by Franklin J. Parker, CFA
The Summary
- Jobs data last week showed considerable weakness in the labor market through January. While this would normally be bad news, poor data provides cover for the Federal Reserve to continue printing money (called Quantitative Easing or QE) and Congress to send cash directly to households. Both of these are very positive for market prices in the short term, and investors will continue to watch Washington for signals that further stimulus is still on track.
- This week we get a large percentage of the S&P 500 reporting earnings, including consumer brands like Coca-Cola, Pepsi, and Walt Disney. Investors will watch these calls very closely. Big tech posted absolutely stellar earnings last week. AMZN was the superstar, but market reaction was muted with Bezos’ announcement that he is stepping down as CEO. GOOGL posted earnings 45% above this time last year (which was pre-pandemic)!
- Inflation data posts on Wednesday. Inflation has become a much more important data point that usual because it is the only real constraint on central bank activity. If inflation begins to surge, investors will expect the Federal Reserve to reign in QE, which would force investors to re-evaluate lofty stock valuations. In short: hotter inflation leads to a stock and bond market selloff, in our view.
The Details
Though it has been improving, no matter how you slice it the fundamental economic data is pretty bad. There are several data points which are at their worst levels since records have been kept. For example,
- Weekly initial jobless claims,
- The headline unemployment rate, and
- The year-over-year contraction in consumer spending,
are all at levels never-before seen. You couldn’t guess that by looking at stock and bond markets, though! The level of divergence between stocks and the real economy is staggering. It only makes sense when we consider the role of newly-printed cash flooding into the economy. Most of that cash finds its way into financial markets sooner or later, and it serves to push prices higher. My own research shows that, all else equal, giving investors more cash makes them perfectly willing to pay a higher price for the exact same security.
So, while I am indeed concerned about valuations (stocks have only been more expensive twice in history: 1929 and the late 1990s), these valuations are sustainable so long as the Federal Reserve keeps doing what it is doing. When current policy ends, it seems likely to me that current valuations will become unsustainable and a market dip becomes considerably more likely. Our portfolio positioning will be heavily influenced by our outlook on Fed policy.
Chart of the Week
With all the talk of Federal Reserve policy and its effects on asset prices, I thought it prudent to also discuss consequences of this policy. Inflation is, of course, the primary concern (and my nuanced thoughts on inflation deserve an entire post). More pressing, however, is the rise of “zombie” companies. In a nutshell, zombie companies are firms which have existed for five or more years and do not make enough revenue to cover the cost of their debt. This means they are forced to constantly seek new capital from investors to continue operating.
The Bank of International Settlements has now published several papers on this topic, the most recent of which I feature in this week’s chart of the week. Banerjee and Hofmann document the rise of zombie companies in various economies which they directly attribute to central bank policy of low interest rates and easy money. They have found that the share of zombie companies in the global economy has grown from around 4% in the early 1990s to around 16% as of 2017. They also find (unsurprisingly) that zombie companies invest less in physical capital (factories, equipment, etc), are less productive, and are considerably more leveraged than their non-zombie counterparts. In addition, their performance deteriorates significantly as they age.
In the end, an economy full of zombie companies lowers productivity, wage growth, and economic dynamism. That is, of course, not preferable to a dynamic and productive economy. In the end, this may be the most significant immediate side-effect of central bank policy.
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