饮鸩止渴

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MR. MICHAEL CEMBALEST: Good afternoon, everyone.  This is Michael Cembalest with the Labor Day Eye on the Market podcast.  So that was a long summer.  We sent out an Eye on the Market today, day after Labor Day, that covers a lot of ground.  I’m just going to summarize it briefly here.

The big topics are how should we think about a market that is highly concentrated in tech stocks at high valuations?  What’s the cost of engineering this US recovery as the world waits for a vaccine, looking at both what the central banks have done and fiscal deficits.  We’ll discuss some US election rules, dates, and process in light of some very derogatory comments on mail-in voting by the president and his attorney general and a few other things.

So let’s see.  Looking back in January of this year, we spent most of our time focused on the China-US trade deal and the prospects of an election in which Trump was on track to run with one of the strongest economic and market tailwinds of 100 years.  Obviously those things have both changed a lot.  China is very far from meeting its trade deal purchase commitments, but the market no longer cares about it.  And while the US economy is recovering, Trump’s once-in-a-lifetime tailwinds are gone, mostly due to the Coronavirus. 

So one of the things that we did is to keep track of the cost of achieving this recovery we’ve seen so far, which has propelled the S&P 500 to all-time highs again.  There’s no question, so far the recovery looks a lot like a V, right?  If you look at industrial production and retail sales, the recovery in employment and job openings, lumber, steel, electricity output, all these things are recovering with V shapes that are much more V-shaped than the prior recession and most recessions for that matter, because it was never an organic recession to begin with because of the lockdowns.

So the issue here is that this didn’t come cheap.  The increase in fiscal deficits in central bank balance sheets, which we track for this cycle and for a few countries and regions versus global financial crisis, the European balance of payments crisis, the Depression and things like that, the world has never seen a monetary and fiscal expansion like the one that was just produced in a matter of months. 

And we can debate the cost of central bank expansion in terms of risks of inflation, which I consider right now to be pretty low.  But I don’t think there’s any debate that at some point there’s going to be a price to pay for the fact that US gross federal debt is now expected to end the year at World War II peaks, over 100% of GDP. 

And so as an exercise, not that I think either party would consider doing this, but as an exercise, we worked with the Committee for a Responsible Federal Budget to figure out what would it take to bring US federal debt back to pre-virus levels by 2030. 

So in other words, let’s spend the next ten years reversing the last six months of debt expansion.  And it would take the largest tax hikes or spending cuts in history, or we could grow our way out of it, but it would take a growth boom in terms of real GDP growth consistently above 4%, somewhere between 4 and 6%.  And the last time that happened was the mid-1960s, so more than 50 years ago. 

So it’s very unlikely that the US is going to be able to bring these debt levels back down, and I don’t think there is the political will to do this.  And so the US will just have to get used to very high, not quite Italian, but almost Italian levels of government debt.  I agree that it was the right thing to do for now, because it sustains private sector demand, and the benefits outweigh the cost to the economy.  But these experiments can have a lot of unprecedented consequences.  And down the road, the US flexibility to respond to all sorts of geopolitical natural disaster, climate, and other emergencies will be impaired by having this level of debt. 

So to be clear, US debt levels may rise even further, right.  I mean Trump has been running massive deficits at the time of full employment before the virus.  And Biden’s agenda proposes about $5 trillion worth of taxes and $8 trillion of spending.  So if anything, roughly proportional, like the Biden proposals goes through.  If he’s elected we’ll have a lot of increase in the US debt anyway.

Some people respond to this Biden plan very negatively.  I think for me it’s a split decision.  A lot of the items that Biden wants to spend money on have pretty high growth multipliers, whether it’s housing, education, infrastructure, and jobs, and some of the healthcare, but not all, some of the healthcare proposals. 

So I don’t think it is a priori negative for economic growth.  I do think there would be some headwinds for the corporate sector.  Because a big, very big part of how this spending expansion would be financed would be through corporate taxes.  And one of the things that you have to pay close attention to is Biden’s people are clever in the way they say this.  They say we’re only going to raise corporate taxes by half of the Trump corporate tax rate cut. 

But the rates aren’t the way to look at this.  If you include all the base broadening and sector-specific tax proposals, Biden’s proposing raising up to around $2.5 trillion of new corporate taxes.  That’s many multiples higher than the reduction in taxes that came with the Trump corporate tax cuts in 2017.  So there will be another time and place to talk about the wealth taxes.  I mean there’s, between the payroll taxes and taxes on the wealthy, there’s a proposed couple of trillion dollars in terms of taxes on the wealthy. 

But right now I think the bigger issue for investors is the headwinds to the markets that might come from this much corporate taxation, and this could take a reasonable chunk out of after-tax earnings.  And so we’ll have to wait and see what gets passed and how it gets passed and when it gets passed.  But the biggest headwind here is from that.

So I see a positive outcome for growth and employment, but some headwinds on valuation.  Now some people might say well that’s fair because for the last 25 to 30 years, there’s essentially been an implicit wealth transfer from workers to owners of capital, and this would just be reversing some of that by reducing corporate valuations to transfer wealth back to median income workers.  And I think that’s explicitly part of what the Biden agenda is all about.  Everyone can make their judgments in terms of what that means for them.  But I think that’s the broad outline through which you should be looking at Biden’s agenda. 

The other challenge for the equity markets is obviously the concentration, high valuations in the concentration in terms of the contribution from just a few large tech and social media stocks.  So there’s a bit of good news and bad news, and I’m going to try not to cherry pick any specific data point.  The profit margin news on the corporate sector is pretty good.  While profit margins obviously got whacked in Q2, they fell to a level that’s still basically the highest level seen in the last 50 years or so.  US companies are highly profitable and had the wherewithal, a lot of them anyway, to absorb the hit that came from COVID.

And so in other words, tech and pharma and biotech, some of these pre-tax margins were still 20 to 30%, and they were more than twice the margins of some of the cyclical and consumer staple companies.  The challenge is the PE ratio for the market overall, even if we look at it relative to 2021 earnings, which assumes a normalization of earnings back to 2019 levels, these valuations are pretty high.  And it’s hard to see how you could get a further valuation boost to market levels.  I think from here it would have to be earnings-based. 

The top five stocks now represent the largest share of market cap since 1990.  It’s actually, I think it’s almost double the level that it was in 1999.  In other words, the contribution to the overall market from Apple, Amazon, Microsoft, Apple, Facebook is double what the top five firm contributions were in 1999.  Now there’s a big difference between now and then.  The free cash flow of the largest companies back in’ 99 was terrible.  It was like 8%, and now it’s closer to 20.  So these companies are more profitable. 

But the valuations reflect that, and so it’s an expensive market where people have been crowding into the stocks that are seen as having the greatest degree of protection from mobility issues resulting from COVID, and it’s going to take a lot of earnings broadening next year to prevent frequent bouts of profit-taking and intermittent stock market corrections.  Right now we’re I guess you would say mildly optimistic on the outlook for a broadening earnings recovery.  A lot of it’s going to depend upon how quickly a vaccine is developed and how quickly it changes the behavior of the people that take it.

The other thing to keep in mind as well, when you look at a world where you’ve got the five largest stocks representing an all-time high in terms of contribution to the market and to employment and to GDP, you have to start thinking about antitrust policies.  There were two or three instances in the last 50 years when you had these antitrust concerns.  Obviously the end of the 1990’s was one of them.  The late 60s and the industrial concentrations was another one. 

And now you’ve got this tech and social media concentration where as a percentage of the overall economy, it’s as high or higher than those two prior episodes, both of which led to some antitrust action by the Department of Justice.  And there’s obviously some politics involved, but the attorney general has overruled the Justice Department lawyers that wanted more time before bringing an antitrust case against Google.  And so a case might be filed as early as September or October of this year.

And to be clear, while there are some political shenanigans in terms of the timing of this, there is bipartisan interest in this Google case in all the 50 states, given Google’s control, I think 90% of global web searches and a third of all online advertising.  So we have to start factoring in some of these antitrust risks.  I don’t think that it’s flashing red as a risk quite yet. 

It’s unclear if the Trump administration has interest in broadening the antitrust actions outside Google.  And if Biden’s elected, he’s expected to increase antitrust enforcement by the Sherman and Clayton Acts and things like that, and to improve bargaining power for the gig economy workers.  He’s also mentioned revoking part of the US Communications Act that gives safe harbor provisions to protect Facebook from crazy things people post there. 

But Biden has called, he’s described calls to break up big tech firms as premature.  And so far his clearest antitrust statements are about farming, hospitals, insurance, and pharma, and not tech or social media.  I think Biden is more focused on protecting critical infrastructure from cybersecurity threats and things like that, and on restoring net neutrality.  And we’d be surprised if a Biden administration really curtailed the ability of the big tech firms to acquire competitors and startups or to force divestitures.

Okay, I know I’m running a little bit long this week, but there’s a lot to cover.  Let’s talk a little bit about COVID.  So I spent a lot of the summer obviously preparing our weekly COVID emails and maintaining the online virus portal that we have.

Here’s the good news.  In most of the developed world, mortality has collapsed relative to the rate of infection.  And there’s a lot of debate about this.  The most likely explanations are younger people are now getting infected, and obviously their mortality rates are much lower, so you have infections up, but mortality doesn’t go up. 

You’ve got more selective ventilation of hospitalized patients.  I think ventilation was going on a lot more frequently in the beginning, and now they realize that there are alternatives to that.  Increased use of certain anticoagulants, blood thinners, and steroids, which have proven very effective ‘cause COVID is not just a pulmonary disease, it’s also a vascular one.  And don’t discount the fact that when hospitals, doctors, and nurses aren’t overwhelmed, mortality rates go down as well.

So that’s the good news.  And now this good news has ushered in I think a strong belief in certain places that the economy should be reopened as quickly as possible, and some people have brought to my attention some issues with COVID data, right. 

So if you’re interested, here are some of the issues with COVID data, why it needs to be interpreted carefully.  These PCR tests that are used in many places to determine public policy and school closings and things like that, the results are highly dependent on how fine-tuned the equipment is to determine positivity.  So if you took a COVID test in one lab in your state, and you did the same exact test in another lab, you could get a positive and a negative, depending on how fine-tuned this equipment is.  And if all of the equipment nationally were calibrated similarly, the reported infection levels in certain places could fall by a lot.  And by a lot I mean 20, 30, 40, 50%. 

So there are issues here in terms of how these PCR tests are used from a policy perspective.  And the reason for all of the debate is how much of a trace, how small a trace of RNA are you actually looking for?  And if you’re looking for any trace, including in people that had the infection and are no longer contagious, because you want to find it for contact tracing purposes, those very fine-tuned equipment will help.  If you’re trying to identify people that are currently contagious and should be isolated, having those fine-tuned equipment approaches is not going to help you.  

So there’s also some reports of hospitalized individuals may be counted as COVID patients when they’re there for other reasons and things like that.  The bottom line is that the PCR tests, flawed as they are, are highly correlated with hospitalizations and really the only way at this point to easily monitor community spread, and I think people have to understand that. 

If you want to read more detail on this issue, it’s on pages seven and eight of the Labor Day Eye on the Market.  We get into all the excess death issues and the cycle issues and the T-cell issues.  There’s way too much being written and said about T-cells at this point.  I agree there’s a lot of emotional, workplace, and economic stress associated with school closings, and I’m not arguing that they should remain remote. 

In fact, I think that the country should be working as aggressively as possible to where expanded testing, contact tracing, and isolation can be used to spot and contain outbreaks, in which case you can reopen the schools.  But that’s for the public health officials to decide.  And I think the libertarian narrative about the virus takes liberties with the real-life complexity of this pandemic.  So anyway, more on that in the Labor Day Eye on the Market. 

And then let me just summarize in closing, if anybody is still here.  The president and the attorney general have been making a lot of very derogatory comments about the mail-in voting process.  To be sure, the mail-in voting process is not riskless.  In 2016, about 4% of all those ballots were lost or miscounted.  This comes from an MIT study.  But that’s not that different from the amount of in-person votes that get lost or miscounted in regular presidential elections due to deficiencies in the election administration, inaccurate voter registration, malfunctioning machines, and things like that. 

So there’s not a lot of evidence you can actually find that vote by-mail-ballots are nearly as destructive or inherently exposed to fraud to the degree that the president and his attorney general have been saying. 

So anyway, but given the comments they’re making and concerns about the political process, if it takes a few days or weeks in some states after the election to finally count up the ballots and figure out who won in each state, I put together a description of the rules, dates, and process in presidential elections, and it’s at the end of the Eye on the Market.  The bottom line is the states have over a month to determine who the winners are in their state, right?  So the drop-dead date is December 8th.  That’s the Safe Harbor date.

And there’s also a process in the Constitution that defaults to Congressional election of the President if on January 6^th, if the Electoral College doesn’t produce a candidate with at least 270 votes.  So there are all sorts of contingencies in the Constitution to handle weird outcomes.  And what’s notable is none of those contingencies involve the current president automatically by law remaining in place until things get sorted out.  So take a look if you’re interested in how contingent elections work, where the House and the Senate pick the president and vice president and if you really want to know the rules. 

I strongly believe that even though there may be quite a few states that don’t know who won the day after the election, within two to three weeks, they will know after they count up all the mail-in ballots.  And the states have discretion about that process as long as they are adhering to the equal protection clause.  So I don’t really think as, they can stamp their feet up and down as much as they want, but I’m not sure there’s much the White House and the Justice Department would be able to do about the process.  So thank you very much for listening, and I look forward to speaking to you again soon.

FEMALE VOICE: Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JPMorgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.

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