weekly relative value - alloya corp · svp, director of institutional fixed . a human tragedy . two...

Weekly Relative Value

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WEEK OF APRIL 13, 2020

Tom Slefinger SVP, Director of

Institutional Fixed Income Sales

A Human Tragedy

Two weeks ago, it was a record 3.3 million initial claims; last week, it was an additional (upwardly revised) 6.8 million in initial claims; and this past week, another 6.60 million claims. That is a shocking 16.8 million people who have applied for unemployment benefits in the last three weeks. The three-week tally implies an unemployment rate of around 13% or 14%, surpassing the 10% peak reached in the wake of the last recession. This is simply stunning. And as shown graphically below, last week’s “continuing” claims were at the highest level ever!

Source: Bloomberg

A record-high 17 million people have filed for unemployment in the last three weeks. Amazingly, it would be significantly higher if overwhelmed websites in many states were able to actually take all the claims. So, expect millions more new claims in the next two weeks, which, in turn, could take the unemployment rate to 20%! For comparison, during the Great Depression, the highest unemployment rate was 24.9% in 1933. Depending on when we end the lockdown, the U.S. could approach or exceed that number.

That potential 20–25% unemployed also represents significant numbers of children and family members who are also without money. Furthermore, millions of mostly younger people are (or were) working in the so-called “gig economy.” Often, they don’t get W-2s and sometimes the work is off the books. Nonetheless, they are unemployed, have no way to get any money and no way to get the paperwork, which the various government agencies

THIS WEEK

• Survey Says… • Massive Demand Shock • No End in Sight! • Abenomics Comes to the U.S. • Will Inflation Rise? • The Real Lesson

PORTFOLIO STRATEGY

“I don't think we should ever shake hands ever again, to be honest with you..." – Dr. Anthony Fauci

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ALLOYA INVESTMENT SERVICES WEEKLY RELATIVE VALUE | 2


require in order to get unemployment benefits. All told, the number of Americans that are desperately in need is well more than the 20–25% filing for unemployment.

Source: McKinsey Global Institute

According to McKinsey Global Institute, 42 million to 54 million American jobs (out of roughly 150 million) are vulnerable to reductions in hours or pay, temporary furloughs or permanent layoffs during the virus crisis.

• Up to 86% of the vulnerable jobs paid less than $40,000 a year. Almost all (98%) paid less than the national living wage for a family of four ($68,808).

• Almost 40% of the vulnerable jobs are in firms with fewer than 100 employees. • 13 million vulnerable jobs are in the restaurant industry. • 11 million are in customer service and sales (including 3.9 million retail clerks and 3.3 million cashiers).

And the economic pain has already arrived. According to the National Multifamily Housing Council, nearly a third of U.S. apartment renters did not pay any of their April rent during the first week of the month. Only 69% of tenants paid any of their rent between April 1 and 5, compared with 81% in the first week of March and 82% in April 2019. What will landlords do when their banks want payment and their renters cannot pay? Think they will easily be able to find renters who can pay?

Another survey conducted by the Peter G. Peterson Foundation found that 73% of Americans have already seen the outbreak depress their incomes; 24% stated “very significantly.” In terms of spending behavior, 48% said they cancelled all travel plans and 35% have postponed (or cancelled) outright a big-ticket consumer item. In total, 71% reported a dampening in total personal or business activities (survey taken from March 24-29). You do not see numbers like this in a plain-vanilla recession, I assure you.

“The U.S. labor market is in free-fall…The prospect of more stringent lockdown measures and the fact that many states have not yet been able to process the full amount of jobless claim applications suggest the worst is still to

come.” – Gregory Daco, chief U.S. economist at Oxford Economics in New York



In perhaps the most sobering reminder yet of the economic fallout caused by the coronavirus pandemic, the San Antonio Food Bank aided about 10,000 households last Thursday in a record-setting giveaway.

Wow.

This is truly saddening. It is the modern-day version of the Great Depression soup lines.

People do not wait hours in food lines for milk and dried beans unless they truly need it.

Finally, if you want a gauge of the enormity of the shock on a global basis, 1.25 billion people work in sectors directly affected by the crisis (retail, manufacturing, hotels, food services, travel). Per the International Labor Organization (ILO), 25 million jobs will be lost. They estimate that after adjusting for the hours slashed for those still working, the actual job losses will come to an epic 195 million jobs. It is hard to wrap my head around such numbers and the human tragedy of it all.

SURVEY SAYS…

With the March release of the National Federation of Independent Business (NFIB) survey, one can safely say, the recession has now arrived. The optimism index of small businesses in the U.S. economy sank 8.1 points to 96.4 in March, marking the largest decline in 37 years. In March, nine of the survey’s 10 components fell.

Source: Bloomberg

And sadly, it will likely get worse before it gets better.

“The NFIB survey collected the majority of responses in the first half of the month, so the sharp decline in employment is not reflected in the March survey data.” – NFIB

“It looked like prairie dogs out there, with all the people standing on top of their trucks, trying to get an eagle-eye view of the line to see how much longer they had to wait,” said Brian Billeck, marketing manager at Traders Village



According to the survey, the biggest problem confronting small businesses is just staying alive. And about 51% did not believe they could survive the pandemic for longer than three months. Some might not even be able to keep going even if they get help. They cite lack of sales due to rising unemployment as their largest concern.

Source: Bloomberg

Big picture: Small businesses are not as visible as large companies such as Amazon and Google, but about half of all Americans work for them. There are currently over 30 million small businesses in the U.S. with approximately 60 million employees. Small businesses (defined as businesses with fewer than 500 employees) account for 99% of all businesses in the U.S. and account for 70% of all employment. There are literally millions of small businesses at risk of failure, and along with them, millions of jobs that will not return in a timely fashion.

Now the government is in a race against time to funnel the money to financially strapped small businesses, many of which might not survive without the help. The government’s gargantuan coronavirus-rescue package, known as the CARES Act, included $350 billion in forgivable loans for small businesses to keep paying employees over the next few months. Please see Alloya’s CARES Act microsite for more information on how Alloya can assist credit unions: www.alloyacorp.org/alloyacares.

Personal consumption makes up roughly 70% of economic growth. Over the next few months, as unemployment surges, consumption will drop. Importantly, the strong correlation between the NFIB’s concern of “poor sales” and unemployment rates, will surge higher. With current expectations of unemployment rates hitting 15%, or more, the concern over “poor sales,” is going to hamper the rehiring of individuals back into the workforce.

Simply, it is small businesses that drive the economy, employment, and wages. Therefore, what the NFIB says is extremely relevant to what is happening in the actual economy. If large numbers of small firms go out of business, the oncoming U.S. recession could be deeper and longer than predicted.

Note: Much of the CARES Act simply replaces lost wages. That is not a stimulus. That money does not generate additional spending. The Small Business Administration (SBA) loans are not a stimulus in the traditional sense. The

money is hopefully going to bring many businesses back from a dead stop. That will be good, but it is not a stimulus.

https://www.alloyacorp.org/alloyacares/



MASSIVE DEMAND SHOCK

Thankfully, we are starting to see the number of new COVID-19 cases stabilize due to lockdowns and social distancing guidelines. We are not out of danger, but this is encouraging. But by locking down the country in the name of the greater good, we have created a massive demand shock, the rapidity of which is like nothing seen in centuries, if ever. And it should be clear that we cannot turn a switch to bring it back. How soon will we want to jump into crowded restaurants, movie theatres, stadiums, hotels, vacations, and all the other areas where we gather as human beings? Certainly, some of the economy will start up again and normalize. But how many workers will it need?

How have our buying habits and patterns changed? We are learning that we can work from home. As an aside, studies have shown that productivity rises significantly for remote employees. As such, some companies will institute this new policy more broadly. Multiplied across thousands of large companies, that means the demand for office space will drop, which means prices for office space will drop. Ditto for 100 other industries.

Source: Cagle

COVID-19 will permanently reshape America’s retail landscape — accelerating a winner-take-all race that started taking shape before stores were forced to close. The growth of e-commerce is going to accelerate. Amazon, Walmart, Target and Costco are poised to come out of the coronavirus crisis even stronger and more formidable than they were before the pandemic. While the bigger will get bigger, small to mid-sized store chains — the nation’s mall anchors — are running out of time to survive.

Think about restaurant buildings. Builders and tenants go to tremendous expense to create the kitchens, which means if a restaurant goes out of business, the property owner typically has to find another restaurant. How likely is that to happen today?

I know it is hard to fathom in a society populated by people who believe iPhones are essential goods, but this experience may leave a wound that ushers in a secular change in consumer attitudes towards debt, savings and expenditure. A new era of frugality.

“Mass gatherings, maybe, in a certain sense more optional. And so until you’re widely vaccinated those [activities] may not come back at all.” – Bill Gates

https://www.cagle.com/dave-granlund/2020/04/covid-19-guns-alcohol-and-tp



To be clear this is not the “end of the world” or a Zombie Apocalypse.

• There are encouraging signs that social controls are starting to slow the momentum of the pandemic. • Another week or so of data are required to be sure a stable slowing trajectory has been established. • Based on China’s experience, fairly strict social controls will likely stay in place in most if not all regions until

early/mid-May (~two months after imposition).

We will recover from this crisis. But we should also not downplay the economic damage done and the human tragedy of COVID-19.

To be optimistic is a good thing. However, when it comes to your risk management strategy, keeping a realistic perspective on the data will be important for navigating the risks to come.

While there is much hope that as soon as the “virus quarantine” is lifted, everyone will return to work, the reality is that many businesses will cease to exist, many will be very slow to return to normal, and all businesses will be very slow to rehire until they are sure there is sufficient demand to support expanded payrolls.

If you are expecting an immediate V-shaped economic recovery over the next couple of quarters, you are likely going to be very disappointed. (Please ignore government cheerleaders and those with an agenda who suggest it will come back sooner.)

The damage being done by the shut down on the economy, and most importantly, the consumer, suggests that not only has a recession started, we may have a long way to go before it is over.

NO END IN SIGHT!

Last week, the Federal Reserve and Treasury announced another $2.2 trillion program to buy bonds and high-yield funds. By creating a special purpose vehicle (SPV) funded with hundreds of billions of dollars from the CARES Act as a “first loss guarantee,” the Federal Reserve will then be able to lend approximately 10 times that amount to the SPV. If losses exceed the base amount, the Treasury and thus the taxpayer would have to fund those. That adds another $4 trillion to the overall government program.

And most likely we will see more of these programs. Clearly, all levels of government and the Federal Reserve are determined to avoid a deflationary depression. This is Mario Draghi’s “whatever it takes” on serious steroids. Yes, that is going to blow the budget out. But for now, we have to get people back to work, with the ability to get food, housing, and the basics as soon as possible.

As job losses mount, income tax revenue declines, and demands for government assistance increase. At the same time, as demand falls, so do corporate revenue and incomes, which result in lower corporate tax revenue.

Note that we are already at $24 trillion total federal government debt in the U.S. That is over $73,000 per person. Add another $3.3 trillion for state and local debt. The U.S. federal government debt is going to hit $30 trillion by 2022. We will be nearing $50 trillion by the end of the decade.

“This is a big experiment. It’s something that’s never been done before.” – Kevin Logan, Chief Economist at HSBC



Public Debt as % GDP

Source: Peter G. Peterson Foundation

The fiscal deficit will likely increase $3-4 trillion as tax revenues fall sharply due to a deep recession. This drop in revenues alone, given that 75% of all government spending is “mandatory,” was already set to cause a surge in the deficit. However, when that drop is combined with the recent “all-out” fiscal campaign to counter the impact of the virus, we are talking about a deficit that will approach 23-25% of GDP.

Since 2008, the economy has been growing well below its long-term trend. Such has been a consistent source of frustration for both Obama, Trump, and the Fed, who keep expecting higher rates of economic activity only to be disappointed. Over the last decade, the Fed’s monetary policies, and the government’s largesse, have inflated debt to even greater levels than those seen during the Great Recession. However, instead of allowing the “clearing process” to proceed, the Federal Reserve, and the government, have opted to throw the “kitchen sink” at the credit markets to try and forestall that process. Ultimately, continuing to “kick the can” not only increases the risk of the next crisis, but slows the economic recovery, and further impedes future economic growth.

The bottom line: The larger the balance of debt, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments. Once we get through the crisis, and unless we have a major reset or debt jubilee, long-term growth will likely continue to downshift towards 1%.

Think Japan.

ABENOMICS COMES TO THE U.S

So where does this money come from?

The Fed – taking a page out of Japan’s playbook – will fully fund the massive 2020 deficit. It is the U.S. version of Abenomics.

The following chart compares the current quantitative easing (QE) trajectory to previous programs. The speed of the Federal Reserve’s securities purchases has been unprecedented. The balance sheet of the Federal Reserve might be $9 trillion this year. Such would be a $6 trillion expansion from the previous levels. There are other even higher projections from serious sources.



This is no longer a game of just “subprime” mortgage debt. This time they are having to bailout debt from credit cards, auto loans, corporate debt, mortgage debt, mortgage servicing, municipal debt, and fund the entirety of the federal deficit. Now that the Fed is undertaking its most aggressive QE program, it is truly doubtful that we will ever be able to normalize monetary policy. And there is no end in sight!

Federal Reserve Balance Sheet: To $9 trillion and Beyond

Source: Bloomberg

In the short-term, the Fed is massively increasing the liquidity of banks (excess reserves) through the various QE facilities to stave off a second financial crisis. Given the banks do NOT want to loan out any funds not guaranteed by the Federal Reserve, the excess liquidity flows into asset markets.

Years of zero interest rates, excess liquidity, and a closed loop between the banks and the Fed, have essentially removed all incentives to take the risk of lending money to businesses and individuals to create economic growth. Instead, that liquidity has fueled assets prices, stock buybacks, and corporate debt, which have led to a wealth gap never before seen in history.

WILL INFLATION RISE?

With the government spending unprecedented trillions of dollars funded by the Federal Reserve, it will have an effect on the money supply. So, going forward, the most important question that we need to deal with is whether or not this massive increase in money supply will lead to significant inflation or hyperinflation in the months and years to come.

The key to inflation is the velocity of money (i.e., the rate at which money changes hands). When Freidman did his famous study (see the red shaded area on the following chart) money velocity was stable or rising. As money supply increased inflation rose.

However, today, and frankly for many years, we have had a period of declining money velocity (see blue line in graph). And as the velocity of money has declined, so has inflation (red dashed line). Let me crawl out on a limb and suggest that the velocity of money is now going to drop even further after COVID-19. When the velocity of money is falling, monetary policy does not lead to higher inflation.

“Inflation is always and everywhere a monetary phenomenon.” – Milton Freidman



As long as aggregate demand remains lackluster, money velocity will remain low and likely continue lower. This, in turn, will lead to a continued period of disinflation, if not deflation. This is why bond yields can definitely go lower and approach the land of negativity outside of the areas of the world, like Europe, where this condition is already rather common.

The money being spent by the Federal Reserve and the U.S. government is not going to create inflation in the short-term. It will take longer than that to get through all of this.

. Source: Bloomberg

THE REAL LESSON

Why have the central banks had to provide so many liquidity backstops and solvency measures all at the same time? Because this was a cycle fueled on leverage on top of leverage. Corporate bonds. Leveraged loans. Credit cards. Auto loans. Student debt. Commercial & Industrial loans. Did I mention federal government debt? Debt bubbles everywhere outside of residential mortgages, and only because this is the primary area of the market that the Fed saved, and continued to save, through the entire cycle.

We went into this crisis with liquidity having been a dirty nine-letter word. At the peak of the prior cycle twelve years ago, global debt at all levels stood at 282% of GDP. Heading into this crisis that ratio was 322% ($255 trillion in outstanding debt or twelve times the size of the entire U.S. economy).

One can blame the coronavirus, but the overriding problem is that this health crisis and aggressive lockdown exposed an economic system long on debt and short of savings. I do not think it is well recognized how vulnerable the global economic and financial system was to any negative shock to cash flows because of the mountain of debt that was allowed to be built up this cycle. I hate to pick on Donald Trump, but he bragged as a candidate in June 2016 he is “the king of debt.” Well, welcome to the results.

MARKET OUTLOOK AND PORTFOLIO STRATEGY

“It will be a long, hard road. Barring some healthcare miracle it seems we're going to have various phases of rolling flareups, with different parts of the economy turning back on, maybe turning back off again."- Minneapolis Fed President

Neel Kashkari



Deciding when to ease restrictions is pure guesswork by politicians and even scientists. And until there is a vaccine or treatment, there is not going to be much of a recovery after the worst point of this deep economic shock because people’s behavior is bound to remain very cautious for a long while. Any re-opening of the economy promises to be gradual and limited to stores and malls. Nobody is going into big crowds, events or airports any time soon. Nobody wants to get sick or die, obviously. And it is not clear that this disease will not mutate. I say until a vaccine, nothing returns to normal and that is likely at least a year away. So, despite the massive stimulus in place, it may not translate into a resurgence in demand.

Source: Cagle

That said, I do sense that we are heading into a new chapter where we can start to pick a point of re-entry and get back to work. We have reached a point where the fear of economic disaster is starting to outweigh the fear of death by the coronavirus. President Trump hinted that he will be relying on his gut instinct as to when the stay at home restrictions are lifted. In any event, if I had to guess, we will be seeing a partial re-opening in some areas beginning in May. It will start as a trickle and then become a trend. That said, I believe economies will re-open to a greatly diminished demand environment, with high saving rates and very low discretionary spending.

And this is why. The number of people who think the economy will get weaker outweigh those who expect it to be stronger by a factor of ten (!) for the next six months. Not six weeks —but six months. What the bulls call “stimulus” is not anything of the sort. Yes, it is sizeable, but part of it gets used to “stay current” and the other part goes into the cookie jar. In other words, I doubt Americans will rush out to purchase new cars, leather sofas or plan a Mediterranean cruise. This argues for a disinflationary, U-shaped recovery rather than a V-shaped recovery.

In terms of portfolio strategy, credit unions should look to invest excess cash reserves in a high-quality, diversified, duration-appropriate ladder strategy. Maintaining high cash reserves will likely continue to negatively impact balance sheet returns over the foreseeable future.

PREMIER PORTFOLIO

Alloya Investment Services’ online trading platform, Premier Portfolio, has been making a positive impact at credit unions across the corporate’s membership since its launch in 2018.

“Premier Portfolio is user-friendly and modern. It allows us to browse current offerings and make immediate purchases at any point throughout the day. The tracking mechanism in Premier Portfolio is very hand. Since the system knows what dollar amount is currently owned in a financial institution, there is no room for error. We love the ability to check term and rate on a single summary. Premier Portfolio takes the guessing out of the equation. It is a highly useful tool and would recommend to anyone using Balance Sheet Solutions (now Alloya Investment Services).” – Darin Higgins, President of Western Illinois Credit Union



Visit www.alloyacorp.org/premierportfolio to learn more about Premier Portfolio and how it can benefit your credit union!

MORE INFORMATION

For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at [email protected] or (800) 782-2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments.

At Alloya Investment Services, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alloya Corporate Federal Credit Union, Alloya Investment Services (a division of Alloya Solutions, LLC), its affiliates, or its employees. The information set forth herein has been obtained or derived from sources believed by the author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.

Information is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding prospects might not be realized. Please contact Alloya Investment Services* to discuss your specific situation and objectives.

*Alloya Investment Services is division of Alloya Solutions, LLC.

“While it’s always great to connect with our Balance Sheet Solutions, (now Alloya Investment Services), Account Executive one-on-one, Premier Portfolio is an amazing and easy tool to use in purchasing investments. We have access to statements, online trading and the ability to look at all of the offering in one place. I highly recommend trying this out!” – Shawn Nikkel, Finance Director of Denver Fire Department FCU

“Premier Portfolio’s online services allows me to access statements and overall market analyses, review a list of available security offerings, as well as purchase SimpliCD’s and Alloya’s certificates. Premier Portfolio is convenient, easy, secure, and has become my go-to place for investing!” – Rhonda Schroeder, CEO of Blackhawk Area Credit Union

http://www.alloyacorp.org/premierportfolio

mailto:[email protected]

weekly relative value - alloya corp · svp, director of institutional fixed . a human tragedy . two...

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