The Capital Letter

The Capital Letter: Week of August 31

Traders work on the floor of the New York Stock Exchange in New York City, March 9, 2020. (Bryan R Smith/Reuters)
Good employment numbers, stock-market uncertainty, New York City’s suspended animation, and more.

It is beginning to seem as if I can begin this letter the same way every Friday:

“Another week has passed in our strange sort of stasis, with no real movement on another stimulus package.”

That is what I wrote last week, and that is what I am writing again this week. To repeat a theme — the greater the disruption that will arise out of the failure to pass another stimulus package now, the greater the reckoning that will come later (and don’t get me wrong: I don’t underestimate for a moment the problems that will be caused by all the debt that is being created).

Nevertheless, at a first (and even a second) glance, today’s unemployment release was somewhat encouraging.

CNBC:

Nonfarm payrolls increased by 1.37 million in August and the unemployment rate tumbled to 8.4% as the U.S. economy continued to climb its way out of the pandemic downturn.

The unemployment rate was by far the lowest since the coronavirus shutdown in March, according to Labor Department figures released Friday. An alternative measure that includes discouraged workers and those holding part-time jobs for economic reasons also fell, down to 14.2% from 16.5% in July and 22.8% at the peak in April.

Economists surveyed by Dow Jones had been expecting growth of 1.32 million and the jobless rate to decline to 9.8% from 10.2% in July.

Nevertheless, it is worth noting the final line of that CNBC report:

Markets initially reacted positively to the news, but stocks turned lower and continued the aggressive sell-off from Thursday.

As it happened, the market made back most of Friday’s earlier losses in the course of the day, but it’s hard not to see some signs of deeper unease. Even if the pull — hope of recovery, however exaggerated — may be faltering, the push — where else do investors put their money? — remains unchanged and has almost certainly been reinforced by Fed chairman Powell’s comments last week.

Writing earlier this week for Capital Matters on how the stock market was doing, David Bahnsen’s comments included, naturally, some observations on what the Fed’s behavior might mean.

There is the obvious, to be sure:

The monetary environment in which we find ourselves is screaming for a higher valuation on risk assets, as the risk-free rate has been brought back down to 0 percent. In a world where the ten-year treasury yield offers 0.6 percent in yield, the historical 16x multiple of equity markets is of very limited relevance. 20x or higher seems high, and it is high historically (other than in periods that later proved to be frothy). However, the market multiple does not exist in isolation — it is a by-product of market pricing that is always relative to a key pricing signal — the risk-free rate. Holding down the fed funds rate to 0 percent (and by the way, seeing every central bank around the globe do the same — over 80 percent of global sovereign debt right now trades below a 1 percent yield!) boosts the valuation of risk assets, most notably the highly desired and widely owned U.S. stock market.

But also . . .

The explosive interventions into debt markets, either through direct bond purchases (quantitative easing) or liquidity provisions (commercial paper, corporate debt, asset-backed securities) has had an incalculable impact on equity markets. Besides the basic reality of $3 trillion (and counting) of new reserves in the banking system and liquidity that finds its way into financial assets far easier than it does the real economy, how significant is it to corporate profitability to have borrowing costs reduced to their lowest level in history? Fed interventions in the corporate bond market (shockingly, both investment grade and high yield) have created extraordinary access to capital for companies that know how to use that capital quite productively…

Under the circumstances, it is interesting to see that, as John Authers put in at Bloomberg:

If we compare the amount of money deployed in stocks to total liquidity, for the U.S. and globally, we . . . find that money isn’t excessively allocated to stocks.

Nevertheless:

Commenting in the Capital Note on Thursday, Daniel Tenreiro had this to say:

There are obvious signs of worry. The VIX, a measure of expected volatility, stood at 26.6 as of yesterday, despite all-time highs in stock indices and relatively muted realized volatility for the past few months. Coinciding with a record high in the S&P, recent levels of market “fear” surpass those at any point during a stock-market peak.

As is well-known, much of the market’s strength has come from the extraordinary performance of a small number of tech names.

Bahnsen, earlier this week:

The five biggest names in the S&P are up roughly 50 percent, whereas the average stock in the index is still down on the year. In fact, 63 percent of the stocks in the S&P 500 are down on the year. The top five companies in the index (1 percent by number) make up a stunning 24 percent of the index by weighting. Those five names are up a whopping 42 percent more than the bottom 495 names in the index. The S&P 500 is composed of a staggering 37 percent in technology names when you add Google, Amazon, and Netflix to the S&P 500 Technology weighting.

Those of us who were watching the markets in 1999/2000 will have uneasy memories of the Dotcom bubble (and of what came next). However, Bloomberg’s John Authers makes this intriguing point:

There are two significant differences with 20 years ago. The popular stocks of today certainly include some that are very overvalued — but they are also making profits on a scale that the internet companies of 20 years ago could scarcely imagine. . . . If there is a bubble in the biggest tech companies, it is arguably in their profits, and how they have been allowed to build up monopolistic market power, rather than in their valuations.

Meanwhile, I continue to worry about what the election could mean for stocks, and by the election, I don’t mean the actual result (although of course that will matter — we will have more on that in due course) but the actual election process. In the Capital Note on August 31, I noted clear signs that markets were beginning to price in a much higher rate of election volatility in November than would normally be expected. I then expanded on this topic in a much longer article on Friday:

Writing in the Financial Times on September 1Robin Wrigglesworth reported that markets are signaling unease about what may lie ahead in the first week of November. It is not so much the election that’s causing agita as the fear that Election Night might not resolve the result. Investors do not appreciate uncertainty, and if everything is still unresolved by, say, late the next day, the only certainty will be uncertainty.

One intriguing detail is that implied volatility for the end of the year is still higher than normal, indicating that traders are positioning for the risk of prolonged turmoil after the poll.

They are, I suspect, right to do so.

Over at Capital Matters, we began the week with a piece so bleak that it could turn every day of the week into a Monday as Martin Hutchinson argued that “The American Economy Is Already Too Far Left for Comfort — or Prosperity”:

First, as government’s size grows, interest-rate distortions and regulation have increased, and the nominally “capitalist” economy has come to work less and less well. Second, today’s young people, like Marx, see few advantages to this “capitalist” system and believe that some new system would work better. They are right, but the new system that would work better is true small-government, sound-money, light-regulation capitalism, as Britain had in the decades that produced the Industrial Revolution. Alas, such a system is not on offer.

Nope.

Despite the title of his article — “Apocalypse Now?” –Kevin Williamson was rather more cheerful than Hutchinson, admittedly a low bar:

Because ideas become ideologies and ideologies become cults, political narratives often are accompanied by apocalypse stories. For libertarians, the preferred apocalypse is hyperinflation, which is always right on the verge of happening but never actually happens.

(Except when it does.)

The world’s central bankers convened in Jackson Hole last week, as they do every year, and Federal Reserve chairman Jerome Powell announced a significant policy shift: While previously the Fed had kept its eye on 2 percent inflation as an upper limit, going forward the central bank will look to maintain an average inflation rate of 2 percent, meaning that inflation could run in excess of 2 percent for . . .  “some time,” as Powell put it with perfect vagueness.

Libertarian ears pricked up, and libertarian noses snuffled the prevailing winds as gold futures climbed and the U.S. dollar weakened slightly.

Apocalypse . . . now?

There is good reason to fear hyperinflation. There is a lot less reason to fear hyperinflation now.

Ramesh Ponnuru seemed to take a somewhat similar view, dissenting from Robert Samuelson’s pessimism over the Fed’s shift:

Two differences from the 1970s militate against his scenario. First, we now have market indicators, albeit imperfect ones, of inflation expectations. We didn’t back then. We’ll have more advance warning, then, if inflation is going to speed to a gallop.

Second, there is a much stronger consensus among economists now that loose monetary policy causes high inflation. In the 1970s the idea of “cost push” or “wage push” inflation was much more widespread. Theories that held that unions were setting off an inflationary spiral by pushing for raises were one example of this kind of theory.

The Fed is, if anything, continuing to move away from this thinking. The very change to Fed strategy that occasioned Samuelson’s column included the announcement that the Fed is no longer going to treat low unemployment as a signal of dangerous inflation to come. Not seeing tight labor markets as the cause of inflation is in itself an advance in keeping inflation under control.

Whether or not it’s necessary to worry about inflation, there is, however, quite a lot of reason to fear for New York City, which is currently expected to survive in a state of semi-suspended animation, with, to take one of the most egregious examples, indoor dining still barred in Gotham.

I argued that this made little sense:

Quite when de Blasio will decide that he has pushed down the virus “enough” is anyone’s guess. His resemblance to one of the more obtuse First World War generals grows by the day. He is fighting the wrong war in the wrong way. And praying for and expecting a vaccine is just another way of saying that his only strategy is to double down on what has been tried so far . . .

The way humanity has learnt to deal with disease has been to find a way to live with it, and to do the most that can, to the extent compatible with keeping ordinary life going, be feasibly done to minimize its effects, while working towards a cure, more effective treatments and, where possible, a vaccine.

But waiting for a vaccine is not an answer. It is an evasion.

Robert Zubrin joined in the applause for government intervention with his review of Mary Ruwart’s Death by Regulation (well, when I say applause . . .):

The FDA was established in 1906 by the Pure Food and Drug Act, but it was relatively harmless until its powers were radically expanded in 1962 by the passage of the Kefauver–Harris amendments that gave it absolute power over the pharmaceutical industry. As documented extensively by Ruwart, since that time, the FDA has indulged in ever greater abuse of these powers, inflicting alarming harm on America — and humanity at large — in the process.

By radically and continually expanding the paperwork, testing, and other legal and regulatory obstacles to bring a new drug to market or treatment to practice, since 1962 the FDA has caused the development time for new drugs to triple (from an average of four years before the amendments to twelve today), the cost to multiply 40-fold, and the number of new drugs introduced per year to be cut fivefold. Within five years of the amendments’ passage, 98 percent of U.S. drug companies (including all the small innovative ones) were eliminated from the drug-development business. Before the amendments, 50 percent of all new drugs invented worldwide were developed in the U.S. Today, it is 15 percent. Not only that, many new life-saving drugs have been kept out of the United States for as many as 20 years after they were put into use in the U.K. or Europe.

“The nine most terrifying words in the English language are: I’m from the Government, and I’m here to help,” as someone once said.

Ed Conard, meanwhile, took a critical look at criticism of the Trump administration’s economic record:

No serious economist would measure a president’s performance blindly from the day they stepped into office until the day they left. The Trump administration should be evaluated for its response to the pandemic, but not for the pandemic itself. With eight years to shepherd the economy, President Obama should be measured by how his policies left the economy relative to the economy prior to the financial crisis, rather than by the economy’s growth from a temporary recession as if the recession were permanent.

By that measure, the Obama administration’s polices grew employment by 7 million workers over employment prior to the financial crisis at end of 2007. His policies did so at a time when the population of 25 to 64 year-olds grew by 8.6 million people. So, after eight years at the helm, the Obama administration created 1.6 million fewer jobs than the growth in working-age adults — the supposed “new normal.”

Kevin Hassett suggested that Joe Biden’s talk about the filibuster should act as a warning to moderates too trusting in good ol’ Joe:

Moderate supporters argue that the same retreat from radicalism that characterized the Obama administration would occur again, while convention speakers enthusiastically pointed to the recommendations of the Biden-Sanders Unity Task Force and promised to deliver.

Logically, if the intent of Vice President Biden were to ignite his base with aggressive promises, but to drop the policies, as happened before, he would perhaps discuss the policies at length, but then discuss his intent to generate bipartisan support in order to enact successful legislation. To some extent, this is the approach the vice president has taken, but ominously he has also expressed a willingness to consider a change to the filibuster rule in the Senate. When asked about it on a call in mid-July, Biden responded, according to the New York Times, “It’s going to depend on how obstreperous they become,” referring, of course, to Republicans.

Count me unenthused — that’s an understatement — about “socially responsible” investing, or anything that flows from it, but, in an thought-provoking piece, Richard Morrison made the case for a more intellectually diverse definition of “socially responsibility,” and set out how it could be implemented:

There are already private certification bodies that offer ESG ratings and endorsements for the companies that choose to seek them. Some, such as the United Nations-sponsored Principles for Responsible Investment, focus on members having some sort of “responsible investing” plan and prioritizing its consideration by senior managers. Others, such as the nonprofit organization B Lab, require applicant firms to adopt a long list of specific policies to get their seal of approval.

But those non-binding certifications — which companies can walk away from if their demands become too great — are not enough for some people. They point out that corporate law and precedent in the U.S. generally requires boards of directors to manage their firms to maximize shareholder returns, meaning that adopting policies that are ethically desirable but not profit-maximizing could expose them to shareholder litigation. Fortunately, it is possible for those business owners and managers who are afraid of being sued for doing too much good to incorporate in most states (including business incorporation fan-favorite Delaware) as a “benefit corporation,” the structure of which explicitly lifts the expectation of shareholder primacy from its directors.

If any change is necessary, it will be in the creation of additional, competing certification bodies. Many investors and managers concerned about ESG issues support the socially liberal B Lab, but there are also many people of goodwill who don’t embrace the same ethical framework and priorities. Why not have a socially responsible business-certification entity informed by the teachings of the Roman Catholic Church? Or perhaps one based on the Adam Smith Society, which has chapters at business schools across the country?

ESG skeptics, meanwhile, can take comfort from Morrison’s skewering of the Business Roundtable’s absurd (and, to me, somewhat sinister) embrace of “stakeholder capitalism”:

But the left-leaning ESG crowd would have you believe that before the last few years (and their own efforts), corporate America was a Wild West frontier of rampant fraud and abuse. America’s corporate leaders haven’t always been successful at debunking that impression. When the CEO members of the Business Roundtable issued their much-discussed “statement on the purpose of a corporation” in 2019, they pledged to compensate their employees fairly and deal with their suppliers ethically. This led quite a few people to wonder: If this is how they’re going to behave from now on, how exactly were they doing business before?

The Business Roundtable CEOs would no doubt insist that they have always acted in such a manner, and last year’s statement was just an opportunity to reiterate that fact. But that’s not the impression many observers got from the huge volume of news coverage and commentary that followed the announcement. If you walked by a nursing home and you saw someone hanging up a sign out front that said, “Here at Shady Pines, We Do NOT Beat Our Residents!,” it might raise more questions than it answers about how they operate.

Isaac Schorr tackled the question of how we should tackle our increasingly difficult and, to many, troubling economic relationship with China:

To stop the Chinese from eclipsing the U.S. as the world’s dominant power, we must not only outcompete them economically, diplomatically, and militarily, but morally as well. Tariffs must not be relegated to the role of cold economic mechanism, but instead to that of a moral statement, used to condemn a regime that blindfolds and binds religious minorities before shipping them off to concentration camps, as a video from a year ago showed the CCP doing.

Brad Polumbo explained “Why the Economic Scars of Rioting Will Haunt Minneapolis for Decades” and Brian Riedl detailed “How the Far Left Fails Basic Math”:

Bernie Sanders’s Medicare for All legislation includes no taxes at all, because no $32 trillion tax proposal exists (his website lists a menu of $16 trillion in mostly middle-class and business taxes). Similarly, when Elizabeth Warren claimed she could finance Medicare for All by taxing the rich, her proposal ultimately relied heavily on universal business assessments while still coming in at least $15 trillion short. Vermont in 2011 enacted a law mandating the creation of single-payer health care but repealed the law when it could not design a tax large enough to finance it. Alexandria Ocasio-Cortez’s and Ed Markey’s Green New Deal has never made the leap from a vague resolution to a specific bill, in part because no taxes could possibly fund that stratospheric cost.

In short, free-lunch socialism is a mirage. Europe finances big government with broad-based payroll and value-added taxes, and so would the U.S. The idea that taxing 800 rich people can finance trillions of dollars in permanent new benefits for 330 million people is laughably absurd. Perhaps Washington should instead finance a smaller program to distribute calculators to voters — and politicians.

Finally, we produced the Capital Note (our “daily” — well, Monday–Thursday anyway). Topics covered included: dollar weakness, lumber (!), the madness of crowds, the elusive V, Abenomics, the Japanese land bubble, the market flywheel, the stock sell-off, and euro-zone woes.

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