Omicron Vs. MMT: The Biggest Stock Market Threat
- The Omicron panic has caused much volatility in the markets.
- But, ultimately, the risk will be priced and the bull market will resume.
- MMT, on the other hand, will end up killing the stock market.
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Only when the tide goes out do you discover who's been swimming naked. - Warren Buffett
Written by Sam Kovacs
Many of my articles start by a Warren Buffett quote.
This is not a coincidence. As a teenager, I devoured all of his annual shareholder letters, and the man left an imprint on me.
Having been through decades of market ups and downs, he has seen enough and made enough witty remarks to always be perfect introductions to my articles.
Last week, the world panicked a little.
I was happily touring Morocco, when we got notified that Morocco would be closing the border a few hours before our flight back to France.
I remember thinking "wait, what?... why?".
We rushed back to the hotel, booked a flight to Dublin, had lunch in Dublin, before heading back to Paris, in what ended up being a 22 hour long day.
But all along our journey, my mind was thinking of the ramifications: What does this mean for the economy? For markets? How do we handle stimulus, inflation and all if international travel is stopping again and nations once again face lockdowns?
I thought about this and read everything available every day since then. And concluded that Modern Monetary Theory is a bigger risk to markets than Omicron.
Omicron: Unknown outcomes - all will be overcome
I'm not a doctor, I'm an analyst. Whenever we talk about the pandemic, we get called out on the basis that we're not experts.
And it is true, we're not medical experts, but we are financial market experts.
We don't have day jobs. Everything we do, it's stock market related.
In late July, when we published "Delta Variant: The Market's Got It All Wrong," we warned that the market was mispricing Delta, and that the market and reopening trade would resume.
We highlighted energy (XLE) as being the best place to invest.
Since then the S&P 500 (SPY) has increased a further 3.8%. Energy prices (CL1:COM) took off, and Chevron (CVX) which we highlighted, increased by 10% since.
Now with the Omicron panic coming at the same time as the US participated in an unprecedented coordinated release of strategic reserves, oil prices have dropped again to $69.
Before the Omicron episode, I hadn't anticipated OPEC to retaliate to the strategic release. I now believe they will halt all further output hikes, as the organization has erred on the side of caution since the onset of the pandemic.
I target that oil prices will likely remain between $65 and $75 for the foreseeable future. You might think "safe bet", and you'd be right. Still it is one which maintains most oil companies in deeply profitable situations,
Concerning the Omicron variant, there are still a lot of unknowns. The market hates unknowns, because they are difficult to price.
The two unknowns that are yet to be determined are:
It is therefore easy to create a matrix of outcomes from worst to best:
- More transmissible - More virulent:
- Just as transmissible - More virulent
- More transmissible - Just as virulent.
- Less transmissible (False alarm)
- More transmissible - Less virulent.
Of course you can break down more outcomes, but not without unneeded redundancy.
Effectively, if it turns out that the variant is more transmissible AND more virulent, then this will cause a drag on economic growth in 2022. However if this is the case, Moderna (MRNA) estimates that by Q1 2022 it will likely be able to produce a vaccine at large scale. Furthermore, Scott Gottlieb, a director of Pfizer (PFE) stated that " There's a reasonable degree of confidence in vaccine circles that [with] at least three doses . . . the patient is going to have fairly good protection against this variant."
That's our worst case scenario, which likely causes a drag on markets for a few months, before the indices then resume their roar upwards. This would also be applicable for the other bad outcomes.
The neutral outcome is entirely possible. If it turns out Omicron is less transmissible than Delta, it will fail to take over as the dominant variant, and it has no impact on the economy.
There is also a potential good outcome, which is wishful thinking, but not impossible. This is if it turns out that the variant is significantly less virulent despite being more transmissible.
Some people mistakenly believe that Darwinian pressure on viruses push them to become less virulent over time. Because of the lag between when Covid-19 infects and causes illness, there is less of an incentive for the virus to evolve this way, as transmission happens before the illness.
So a good outcome is possible, but would be due to good fate rather than to a natural evolution of the virus.
Those are the possible outcomes. None of them, in my opinion will have durable (greater than a few months) impact on markets.
Time will tell, but I do not believe Omicron to be an important threat to markets, just as Delta was not the threat many feared early in the summer.
Modern Monetary Theory - known outcomes, won't be overcome.
But there is a bigger threat to markets than any potential virus variant to markets.
It is called Modern Monetary Theory, or MMT for short.
And while you can call me out on my lack of scientific credentials, I have a graduate degree in economics from the most prestigious school in France. (self pat on the back)
Here's the thing.
Developed countries around the world have become intoxicated with MMT.
This is not the first time that politicians fall in love with an economic theory which works in a vacuum, but not in the real world.
It happened in the 30 years which led to the Great Financial Crisis, when the idea of efficient markets led to a constant decrease in government intervention.
Anybody who know me personally knows that I hate government intervention, and the rise of autocratic politics throughout the developed world as a consequence of Covid.
But that doesn't change that the belief of efficient markets led to some very questionable decisions, which ultimately, because of misplaced incentives, ended up in the largest crisis known in a century.
This happened because a lot of the assumptions in the model of efficient markets, simply weren't present in a real world environment. Namely: perfect information by all market participants.
Anybody who left the university halls for a minute would understand that while the theory was effective at explaining rudimentary economic concepts to undergraduate students, it has no place to be applied blindly in the real world.
MMT is no different.
There's a common joke which I'll put in quotes so you can skip it if you're not in the mood for humour:
An engineer, a priest and an economist are stranded on a desert island, with plenty of can food but no can opener. The priest says: Let's pray the lord for a divine intervention so that we can open these cans. The engineer says: Let's use the trees to craft a device which can pry the cans open. The economist interrupts them and says: Folks, stop. Let's first assume we have a can opener.
So what are the assumptions of MMT, and which are faulty?
MMT assumes that if a country is the sovereign issuer of their currency, the Fed can print money used to purchase bonds to finance government spending. This circumvents the need for higher taxes and provides instant cash to stimulate the economy.
MMT posits that as long as the economy is under its "full potential", there will be no inflationary pressure from the extra cash.
It also posits that invariably, when the economy catches up and inflation flares up, government can simply "take out" money from the economy, just as simply as they put it in through higher taxes and spending cuts.
Which of those assumptions does not work in the real world?
The short answer is the last assumption. It is difficult, if not impossible to generate the political will required to raise taxes and reduce spending enough to take out the injected cash of the economy and burn it.
Why is this so?
To answer that, let's look at how the US has been doing at implementing MMT.
How has MMT worked out for the US?
First it is obvious they have had no trouble at injecting more cash into the economy.
Using M2 monetary supply as a yardstick, there are 40% more dollars in circulation today than there were in February 2020.
And certainly, as the theory had predicted, the economy returned to some form of full employment, which can be viewed as a good yardstick for the economy's potential.
The fewest Americans were claiming unemployment since 1969. Think about that.
This new "full employment" might have come in at an equilibrium which is lower than we were previously accustomed to at 81.7% labor force participation rate vs ~83% pre pandemic.
Source: NY Times
But nonetheless, hats off to MMT, the real world is going along with the theory as planned.
Even, as announced, inflation has picked up.
Politicians at first said that inflation was entirely transitory, and would wane by year end. We weren't so sure, and repeated this throughout the year.
Ok, now we are sure: they were wrong.
Now they say that inflation will likely persist well into next year, but then the supply side causes of inflation will wane at some point.
They will, but thinking that it will be enough to stop inflation is incredibly wishful thinking.
You see, some form of disruption from supply, demand or both leads to inflation. These are the initial causes of it.
This cycle, we had both a demand shock thanks to all the helicopter money, and a supply side shock linked to supply chain bottlenecks across industries.
But this ignores the feedback loop induced by inflation. Removing the root causes does not stop inflation from feeding on itself. The expectation of higher costs and wages leads to higher prices, which leads to higher costs for others and eventually a further increase in wage expectations, and so on.
A good analogy is that of the small monster you nurture and feed, telling yourself that when he gets dangerous, you'll simply stop feeding him. But when you do stop feeding him, he is dangerous enough, and feeds himself, first with your neighbors, then with your kids.
And the announcement of a taper does not mean that we've stopped feeding the monster, merely that we plan on feeding him less and less over the course of upcoming months.
A hawkish fed in a slowing economy would truly be something unexpected. Likely, there will be a wait and see phase in the next few months as the Fed also waits for a read on Omicron's economic impact.
But hopefully you get a feel for the situation the Fed is now in. Truly between a rock and a hard place.
And we're not even talking about taking cash out of the economy. That has not been discussed by ANYBODY at this stage.
We're merely talking about stopping the stimulus.
However stopping QE is not the only form of stimulus. Monetary policy also dictates that lower real rates stimulate demand. Real rates are adjusted for inflation.
We're currently experiencing negative real rates, which insofar as monetary policy goes, is like having the stimulus foot firm on the pedal.
Those rates need to go up to reduce the stimulus on the economy.
But the current predictions suggest a 1.5% fed funds rate by the end of 2023.
Not enough to counteract inflation.
Therefore, we've engaged in an inflationary cycle, with no real good way out.
Some of you may remember how Paul Volcker killed an inflationary cycle. I merely read about it in books, as it predates me. He had no choice but to kill the economy and the markets in the process, leading to a sustained recession.
What does this mean for markets
The good news for markets is, as we pointed out, the music is quite a way from stopping, as despite the taper we remain in "stimulus mode".
The bad news for markets is that, when the music stops, there will be no real place to hide.
The music will stop with high rate increases. This is my prediction. This could happen in late 2022 or 2023, as the market gets crazy on all the "free money" that the government failed to take back from the economy.
Let's look a little at how this impacts various asset classes:
- Stocks will be at all time high levels, and higher rates lead to future cashflows discounted more, which will reduce P/Es. This is a fancy way to say stocks will come down. Those with profits heavily weighted in the future will take the biggest whack.
- Bonds will come crashing down with higher rates. It's a straightforward relationship between yield and price.
- Cash will be no good as you'll be losing value for holding it.
- Crypto like Bitcoin (BTC-USD) and Ethereum (ETH-USD) will suffer contagion and drop also.
- Real assets and commodities will prove to be the best place to be.
So from a wealth management position, individuals would be highly encouraged to take on long term fixed rate debt and buy real assets like farmland or prime real estate with it.
By taking fixed rate debt when it's still cheap, and buying real assets, the burden of inflation is passed on to the lender, while benefitting from the inflation-linked value of the real asset.
This is the only commentary I'll make outside of stocks, as on Seeking Alpha, we only address how to best manage a portfolio of dividend stocks, which are managed with the goal of retiring on dividends.
Here, the answers aren't as clear cut, as stock valuations might suffer. However, it is clear that the focus should be on stocks with as many of the following attributes:
- Stocks with cheaper valuations. When discount rates go up, stocks with already lower valuations take a relatively smaller hit.
- Stocks with high quality operations. No getting caught skinny dipping. Only the highest quality assets should be bought.
- Stocks with pricing power. The key is to pass the hot potato of rising prices. Companies which can offset the increased costs to the customer don't carry the burden of inflation.
- Stocks which grow faster than inflation. If you can't pass on the costs of inflation, then maybe you can grow faster than it, to still generate wealth at the inflation adjusted level.
In the past few weeks, we've given many such ideas in various articles (here, here, and here) but to save you a click, here is an overview of tickers of interest which are discussed.
It would make the article impossibly long to go into any further analysis here.
The sector which will likely do the best because it has a positive relationship to interest rates and is currently at dead low valuations, all while presenting plenty of high quality companies. Both banks and insurance companies look good. Here are some of our favorite.
- Morgan Stanley (MS).
- KeyCorp (KEY)
- Regions Financial (RF)
- Allstate Corp. (ALL)
- Prudential Financial (PRU)
Energy and inflation are positively correlated, as the price of oil is usually what kicks off an inflationary cycle. At $65-$75 per barrel, most top quality operations print cash like they're the Fed. These have perfect ability to pass on costs as such, and are still priced like everybody is already driving an EV and plastic has totally disappeared. Here are some top ideas.
Real Estate prices have always been decent inflation hedges, and buying stocks of those which have the ability to pass on the bulk of costs to tenants (such as triple net REITs) and inflation escalators built in, is a good way of safeguarding your portfolios. Here are some which are well priced.
Finally Healthcare stocks are good picks to weather inflation as they are resilient throughout the cycle and have strong pricing power. 2 popular names which are great value today would include:
Hopefully you realize that the current theory being applied by politicians to the real world economy poses a much larger threat to the economy and to the markets than any Covid variant possibly could.
You can be proactive and organize your portfolio to weather the hit, or you can run the risk of getting caught skinny dipping. The choice is yours.
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of ALL AMGN AMT BMY CVX EOG MS PRU RF STOR SU VICI ETH-USD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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