Cash Is King

Published in Breakfast with Dave -- August 21, 2023

As I gaze at this unprecedented 40-month stretch of outperformance of stocks over bonds, I can’t help but think of how the global pandemic was an absolute boon for the economy. Look at what happened:

COVID-19 unleashed a whole new narcissistic psychology towards consumer spending — intensifying the need for “bucket lists.” The term YOLO (You Only Live Once) became as ubiquitous for the economy as FOMO (Fear Of Missing Out) did for the equity market.

The government unleashed, in bipartisan fashion, not one but two unprecedented cash transfers to the household sector. Every penny got spent because consumers know that in tough times, Uncle Sam will always be there to hand out the goodies. The effect of drawing down excess savings to stimulate consumption lasted more than two years and blunted the suppression from the most aggressive Fed tightening cycle since 1981.

Because the Fed took rates to near zero in 2020 and 2021 (while also buying MBS en masse), homeowners had a lifetime opportunity to lock in their mortgages at rates between 2% and 3%. Fully 85% of mortgagors did so and while this enabled them to escape the impact of higher interest charges as the Fed tightened, these folks ended up becoming prisoners in their own homes. They can’t move without a serious financial penalty. So, as a result, there has been no turnover — no inventory in the resale market. So guess what happened? A massive wealth effect from a price bubble in home prices that exceeded what we saw in 2005-07, and a boom in the homebuilder stocks since the only game in town for new housing market entrants was in the universe of newly-constructed units.

Because of the reckless government response to the pandemic, companies became separated from their workforces. The vagaries of the lockdowns— but it didn’t have to happen this way. In a panic, the government not only doled out massive subsidies and stimulus checks, but via generous expanded and extended unemployment insurance benefits, workers were paid not to work for much of this cycle. This, more than just the Great Retirement theme (another byproduct of COVID-19), created the conditions for an elongated period of labor supply-demand mismatch and not only forced companies to sharply boost wage compensation (centered in the low-skilled services sector most impacted by the pandemic), but to this day has caused firms to hoard labor in the past year even as economic growth cooled off.

This lingering fear among business owners that if they ever do lay off staff for cyclical reasons that they may never end up finding them again — the scars from the pandemic and the public policy response — means we may never get the labor market to play along with the Fed’s stated intent to boost the unemployment rate from 3.5% to 4.5%. This may be the most important reason of all for the Fed’s relentless hawkish tone and its feeling that it needs to do even more on the policy tightening front and underscored in the most recent set of FOMC minutes: a loosening up in the labor market.

This obviously is proving hard to accomplish— the vagaries again, of not just COVID-19, but the government’s reaction function dating back more than two years. The bond market has clearly paid a price. Round two of the drawdown in the equity market is set to follow. Cash is king.