most summers. Moreover, utility workers, those in retail, real estate professionals, and mine workers are in positions less likely to be impacted than those showing reduced quits such as manufacturing, finance, and food services.

In the past, an increase in resignations overall or in the industry suggested an increase in bargaining power (demand for positions increase or supply of workers decreased). This has not been the case for the industries with the greatest pickup in quits.

Peter Morici, an economist and professor emeritus at the University of Maryland, believes the quits should be viewed as a sign of progress in the job market; his reasoning is any concerns workers may hold are not new for July, yet resignations materially rose. He believes Americans are learning to live with the virus, so the increase in the rate of quitting foretells more career and personal confidence than prior months.

 

Take-Away

As individual workers and companies learn better to assess the current environment and the options available, they become more likely to make decisions. As with many other areas of life and business, postponing a decision or standing still should also be viewed as a decision.  That decision should be given as much review as making a move. Doing nothing is often riskier than continuing to move in ways that will help your future. Individuals and or corporate management should always remain mindful that they’re continually in competition. Those they are in competition with are moving in ways that they believe will give them an advantage. There will be costs to those focusing too closely on those things already under better control and not opportunities that they have put on hold.

The next BLS report that will include JOLTS for the month of August will be released on October 6.

Paul Hoffman

Managing Editor, Channelchek

 

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View our full schedule of Virtual Road Shows and sign up for one here.

 

Sources:

JOLTS Definitions

Consumer Sentiment Dropped as Stimulus Checks Ran Out

Amazon Update, How We’re Responding to the Crisis

March 21, 2020 email from Jeff Bezos

BLS JOLTS

Is it Safe to Shop

Car Sales Down 20%

 

Picture:  Wolf of Wall Street (quitting scene)

 

Economic Disparity Issues May Lead to a “K” Shaped Recovery

 

The economic retreat associated with the COVID pandemic was sharp.  The U.S. GDP declined by 32% in the second quarter.  Indications are that the economy is beginning to improve, although the pace of improvement is uncertain.  This uncertainty opens the questions:

    Will it bounce back quickly, creating a V-shaped recovery? 

    Will the economy slowly accelerate upward in a U-shaped recovery? 

    Could we experience a slight rebound and then fall back before rising again in a W-shaped recovery? 

    What if the economy stagnates at current low levels, this would create an L-shaped growth trend? 

A fifth option is a “K” shaped recovery. The concept of a K-shaped recovery has become a rallying point for the Joe Biden presidential campaign.  Biden referred to the concept in a speech on September 4^th describing how high earners are fairing better than low-wage workers during the recession.  Symone Sanders, a senior campaign adviser to Biden, reiterated the claim on Fox News Sunday.  Tim Murtaugh, the communications director for the Trump campaign, fought back, claiming that working-class and middle-class Americans are both benefiting from the rebounding economy, even if not equally.  The extent of the division between the haves and the have nots has implications that affect more than just the upcoming presidential election.  If true, it can help identify the industries and companies that will do well as the economy rebounds and those that will do poorly.

 

 Source: U.S. Chamber of Commerce

recently, a new letter is being used to describe the economic recovery: a K-shaped recovery.  In a K-shaped recovery, some industries do very well, such as office and tech companies.  Other industries do poorly, such as entertainment and food services companies. The recovery would affect workers differently. White-collar workers with adequate technology can adjust their jobs to work from home.  Blue-collar workers, who work at manufacturing plants and restaurants, can not.  Single paycheck families are less affected by homeschooling and reduced daycare options.  Dual income families are not as flexible.  Households fortunate enough to own stocks and homes are thriving while those straddled with debt are not. Such a recovery would increase the wealth disparity that has been growing in recent decades.

 

 

Evidence of a K-shaped recovery

There is an indication in the unemployment numbers.  The financial services sector has already recovered 94% of its pre-pandemic employment, while the leisure and entertainment sector has only brought back 74%.  Neiman Marcus, JC Penney, Pier 1, and J. Crew have all filed for bankruptcy this year.  The U.S. Bureau of Labor Statistics report for July shows that teenagers were the largest group to return to work while unemployment measured among African Americans remained flat.  These employment reports seem to bear out the trend that white-collar workers are doing better than blue-collar workers during this summer’s recovery.

Stock market strength generally favors the rich.  There’s a joke that the best way to become a millionaire is to start with a million dollars.  Similarly, the best way to increase wealth is to be wealthy.  The stock market has been strong this summer, shrugging off weak economic news.  The strength has benefited the wealthy disproportionately at a rate that has never before experienced.  The wealthiest 1% of the population now owns 52% of the stock market, up from a level of 40% just twelve years ago.  The chart below shows that the percent owned by the top 1% has grown steadily in recent years. 

 

 

A similar story can be told when looking at housing.  Housing Starts surged 22.6% in July while interest in renting stalled. The chart below shows that both housing listings and rental listings have risen during the economic recovery.  However, it also shows that house listings are far outpacing rental listings.   If homeownership is a reflection of wealth, the growth in housing relative to rental activity may be a sign of an increased disparity between the economic classes.

 

 

Counter Argument to the K-shaped Recovery

The start of a recovery may not affect all industries at
the same time but should eventually.  It is easy to understand why white-collar jobs are better positioned to benefit from a new “stay at home” economy.  However, these advantages may prove temporary if the pandemic eases and people return to restaurants and other entertainment venues.  It certainly could be the case that there is pent up demand that may be unleashed if a vaccine is implemented.

Let the free market be.  The success or failure of individual industries is largely a function of supply and demand.  If blue-collar jobs are not coming back, it may be a sign that there is less demand for those jobs.  Such a transition may require workers to retrain to new jobs.  A restaurant cook becomes a package delivery person, for example.  Such a transition is natural, and interfering with the transition only creates problems further down the road.

 

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Enjoy Premium Channelchek Content at No Cost

 

Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you here.

 

Sources:

https://www.cnbc.com/2020/09/04/worries-grow-over-a-k-shaped-economic-recovery-that-favors-the-wealthy.html, Jeff Cox, CNBC, September 4, 2020

https://thehill.com/homenews/sunday-talk-shows/515303-symone-sanders-warns-of-k-shaped-economic-recovery, Zack Budryk, The Hill, September 6, 2020

https://www.foxnews.com/politics/trump-campaign-biden-k-shaped-economic-recovery, Andrew O’Reilly, Fox News, September 7, 2020

https://www.washingtonpost.com/politics/2020/08/19/finance-202-economists-talking-up-k-shaped-recovery-stocks-surge-inequality-widens/, Brent D. Griffiths, The Washington Post, August 19, 2020

https://www.uschamber.com/series/above-the-fold/the-k-shaped-recovery-and-the-cost-of-inaction, Suzanne Clark, U.S. Chamber of Commerce, September 3, 2020

https://www.forbes.com/sites/lisettevoytko/2020/08/07/18-million-jobs-added-in-july-as-us-economys-pandemic-recovery-falters/#39a7c53b13db, Lisette Voytko, Forbes, August 7, 2020

 

The Fed Updated Its Approach Toward Influencing Inflation and Employment

 

The policy goals of the Federal Reserve are to support economic conditions that achieve both stable prices and maximum sustainable employment. On August 27, the Federal Reserve’s Federal Open Market Committee (FOMC) announced updates to its Statement on Longer-Run Goals and Monetary Policy Strategy. With respect to maximum employment, the FOMC stated that its policy decisions would be informed by its assessments of shortfalls of employment from its maximum level instead of deviations from its maximum level. With respect to price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2%. It now will seek to achieve inflation that averages 2% over time, meaning those following periods when inflation has been running persistently below 2%, monetary policy will likely aim to achieve inflation moderately above 2% for some time. The updates were intended to address the challenges of implementing monetary policy in a persistently low-interest-rate environment. What are the implications of the new policies?

 

Stable Prices and Inflation Goals

The FOMC believes that an inflation rate of 2% per year, as measured by the annual change in the price index for personal consumption expenditures, is congruent with achieving its dual mandate. The chart below, sourced from the Wall Street Journal, illustrates core inflation relative to the Fed’s target since 1994. 

Source: Wall Street Journal, August 27, 2020.

According to Federal Reserve Board Of Governors Chairman Jerome Powell speaking at an August economic symposium sponsored by The Federal Reserve Bank of Kansas City, inflation that runs below its desired level can lead to lower long-term inflation expectations, which can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations. This is perceived as problematic, given that expected inflation influences interest rates. Chairman Powell stated that if inflation expectations fall below its 2% target, interest rates would also decline, which would leave the Fed with less ability to cut interest rates to boost employment during an economic downturn. The chart below, sourced from The New York Times, illustrates the effective federal funds rate over time. Despite decreases in the fed funds rate, inflation has remained below the Fed’s 2% inflation target in recent years.

Source: The New York Times, August 27, 2020.

While some worry about the potential for Fed policy to result in asset bubbles that could destabilize the economy, Chairman Powell indicated that if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, the Fed would not hesitate to act.

 

Maximum Employment

To assess the sustainable maximum-employment level, the FOMC considers a broad range of labor market indicators. Because the structure of the labor market is strongly influenced by nonmonetary factors that can change over time, the FOMC does not set a fixed goal for maximum employment. The policy update appears to indicate that the Fed will be less apt to increase rates to stave off fears of inflation at times when unemployment is low. Chairman Powell stated that the new policy reflects the view that a robust job market can be sustained without causing break-away inflation.

 

The Take-Away

While critics of the updated policies believe it will inflate asset prices without enhancing economic growth, others believe the inflation target should be raised to avoid deflation. Based on Chairman Powell’s remarks, it appears the Federal Reserve is more concerned with the prospect of inflation running below its 2% target than above it. Importantly, the new policy framework seems to suggest that interest rates will remain lower for longer. However, it will be important for the Fed to strike a balance between interest rates and inflation. Low-interest rates have penalized savers, who are finding it difficult to earn an adequate return on cash. Other financial assets, including equities, have benefited, along with housing due to low mortgage rates. Precious metals are often prized as a store of value and hedge against inflation. Since the end of the first quarter through September 2, gold and silver futures prices have risen 21.7% and 93.0%, respectively. Time will tell whether the Federal Reserve will get it right this time.

 

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Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you here.

 

Sources:

Monetary Policy: What Are Its Goals? How Does It Work?, Monetary Policy Principles and Practice, Board of Governors of the Federal Reserve System.

Federal Open Market Committee Announces Approval of Updates to its Statement on
Longer-Run Goals and Monetary Policy Strategy, Press Release, Board of Governors of the Federal Reserve System, August 27, 2020.

New Economic Challenges and the Fed’s Monetary Policy Review, “Navigating the Decade Ahead: Implications for Monetary Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jerome H. Powell, Chair, Board of Governors of the Federal Reserve System, August 27, 2020.

Fed Chair Sets Stage for Longer Periods of Lower Rates, The New York Times, Jeanna Smialek, August 27, 2020.

Fed Changes Its Approach to Inflation, as Leaders Aim to Navigate Future Crises and Reach Full Employment, The Washington Post, Rachael Siegel, August 27, 2020.

Fed Approves Shift on Inflation Goal, Ushering in Longer Era of Low Rates, Wall Street Journal, Nick Timiraos, August 27, 2020.

 

 

How Plausible is a Massive Permanent Switch to Work from Home?

 

The COVID-19 crisis has already caused significant changes in the way we live, from face mask regulations to social distancing, to restrictions on capacity. Many predictions have been made by the chattering class about how COVID-19 will change the way we live and work. But how plausible are some of these predictions?

One of the most common forecasts is a permanent move to “work from home” setups. Such a move enforces social distancing on employees, making wholesale disruption from another crisis less likely. From a company’s standpoint, employees working from home could reduce the amount of real estate needed, enabling firms to reduce a whole host of costs associated with owning or leasing real estate. According to the Bureau of Labor Statistics, pre-pandemic some 15% of U.S. employees had regularly scheduled work at home days, with about 25% of U.S. employees working from home at least occasionally.

Those Least Likely 

But how plausible is a massive switch to work from home? According to the Bureau of Labor Statistics, as of July 2020, there were approximately 118 million private-sector non-farm payroll jobs. Of these, some 20 million worked in the manufacturing, construction, and mining industries. Trades unlikely to see any meaningful move to “work from home.” Another 26 million jobs were in the Trade, Transportation, and Utilities segment. It wouldn’t appear many of the 5.3 million transportation jobs can be done at home. How many of the 14.8 million retail jobs can be done remotely is up to debate. How many of the 19.5 million health care jobs or the 12.6 million Leisure jobs can be performed from home? Now, some 21 million jobs are in the Professional & Business Services and Finance classifications, and its possible some portion of these jobs could be accomplished from home.

Other Challenges

But apart from the deciphering, whether a job can be performed adequately remotely, there remains a whole host of other questions. Working at your kitchen table temporarily is one thing. To do so on a full-time basis is untenable. Who pays to create office space in existing housing? Who pays to furnish such an office? What about utilities? Office supplies? Will employee collaboration be better or worse under a Zoom environment versus a face-to-face environment? How much flexibility is built into work schedules when an employee has their office in the home and can access it 24/7/365? Does a company need to alter the way productivity and performance are measured?

While a work from home reaction to a serious crisis sounds reasonable at face value, many more questions need to be answered before such a switch becomes plausible.

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Enjoy Premium Channelchek Content at No Cost

 

Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you 
here.

 

Sources:

1. https://www.politico.com/news/magazine/2020/03/19/coronavirus-effect-economy-life-society-analysis-covid-135579
2. https://www.shrm.org/hr-today/news/hr-magazine/summer2020/pages/how-the-coronavirus-pandemic-will-change-the-way-we-work.aspx
3. https://www.forbes.com/sites/williamarruda/2020/05/07/6-ways-covid-19-will-change-the-workplace-forever/#442ea46c323e
4. http://www.ila-net.org/Reflections/rriggio.html?gclid=Cj0KCQjwvvj5BRDkARIsAGD9vlJMwG5tZcYVsCtBbSAN-hH-HUX_uv8ES8-mNOMe49i5ZKg7FRqUvDIaAseiEALw_wcB
5. https://www.thedrum.com/opinion/2020/06/10/six-ways-covid-19-changing-business-the-better
6. https://www.mckinsey.com/business-functions/risk/our-insights/covid-19-implications-for-business
7. https://review.chicagobooth.edu/behavioral-science/2020/article/covid-19-will-change-way-we-think-risk

 

Backed by the Full Faith and Credit of Blockchain
Is the U.S. Ready for a Federal Reserve Digital Currency?

 

Cash may carry viruses, but computer code doesn’t.  Oh, wait a minute…

Last week The Federal Reserve discussed the research they’re undertaking to better understand the risks and benefits of central bank cryptocurrencies. I suspect risk of infection, both digital and microbic, are also being reviewed. The main considerations include speed, security, privacy, and resiliency. The task they’re undertaking in conjunction with MIT over the next several years will involve intense experimentation, modeling, and creative exploration.

 

Background:

According to a news release from the Federal Reserve Board of Governors, The Federal Reserve Board’s Technology Lab (TechLab) has been experimenting with crypto-currency technologies. TechLab conducts research that now includes the exchange or use of existing cryptocurrencies. Their activities are designed to further the Fed’s understanding of payment technologies so they may better develop views and policies. TechLab is composed of people with varied experience in the field of exchange mediums,  economics, law, information technology, and computer science.

It is the position of the Fed’s Board of Governors that it is essential, “given the (U.S.) dollars important role” that the Federal Reserve remains on the forefront of research and policy development regarding central bank digital currencies(CBDC). “Like other central banks, we are continuing to assess the opportunities and challenges of, as well as the use for, a digital currency, as a complement to cash and other payment options,” said Federal Reserve Board Governor Lael Brainard.

In addition, the Federal Reserve Bank of Boston is collaborating with researchers at the Massachusetts Institute of Technology (MIT) on a multiyear effort to build a hypothetical digital currency for central bank use. This project is intended to support the Fed Board’s broader efforts in assessing safety and efficiency of digital currency systems overseen by central banks. The project with MIT is said to focus on developing an understanding of the capacities and limitations of the technologies. It is not supposed to
serve as a prototype for a Fed issued digital currency.

 

Federal Reserve Boston:

The Federal Reserve Bank of Boston’s multiyear collaboration with the Digital Currency Initiative at MIT will explore the use of existing and new technologies to build and test a hypothetical digital currency platform.

“We are thrilled to be working with the Digital Currency Initiative at MIT and our colleagues in the Federal Reserve System to learn the intricacies of building a CBDC platform,” said Boston Fed President and CEO Eric Rosengren. “Jim Cunha is leading our team here in Boston, and I know they are committed to researching and testing the leading technologies available to determine if they can meet the design requirements of a U.S. based central bank digital currency.”

The Boston Fed and MIT have mapped out their collaboration into work phases that extend over two to three years. The first phase involves jointly building and testing a hypothetical central bank digital currency (CBDC). The first phase objective is to determine how to develop the architecture for a scalable, accessible cryptographic platform able to meet the needs of a U.S. dollar CBDC.  Design considerations include stringent requirements for speed, security, privacy, and flexibility.

In later phases, researchers will assess technology trade-offs by coding and testing various architectures, to see how they impact the CBDC’s design goals. The research results will be published jointly with MIT, and the code would be licensed as open-source software, so anyone can use or continue experimenting.

Separately the Boston Fed will evaluate other systems to better comprehend the pros and cons in supporting a CBDC.

 

MIT Digital Currency Initiative:

The MIT Digital Currency Initiative’s (DCI) collaboration with the Federal Reserve Bank of Boston to build a hypothetical digital currency brings additional expertise and a “laboratory” to the project.

The DCI has a lab which, according to their website, includes as their goals:

1. Conduct research on blockchain and digital currency, broadly defined within two categories:
• 1. Core software and infrastructure development that addresses questions about security, stability, scalability, privacy, and the internal economics of these systems
  2. Pilot projects and other research initiatives aimed at exploring and testing applications and use cases for the technology within business, government and society at large.
2. Be a neutral convener for governments, nonprofits, and the private sector to research and test concepts with high social impact.
3. Foster diversity and inclusion in the development and adoption of this technology by promoting access to educational resources among a wider body of students inside and outside MIT.
4. Equip students with skills to drive innovation in blockchain technology

 

They are at the forefront offering classes and labs in blockchain, cryptocurrencies, and markets. A short (six week) class is available online.

 

Take-Away

Technological innovations inspire new ways to think about money. Consistent with its role in promoting a safe, accessible, and efficient U.S. payment system, the Federal Reserve is engaging in research and experimentation with the latest payment technologies. As with most things in a rapidly changing world, methods of exchange are also in flux.  Payment systems overseen by the U.S. Federal Reserve system need to be attuned to what tomorrow may bring. Researching the strengths and weaknesses in a potential digital currency in advance can help avoid any ill-informed decisions down the road.

The Federal Reserve also continues its collaboration with other central banks and international organizations as it advances their understanding of CBDCs. The acceptance of cryptocurrencies is now so widespread that top schools like MIT offer educational programs in the technology, economics, and law associated with the non-cash currency.

 After reviewing the brochure for the six-week online DCI class at MIT, I learned that the online course is $2,600. It lists various payment methods. You can pay via credit card, debit card, bank deposit, or EFT. At the moment, cryptocurrency payers need not apply.

Paul Hoffman

Managing Editor

 

Suggested Reading:

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Fintech?

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Once Thought Insurmountable are Falling Fast

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Content at No Cost

 

The Federal Reserve Bank of Boston announces collaboration with MIT to research digital currency

MIT Media Lab CRYPTOCURRENCY

MIT Lab Online Short Course Cryptocurrency

Does Money Carry Germs

https://dci.mit.edu/

COVID, Sex, and the Business Cycle

 

There will be far fewer newborns named Karen in 2021. Overall, in the U.S., there will be far fewer newborns period. This is not because young adults of childbearing age are meme-o-phobic like the Karen-avoiders. More simply, it seems humans just don’t breed well in captivity, or when their finances are challenged.

This runs completely counter to the prognosticators that only a couple of months ago had wryly told us that there would be a baby boom in the coming year.  Do you remember reading the articles pushing the notion that sharing space, with little else to do, would lead to babies? At that time, my email inbox was full of “stocks to buy” to take advantage of the coming baby boom. This all made for very interesting conjecture, but it was not real world. To write this column, I went back and reread some of what was projected a few months ago. I focused on the advice — the stocks presented as outperformers next year because of the overabundance of babies. Like everything else in 2020, betting on the opposite of “conventional wisdom” has had the greatest payoff. Here is what’s actually happening to family size and what it means to investors.

 

Postponing Propagation

The Guttmacher Institute is a respected research organization committed to advancing sexual and reproductive health and rights in the United States.  The researchers at Guttmacher surveyed 2,000 American women in late April and early May and discovered that 34% planned to delay pregnancy or reduce their expectations of the number of future children. The reduction was directly related to the coronavirus pandemic. This was twice the number of the 17% who said they now preferred more children or to increase household size sooner.

In June, the Brookings Institution, the think-tank research provider specializing in social science and economics, 
released a study predicting the U.S. will have “a large, lasting baby bust.”

The Brookings researchers forecast that there will be 300,000 to 500,000 fewer children born in the U.S. in 2021 compared to if the pandemic had not occurred. This equates to a decrease of 10% from 2019. Based on their research, it is likely that the number of children never born is likely to be several times larger than Americans whose lives are ended by the novel coronavirus (current estimate is near 160,000). The impact of this population growth derailment will be long-lasting – Many of the curtailed births represent people who would have easily lived into the 22nd century.

This raises the question of whether postponing births will have an impact on total births for the decade. Evidence suggests that each time a child is postponed, the chances of that specific mother having a “catch-up” birth is reduced. According to Pew Research, “The expanding literature on the effects of unemployment on childbearing suggests that experiencing unemployment leads to different childbearing propensity for men and women.” They found that for men, being out of the labor force has a very negative impact on their propensity to father children. The results were a bit more contingent for women. Globally, their various studies have concluded: “Because a vast majority of women interrupt work after giving birth to a child and the maternity and parental leave allowances usually do not fully compensate for their lost wage, males’ ‘breadwinning capacity’ remains of paramount importance for couples’ childbearing decisions.” In July, the unemployment rate for men between 25-34 years-of-age was 11.7% up from 3.9% in January, for women of the same age group unemployment in July measured 11.1%, which was more than three times the January level of 3.5%.  The higher unemployment rate among men suggests that the Guttmacher survey of women may actually understate the couples’ propensity to grow their family.

 

Repercussions

Recessions mean fewer children and fewer children lead to more recessions. One year can impact decades of business activity with this vicious circle. The spike in unemployment and a decline in GDP has already had an impact on reducing the number of expectant mothers (relative to 2019). Further, with guidelines prohibiting large groups from gathering, engaged couples (as many as 75%) are postponing their big wedding until next year. For most, this will push any plans for children farther down the road.

Surveys such as the National Survey of Family Growth show that the average American woman wants two children or possibly three. Depending on how long the economic pace remains challenging, the pandemic may leave that desire unfulfilled.

For the economy, the companies that are likely to take the first hit are those that had been touted earlier this year by newsletters telling us we could profit from the coming births. On May 22^nd, I received one of these emails that listed baby clothes manufacturers, toymakers, formula, a manufacturer of birth center equipment, and a daycare company, as worthwhile investments. The second group most impacted are companies that make more durable goods (think washer/dryers, soccer mobiles, furniture, carpeting, etc.).  Young adults will have a reduced need and reduced means to nest (fix up their homes). This will lower sales of all the related purchases they would have otherwise considered.

 

Down the road, a lower birthrate leads to fewer future workers. The Social Security system is at risk as it collects funds from today’s workers to make payments to today’s retirees. As of the last evaluation, the system becomes insolvent in 2034. A slower rate of births will compound their difficulties. Every two-tenths decline in the total fertility rate (that is, two fewer children per 10 women) requires an increase in the Social Security payroll tax of about 0.4 percentage points, according to the 2020 Annual Report of the Trustees of the Social Security Trust funds.

 

Outlook Past 2020

Business growth and wealth creation depend on consumption, productivity gains, and a low level of burdens on companies and income earners. Service industry employment now accounts for 71% of all nonfarm employment. Prior to what I’ll call the 2020 surprise(s), manufacturing in the U.S. began to increase.  The percentage may still increase further, but any higher rate may be on a lower overall number of employed. This higher percentage may be the result of reduced reliance on Chinese manufacturing.

Baby boomers are now in or within ten years of retirement age. The increasing cost of maintaining a substantial elderly population falls on those still in the labor force. The labor force is shrinking, and the pandemic lead decrease in births will in 20 years place further strains on government programs like Social Security.

Over the next ten years, there will be the largest wealth transfer in history. Baby boomers who have dominated the focus of marketers on everything from music to investment products will begin to leave their legacies to their children, mostly millennials. This younger age group has already become the largest demographic block; they will soon become the greater consumers. How they allocate mom and dad’s savings remains to be seen. But the new wealth handed to a generation with fewer kids will provide a great deal of discretionary buying power and possibly stimulus which can provide for economic growth.

Americans have always been quick to adapt when money is at stake. One thing that the “lockdown” provided was a push for companies to adopt technology that makes being physically together less important. This impetus to move faster to the inevitable office-optional future will help clear the path advancement and world needing fewer workers. Think about it; the largest problem with the lower birthrate is there are fewer people to provide goods and services (GDP). If many jobs require less as a result of changes in work environments, then productivity increases are established (more done in the same amount of time), and efficiencies are created (more done with less). This will either provide more profitable companies (economic stimulation), or the ability to get more for your dollar, which provides for a higher standard of living.

The problem with the scenario presented above is that it looks forward several years. In the interim, there will, no doubt, be hardship. People will have to reinvent themselves; some won’t do it successfully, those that do will have to first take a step backward.

 

Take-Away

Back in the 1970s, scientists talked about the population explosion the way some discuss global warming today. It was going to mean a horrible challenge for civilization. Slower population growth has to occur at some point. As a presidential hopeful in 2012,, Newt Gingrich promised a permanent human colony on the Moon and a shuttle to Mars. Discussions of outgrowing the planet have a long history. Increased longevity has been a good thing, but it has its drawbacks. Resources are limited.

The economic system we rely on has depended on constant growth in our population to provide for funding to the many liabilities and obligations of our government. Repaying the national debt would naturally be more difficult with a smaller tax-base, and an increase in longevity further stresses many government programs. We live on a finite planet with finite resources. Continual growth is mathematically unsustainable. The pivot that we have made as a result of the pandemic to do the same or more with increased efficiency than having someone else prepare our meals, having to commute to an office, consulting a retail sales clerk at a department store, etc., has been a forced awakening to unnecessary waste. The drawbacks of a reduced birthrate, on a planet that is currently housing 7 billion people, may continue to steer us toward solutions to problems that we have not been addressing.

Workers who have computer and technology skills should continue to excel in the next stage. Businesses that adapt and adopt early will thrive. Stock market investors looking for outperformers will need to assess who the winners and losers will be based on who is moving quicker to adapt. Change always creates losers. Losers always help create larger winners. As investors, this is what we need to sort out.

The most reliable thing change always creates is opportunity. Pay attention, watch what is going on, get analyst insight as to the inner workings of growth industries you are considering. Find the companies that can do more with less.

Paul Hoffman

Managing Editor

 

Suggested Reading:

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Warren Buffett Vs. Elon Musk, Who’s Right?

COVID-19, Scary vs Dangerous

 

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Sources:

Yes, People Really Aren’t Naming Their Babies “Karen” Anymore

Blackout Baby
Myth

Projected SARS-CoV-2 US Deaths as of Aug. 6 2020

Life Expectancy

Unemployment and Birthrates (Pew Research)

Bureau of Labor Statistics (Labor Force, July 2020)

The Effects of Aggregate and Gender-Specific Labor Demand Shocks on Child Health

Natality Trends in U.S. (CDC)

Survey of Reproductive Health Experiences

Brookings Institute, Covid Baby Bust

Will Coronavirus Spike Births?

Pandemic Impact on Social Security

10 facts About American Workers (Pew)

Utilities Currently Provide Attractive Return For The Risks Investors Incur

Electric, gas, and water utilities are called natural monopolies.  Since it is more cost-efficient to have only one utility providing service to a neighborhood, regulators give a utility monopoly rights in exchange for regulating the price they charge customers.  Rate setting is a complicated process, but the basic concept is to set prices so that utilities get the chance to recover all their costs and be left with a residual amount to compensate investors for the risks taken.  The residual amount is referred to as the allowed return on equity, and it is one of the most contested components of any rate case.  Typically, the allowed ROE is set at a level above the risk-free interest rate.  Long-term government bond yields are a good proxy for risk-free interest rates.  The figure below shows that there is a strong correlation between 30-year Treasury Yields and the allowed returns granted one year later.

Source Valuescope

The graph shows that the allowed ROE premium over long-term government bond yields has traditionally been 500-700 basis points.  However, allowed returns do not automatically change when interest rates change.  There is some stickiness that prevents returns from rising when bond yields rise or fall when bond yields fall.  Note in the graph below that as yields have fallen in recent years, the spread between allowed returns and bond yields has grown.

 

If we plot the allowed return premium against the 30-year US Treasury yield, we see a negative regression line.  The figure below shows that when bond yields are near 6%, the allowed return premium has only been 500 basis points but when rates fall to 2%, the premium rises to 700 basis points.

 

This is an important fact to consider now that 30-year US Treasury bond yields have fallen to 1.2%.  Allowed returns can be expected to fall from their current level of 9-10%, but will they go as low as 8% (700 basis point premium)?  Or, will they stick at a level near 9% (800 basis point premium) as the regression formula in the chart above would seem to indicate.

The implications of rapidly declining bond yields and authorized returns are many.  First, many utilities may attempt to stay out of rate cases.  Remember that actual return and allowed returns are not the same thing.  Once a utility’s rates are set, it may earn above or below its allowed return depending on customer usage, operating costs.  Typically, earned returns will slip as operating costs rise with inflation until earned returns get so low that the utility files for a rate increase.  Occasionally, earned returns are above the earned returns and regulators call the utility in for a rate decrease.  However, rate decreases are rare.  In the case of falling allowed returns, a utility may accept earning below its allowed return because it knows it would not get a rate increase anyways when its rates are set based on a lower allowed return.

A second implication of a sudden drop in interest rates is that utilities may be earning higher returns than needed for several years.  As mentioned earlier, regulators are slow to request utility rate decreases.  Utility investors may reap the benefits of higher return if they are able to hold the line on operating costs.  This could make utility stocks an attractive investment until regulators catch up with the drop in interest rates.

 

Suggested Reading:

Nuclear Energy Expectations Through 2050

COVID-19 May Be Killing  the US LNG Market

Virtual Investment Conference, August 2020

 

Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you  here.

 

Source:

https://www.valuescopeinc.com/energy-roe/, Valuescope, August 26, 2019

https://marketrealist.com/2016/11/look-us-utilities-return-equity/, Vineet Kulkarni, Market Realist, 11/1/2016

https://www.spglobal.com/marketintelligence/en/news-insights/research/average-u-s-electric-gas-roe-authorizations-in-h1-18-down-from-2017, S&P Global Market Intelligence, 8/2/2018

Corporate Taxes: Who Pays? What’s the Rate? How Much is Raised?

Corporate income taxes are levied by federal and state governments on business profits. The taxes, and more specifically, the tax rate, have become another contention point. Under President Trump, the Tax Cuts and Jobs Act of 2017 (TCJA) lowered the corporate tax rate from 35% to 21%, while some related business deductions and credits were reduced or eliminated. Prior to the 2017 legislation, the headline corporate tax rate had been at 35% since 1993 and had been on a downward trajectory since hitting 52% in 1952. Democratic Presidential nominee Joe Biden has stated that his administration “will ensure that corporate America finally pays their fair share in taxes.”

The Rate

Although the Federal headline rate is 21% today, when including the average state and local taxes, the statutory corporate income tax rate in the United States is 25.7%. This rate puts the United States in line with the average amongst the Organisation for Economic Co-operation and Development (OECD) member nations, according to the Tax Foundation. Notably, the Tax Foundation notes that before the TCJA passed, the United States had the highest combined statutory corporate income tax rate among the OECD nations at 38.9%, approximately 15 percentage points higher than the OECD average, which could have put U.S. corporations at a significant competitive disadvantage to their international peers.

Finding a true effective tax rate for business is elusive, however, since many U.S. businesses are not subject to the corporate income tax but are taxed as “pass-through” entities. Pass-through businesses do not face an entity-level tax. But their owners must include their allocated share of the businesses’ profits in their taxable income under the individual income tax. Pass-through entities include sole proprietorships, partnerships, limited liability companies (LLCs), and S-corporations.

The Amount

So how much revenue does the corporate income tax actually raise? The corporate income tax is the third-largest source of federal revenue, although substantially smaller than the individual income tax and payroll taxes. It raised $230.2 billion in the fiscal year 2019, 6.6% of all federal revenue, and 1.1% of gross domestic product (GDP). The relative importance of the corporate tax as a source of revenue declined sharply from the 1940s when the corporate tax raised 7% of federal revenues to the mid-1980s when it raised 1% of revenue. Since that time, it has averaged less than 2% of GDP, according to the Tax Policy Center. On a dollar basis, in 1952, corporate taxes raised $21.2 billion in 1993, $117.5 billion, hit a high of $370 billion in 2007 and $299.6 billion in 2016 before the TCJA was enacted.

The Burdened

So who really pays corporate taxes? On the face, the corporation that writes the check pays the tax. But if corporations seek to hit specific profitability levels, if taxes are raised, what actions do the corporation take to protect its profitability level? Some economists, such as Gregory Mankiw, suggest when the government levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people—the owners, customers, or workers of the corporation. The corporate income tax reduces shareholders’ after-tax returns, causing them to shift some of their investments out of the corporate sector. Shareholders will shift some investments to non-corporate (“pass-through”) businesses and some to foreign businesses not subject to the U.S. corporate income tax. The shift to these other sectors lowers the after-tax return on investments in these sectors. The shifting of investment out of the corporate sector continues until after-tax returns—adjusted for risk—are equalized in the corporate and non-corporate sectors. Thus, the corporate income tax reduces investment returns in all sectors, according to The Tax Policy Center.

While the overall tax rate grabs the headlines, the subject of corporate taxation is significantly more multifaceted than a single number.

 

Suggested Reading:

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Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you here.

 

Sources:

Tax Policy Center

The Role of Confidence in Today’s Fed Policy

In recent years, the government and the Federal Reserve have been employing a policy closely aligned to Modern Monetary Theory (MMT).  Under MMT, the government pushes the economy up to a point near full employment by stimulating the economy through fiscal spending and a loose monetary policy.  Government is less concerned with running up the federal debt than expanding the economy.  At the same time, the Federal Reserve declares its intent to keep interest rates low by buying bonds.  By stating interest rate targets, it may not even need to actively buy bonds in the open market as investors will be reluctant to sell bonds at interest rates above targeted levels.  Lower interest rates, of course, serve the government well as its debt grows.  MMT argues that federal debt should not be a concern because the government can always print money.  Given the political attraction of being able to spend without worrying about debt levels, politicians on both sides of the aisle have been embracing MMT.

 

Such a policy has served the United States, Japan, and Germany well in recent years.  But the policy relies on two key assumptions.  First, the government will only stimulate the economy up to the point that it begins to cause inflation.  Once there are signs of inflation, the government will reduce its spending or raise taxes to lower private-sector spending.  If consumers do not believe the government will cut back on spending, they will continue to consume ahead of price increases.  Second, investors must believe that the Federal Reserve will step in to support its price targets.  If investors believe interest rates are about to rise, they will sell bonds and offset any efforts by the Fed to buy bonds.  At the heart of MMT is the belief that federal debt is different from private debt and that rising federal debt will not crowd out the ability of the private sector to issue debt.  To date, foreign investors have actively purchased U.S. debt. 

When the economy shut down this spring, the government stepped in with a heavy dose of both fiscal and monetary stimuli just as it did after the Great Recession when it bailed out troubled banks.  That stimulus helped offset reduced private sector spending.  The action did not lead to inflation because unemployment levels were high.  But what will happen when the pandemic ends?  The economy entered the pandemic in a position of near full employment.  In fact, some would say that it was operating at a rate below the transitional unemployment rate.  When unemployment gets too low, workers are not available to find their way towards fast-growing industries.  This can reduce future economic growth.

 

Source: U.S. Bureau of Labor Statistics

 

So, what happens if furloughed workers return to work at the same time the economy is exploding with pent-up demand.  Under MMT, the government should react by raising taxes and increasing targeted interest rates.  However, raising taxes and increasing interest rates may be difficult to do in a politically charged environment.

 

 

And, what happens if bond market participants lose confidence in the United States?  Interest rates could rise in defiance to the Federal Reserve’s attempts to target low rates.  In such a scenario, the Fed would be forced to print more money to buy bonds, essentially doubling down its bet.  In essence, MMT is comparable to the gambler who keeps doubling his bet, thinking that eventually, he will win and eliminate his losses.  Like the gambler, MMT supporters are not concerned with debt, and the gambit works as long as the holders of debt remain confident that it will be repaid.

 

Suggested Reading:

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Sources:

https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained, Dylan Matthews, Vox, April 16, 2019

https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3, Jim Edwards and Theron Mohamed, Business Insider, March 2, 2020

https://www.marketwatch.com/story/heres-who-owns-a-record-2121-trillion-of-us-debt-2018-08-21#:~:text=Some%2070%25%20of%20the%20national,information%20from%20the%20U.S.%20Treasury., Jeffry Bartash, MarkeWatch, August 23, 2018

The Complex Relationship Between the Pandemic and Market Volatility

The Coronavirus pandemic has impacted the global and U.S. economies and led to a sharp rise in unemployment. The U.S. unemployment rate was reported at 13.3% for May based on U.S. Department of Labor statistics, representing levels not seen since the great depression (Exhibit 1). There are currently over 40 million Americans unemployed. Following 128 months of expansion, representing the longest on record since 1854, U.S. entered a recession in February. As the markets react to the uncertainty attributed to coronavirus infections and unemployment, the volatility in the markets seems to be inevitable (Exhibit 2).

Exhibit 1. The Percentage of Unemployment in the last 10 years in U.S.

 

Exhibit 2. The Overlay of S&P 500 (SPX) Index and CBOE’s Volatility
Index (VIX)

Source:
indexindicators.com and Noble Capital Markets

Nobel Laureate and NYU Stern professor Robert F. Engle and his co-authors (Ahmet K. Karagozoglu and Nazli Sila Alan) wrote a working paper on a forecasting model for the impact of COVID-19 pandemic on volatility in global equity markets.  The paper recently became available on the Volatility and Risk Institute at NYU Stern School of Business website at https://vlab.stern.nyu.edu/covid19. The authors used a multi-regime forecasting model to investigate the impact on market volatility. The findings include

1. daily number of active cases are significant predictors of realized volatility,
2. stricter policy responses by individual countries result in lower stock market volatilities,
3. higher negative managerial sentiment causes an increase in realized volatilities.

 

Exhibit 3. Daily COVID-19 Cases for selected 7 countries January 22 to
May 1, 2020

Source: Alan, Engle, and Karagozoglu,
“Multi-regime Forecasting Model for the Impact of COVID-19 Pandemic on
Volatility in Global Equity Markets”, Volatility and Risk Institute Working
Paper, Stern School of Business New York University, June 15, 2020

Two different measures of equity market volatility (i) GJR-GARCH volatility based on global stock indices and, ii) realized volatility based on intraday prices of country specific ETFs), were used to differentiate the market uncertainty attributed to the pandemic. The intraday 5-minute returns for 46 country-specific ETFs were used to determine the realized volatilities, and daily GARCH volatilities are estimated using the stock market indices of 88 countries around the world. Dr. Engle received the 2003 Nobel prize in Economic Sciences for his work on analyzing economic time-series data, that formed the basis of the GJR-GARCH model used in this paper.

The largest increase in volatility levels were observed on February 24th, March 9th, and March 16^th , then realized volatility (RV) returned to its pre-pandemic levels on April 3rd. GARCH and RV volatility levels for seven of sample countries are shown in Exhibit 4.  The U.S. stock market reached peak volatility level on March 16th, 4 days after the Italian market. The volatility levels for all countries have been declining since then.

Exhibit 4. Daily Realized Volatility (5-min) for selected 7 countries
between January 22 to May 1, 2020

CHN (China), DEU (Germany), ESP (Spain), GBR (United Kingdom), ITA (Italy), KOR (Korea), and USA Source: Alan, Engle, and Karagozoglu,
“Multi-regime Forecasting Model for the Impact of COVID-19 Pandemic on
Volatility in Global Equity Markets”, Volatility and Risk Institute Working
Paper, Stern School of Business New York University, June 15, 2020

In Exhibit 4, the daily median realized volatilities (RV), calculated using 5-minute intraday returns for country specific ETFs and GARCH volatilities are shown for seven countries including China (CHN), Germany (DEU), Spain (ESP), United Kingdom (GBR), Italy (ITA), Korea (KOR), and the USA. A total of 46 country specific ETFs were analyzed and estimated using GARCH model for daily stock index returns of 88 countries as well as the CBOE VIX for the U.S.

The analysis of text of publicly traded firms earnings call transcripts of in various countries (Textual Data Analytics of Transcripts database of the S&P Global Market Intelligence for 6,500 publicly traded firms from 38 countries) was used to correlate managerial negative sentiment due to the pandemic and the broader market volatility. Negative Sentiment were identified as the ratio of total number of negative words to total number of Master words in the same transcript.

Exhibit 5. Daily Median GARCH Volatility for Global Equity Markets vs
Mean Global COVID-19 Curvature and The Comparison to CBOE Volatility Index
between January 22 to May 1, 2020

 

Source: Alan, Engle, and Karagozoglu,
“Multi-regime Forecasting Model for the Impact of COVID-19 Pandemic on
Volatility in Global Equity Markets”, Volatility and Risk Institute Working
Paper, Stern School of Business New York University, June 15, 2020

The empirical analysis suggests a complex relation between the pandemic metrics and stock
market volatility. The multi-regime forecasting model for the relation between equity market volatility and the coronavirus pandemic hypothesize that the number of active cases and negative sentiments by the management teams are powerful predictors of daily cross section of volatilities, while stricter policy responses by individual countries result in lower stock market volatilities.

 

Suggested Reading:

 

More
Accurate than Polls to Gauge Election Outcomes

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Are
we on the Verge of Acquisition-Mania?

 

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Sources:

https://vlab.stern.nyu.edu/static/Covid19Volatility_MultiregimeForecasting_VRI_NYU_20200615.pdf

Vacations, Viruses, and Vantage Points

My ex-wife would not get on a plane. She was certain, if we flew, she would die. Together we found other ways to make the planet our playground — workarounds that might scare someone with alternative fears. We’d drive 1200 miles with no sleep, keeping pace with speeding 18-wheelers. Some weekends we’d bicycle the steep inclines in the Pennsylvania mountains. Summers we’d cruise for weeks at a time from as far north as Boston, to as far south as Cape May.  On these vacations, she was completely at-ease, paying no mind to the statistical risk, road conditions, sea conditions, or impossibility of stopping a speeding bike while descending down a mountain. She didn’t perceive any of these workarounds as potentially deadly. She would not, however, get on a commercial aircraft, “too dangerous” for her.

Distortion of risk in one’s mode of travel is not unusual.  As a person who models investment probabilities, I find this distortion of probabilities and others worth exploring.  We are now halfway through 2020, a year marked by fear and panic surrounding the dangers of Covid-19.  Measuring then categorizing the risk to health has been tricky; our increased understanding of the disease helps.

Covid-19 Concerns

The novel coronavirus that is the cause of this pandemic has been, for 130,000 Americans, deadly.  So, awareness and precautions for individual safety and the well-being of others are prudent. But, the risk of the average person dying compared with the perceived danger may not match. After all, we deal with much deadlier diseases every day without immersing ourselves in concern. We live with the idea that cancer, diabetes, and heart disease each kill far more people a day than coronavirus. Even snakes kill 137 people a day. We are not up in arms clamoring to stay inside until we eradicate snakes. So why is the Covid-19 reaction so extreme?  One answer is similar to fear of your plane crashing. When a plane does go down, the story is intensely reported by the media, traditional and social. This exposure causes the risks inherent in flight to feel very high and scary. We know by measuring actual cases that the danger of flight isn’t greater than being killed by, let’s say, the next mosquito we encounter. And yet, we don’t lock ourselves in our homes based on the death risk from mosquitos. Concern surrounding Covid-19  for some is that they will catch it and die. Others don’t want to be infected as they may spread it to someone else who may have a bad outcome. For others, the concern is that the danger or fear will dramatically alter their life, business, family, recreation, travel, etc. There are also people who fear that people they know are at great loss resulting from the reaction to perceived danger.

For now, the historically unprecedented lockdowns and economic sedation continue with very little argument. From discussions I have had, it seems that a significant portion of the population has come to believe that this coronavirus is one of the scariest things the human race has ever dealt with. It is definitely a little scary; it is, after all, it’s invisible, but is it dangerous? Could it be that a large portion of the population may be confusing “scary” with “dangerous.” They are not the same thing.

Covid-19 Dangers

There are four ways to categorize different realities. A situation can be:

• Scary, but not dangerous
• Scary and dangerous
• Dangerous, but not scary
• Not dangerous, not scary

COVID-19 continues to rank high in the scary category. I’m sure that the radio station I listen to is like many others throughout the country; it alerts me every 20 minutes of new cases. TV news, Facebook, and Twitter bombard us with relentless new case tallies without context. This magnified information, as with a single plane crash, impacts the population’s psyche. A Google search of the word “COVID-19” retrieves over 5.8 billion results. We’re surrounded by scary stories from those that are far too closer to home. To date, the virus has cut short the lives of a growing number of citizens. But is it very dangerous? On a scale of harmless to extremely dangerous, it would still fall into the category of slightly dangerous for by most definitions, (excluding the elderly and those with ill-health).

 

Google Trends

Approaching July 4^th
weekend, Google Trends shows the term “Covid-19” being used 375% more than the
term “Independence Day.”

By comparison, there are more dangerous risks. Many give little thought to heart disease, which is the leading cause of death in the United States, killing around 650,000 people every year, 54,000 per month, and 324,000 people at the 2020 mid-year mark. This qualifies as extremely dangerous. Yet, most people are not very frightened at all.

Lives are improved for those that can distinguish between fear and danger. It doesn’t matter if it is fear of getting on a plane or boat or unwillingness to leave one’s house during this health situation. Fear is an emotion; it’s a perception of risk. As an emotion, the most important facts often don’t enter an individual’s calculation. Media hype blurs reality even more.

What if the top analysts at FICO adopted much stricter standards because they felt (emotionally) lending suddenly became much scarier, even if trends and other metrics they follow didn’t support the fear?  This would impact the ability of borrowers to get loans, rates on loans, and the overall freedom of innocent people would change because a few people are scared, without supporting data. Imagine if an insurance actuary with a personal fear then grading the risk of something 1,000 times riskier than the measured data indicates. This would unnecessarily have a negative impact on the business and those seeking insurance. This is exactly what people have done regarding COVID-19: decisions based on fear and perception of danger even though data is now available.

Covid-19 Data

According to CDC data, 81% of deaths from COVID-19 in the United States are people over 65 years old, most with preexisting conditions. If 55-64-year-olds are added in, that number jumps to 93%. For those below age 55, preexisting conditions play a significant role, but the death rate is currently around 0.0022% or one death per 45,000 people in this age range. Below 25 years old, the COVID-19 fatality rate is 0.00008%, or roughly one in 1.25 million. Fear, not data, is impacting all industries and every aspect of life. For instance, the perceived danger is keeping schools and daycare centers closed. This makes it harder for mothers and fathers to remain employed and daycare centers to not close forever.

All human death is tragic. But are we allowing feeling scared to dictate decisions when it leads to taking resources away from areas that are more dangerous, but not as scary, and allocate them to areas that are scary, but less dangerous? At times, this is what is being done. Hospitals and medical practices have had to be very selective in the patients they treat; this is done to allow for beds, if needed, for Covid-19 patients, this has severely reduced surgical procedures. In the weeks following the first stat-at-home guidance, cervical cancer screenings were down 68%, cholesterol panels were down 67%, and diabetes blood sugar tests were off 65% nationally.

The U.N. estimates that infant mortality rates could rise by hundreds of thousands in 2020 because of the global recession and diverted health care resources. Add in opioid addiction, alcoholism, domestic violence, and other detrimental reactions from job loss and despair and the price of attributing excessive danger to the Covid-19 response can be viewed as unfortunate and even tragic.

Any benefits gained through this fear-based shutdown have massively increased dangers in both the short term and the long term. Every day that businesses are shuttered while people remain unemployed or underemployed, the economic wounds grow more deadly, and the scars more permanent. The loss of wealth is immense, and this will undermine the ability of nations around the world to deal with true dangers for decades to come.

Shutting down the private sector (which is where all wealth is maintained and created) is truly dangerous even though many of our leaders suggest we shouldn’t be scared to do it. Even stimulus plans are like a Band-Aid on a massive laceration, it may stop a tiny bit of the bleeding, but the wound continues to worsen, as it worsens, another inadequate Band-Aid is applied until you one day run out. Moreover, we are putting huge financial burdens on future generations because we are scared about something that the data reveal as far less dangerous than many other things in life. Putting this monstrous bill on the yet-to-be-born is an ethical decision that a country that stands against taxing the unrepresented should not take lightly.

Take-Away

Although there may be workarounds to the overblown fear that does not correlate to the risks in a given situation, unnecessary decisions compared to rational decisions are at best inefficient. A shutdown may change the pace of the spread of a virus, but it won’t stop it. A vaccine may immune us, an effective one may never be created. What then? In the meantime, we have entered a odd era, one in which fear overrides danger, and near-term risk creates long-term problems. More people are starting to come to this realization as the data builds. Hopefully, lessons are learned, and in the future, reality becomes the chief guide in steering decisions of this magnitude.  

Paul Hoffman

Managing Editor

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Sources:

Plane
Crash Fatalities

USCG
Boat Safety Statistics

How Safe is Commercial Flight

Cyclist Fatality Rate

Cancer Statistics

Coronavirus Death
Toll

How Many People Has Covid-19 Killed?

AHA Hospital Statistics

Is There Profit to Be Made Off Government Stimulus 2.0?

With all the conflicting chatter surrounding the next round of Covid related government stimulus, the only thing that’s certain is that there will be another round. Expectations differ as to what will be elevated to high priority and what may be different than the previous round. The amount of money involved, likely to be $1- $3 trillion or more, will impact the fortunes of both the industries targeted and ancillary businesses not directly touched.  This, of course, keeps investors listening for clues to where stimulus dollars will be spent, which industries are incentivized, and if infrastructure spending will be ramped up as it was during the economic weakness in 2008-2009.

The direction the final package takes could depend on the soon to be released jobs report which will be out just before the long holiday weekend. The previous jobs report included many positive surprises. If the surge in Non-Farm Payrolls continued, it would weaken the argument for new stimulus checks and extended unemployment insurance.

U.S. Payroll, Actual and Forecast – May/June

Source: Trading Economics
(Calendar)

 

As with most things in Washington, the nature of the stimulus is a high stakes contest. Continued strength and employment gains could weaken the Democrats’ preferred plan of extending benefits to individuals. If Payrolls declined in June, that would pressure the White House and Republican-controlled Senate to support larger measures than they are now considering. The lawmakers are not expected to discuss any plans until they reconvene on July 17, after their Independence Day recess.

The Chatter

Most presume that the next mega-dose of stimulus out of  Washington will set aside a large portion dedicated to infrastructure improvement projects, and perhaps manufacturing support. Much uncertainty lies in how individuals and small businesses are best supported.

In anticipation of any package, materials prices have been rising as commodity traders anticipate all competing plans to include infrastructure projects. Within infrastructure, there are expectations of spending on “green” energy and digital technology. In a CNBC article published on June 24^th titled, “Welcome to the age of copper: Why the coronavirus pandemic could spark a red metal rally,”  it’s shown that copper is seen as a bellwether for the general state of the economy. The demand turned sharply down during the height of the pandemic in March. In recent days, copper has been trading close to its pre-coronavirus high at $5,909 per metric ton. Both here and abroad, there are expectations that demand for copper will dramatically increase as investments in energy generation and distribution have more support from public funds. Any new demand would not create shortages, as copper mines that have been closed during the worst part of the pandemic are reopening throughout the globe.

Expectations from a White House stimulus plan are that it will be designed with an eye toward changing our economic landscape with more domestic manufacturing.  According to White House trade advisor Peter Navarro, the president wants the next stimulus bill to be “at least $2 trillion.” This is close to double the $1 trillion Senate Majority Leader McConnell said he plans to target. However, it’s smaller by a third to the House bill asking for $3 trillion, which was passed on May 15^th. The House bill is not scheduled for a Senate vote.

Government Led Construction Spending in Recessions

 

Spokesmen for the White House have been very public on what they believe should be the primary impetus of any stimulus spending. In an interview on Fox Business News trade advisor, Navarro said a “key thrust” to the stimulus bill should focus on manufacturing jobs. He followed this by highlighting an underlying theme of “Buy American” “Hire American” and “Make it in the USA.”  The strategy would be to remake and improve on what we had before the lockdown. Although the service sector could benefit from more direct attention, the plan more likely would support manufacturing jobs. These jobs would then be expected to have a ripple effect creating more service sector demand. When asked for specific incentives to be included, Navarro said, the bill will be designed to create demand for more investment in the U.S.  A payroll tax cut is also viewed as a “critical” part of the plan.  The White House views this as critical to create the appropriate incentives for employers to keep workers working.” It also serves as a take-home “pay raise” for workers.

The Beneficiaries

What could tax cuts, deregulation, cheap energy, and beneficial trade deals mean for business? As mentioned, it would help rebuild the country’s manufacturing base. There is a particular focus on domestic production of pharmaceuticals, medical supplies, and equipment. The demand-driven growth could positively impact new tech, including biotech and what Navarro called the “SpaceX economy.” Other beneficiaries could be raw material providers and producers of infrastructure development, including electricity providers. Some of the expectations may already be reflected in equity prices.

Companies with high payrolls doing business in the USA will immediately see reduced costs. Investors should not just look for where revenues will be increased, as cost reduction immediately adds to income statement bottom lines. Government contractors should be busier with projects as diverse as drinking water, roadway construction, border barriers, waterway maintenance such as dredging, bridges, etc.

If stimulus checks are part of an approved plan, this could have a positive impact on discount brokers. After the last round of government checks, there was an increase in the newer breed of app-based traders. Additional funds in their accounts add to the bottom line of no cost per trade brokers that make money off the spread between what they earn on the balances and their cost. Additionally, household name stocks with per-share price equal to or less than the cost of a large coffee at Starbucks may also rise as these securities get more attention from investors on these apps.

Take-Away

Change brings opportunity. Determining what that change will be and how it will impact industries and businesses is how uncommon returns are made. Within political bargaining, there’s universal support for infrastructure projects as a way to update the old and take a giant step forward with the new. This explains why metals such as copper have experienced a strong  rebound. The pandemic demonstrated the need to manufacture medicine and equipment within the U.S. Domestic pharmaceutical companies could continue to gain more investor attention. The attention from “app-traders” to low priced stocks, both those that were giants and have been beaten down, and small and micro-cap stocks that could be on their way to becoming giants, will continue to create runaway opportunities that can no longer be ignored by mainstream investors.

 

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Sources:

Congress Days in Session 2020

Fitch Solutions maintains copper price forecast as economies start to reopen

Copper Demand
Could Soar Thanks to Coronavirus

TRANSPORTATION CONSTRUCTION WHAT IMPACTS
WILL COVID-19 HAVE ON PROJECT FUNDING?

A Wharton analysis predicts Trump’s infrastructure plan could create 1 million new jobs

 

Latest Updates On The Coronavirus
Pandemic

Next Stimulus
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