by Ivan Martchev

May 12, 2020

In conversations with investors, I sense that many see parallels to the infamous V-shaped bottom in the fourth quarter of 2018 and the first quarter of 2019. In the second quarter of 2019, we were already at fresh all-time highs for U.S. stocks. The drama in that period was concentrated in December 2018, when we saw the biggest decline, and January 2019, when we saw the biggest recovery. That was an obvious “V” as typically, large stock market declines in a good economy are pretty good buying opportunities.

The earnings per share (EPS) growth rate for 2018 was 20.5%, but the stock market declined 4.5% that year, even with dividends reinvested. You see the disconnect? That’s why stocks recovered in 2019.

United States Central Bank Balance Sheet versus Dow Jones Industrial Average Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This year is a very different situation than 2018, as we are no longer in a good economy but in a government-mandated recession due to the pandemic – the first mandated recession in anyone’s memory. Instead of tightening, the Federal Reserve loosened monetary policy at the fastest rate in history. You can see that in the explosive growth in the Fed’s balance sheet – it added $2.5 trillion in just two months to top $6.7 trillion as of May 7. I think it is this balance sheet expansion that is supporting the stock market.

Balance sheet expansion is like printing money, but for financial institutions only. It is working for the moment, but I do not believe it can work ad infinitum. There is a point where an expanding balance sheet can break the system. I just don’t know where that point is, and I do not believe that even the Fed knows.

United States Unemployment Rate versus United States Fed Funds Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The unemployment rate reported last week was 14.7% but in reality, it is closer to 20% (there was a 5% seasonal adjustment). I think the economy will normalize fast, especially with promising treatments and vaccines that we know are in the works; but I don’t think it will normalize as fast as Uncle Sam shut it down. In other words, it’s hard for me to see new highs in the stock market this year, similar to what happened in 2019 during the other “V” recovery.

I think it is logical that we have a more choppy summer that does not see new lows due to the Fed’s aggressive action and record deficit spending from Congress, but where the progress of the stock market is more proportionate to the speed of the reopening of the economy, which should be more gradual.

I do think the year 2021 could be spectacular for both the stock market and the economy, particularly with successful Covid-19 treatments and vaccines. If so, the stock market will make new highs as EPS for the stock market in the aggregate make new highs, which won’t be this year and I don’t know yet if it will be in 2021. The stock market usually is forward looking, so it will run ahead of new highs in EPS, but it feels a little early to start the run towards new all-time highs. We just experienced the sharpest cut to EPS estimates for a single quarter on record (Q2) and it’s still early May.

An Emerging Markets Debt Crisis May Be Coming

I was worried that we might have an emerging markets debt crisis in 2018 due to the Fed tightening at the time and the record borrowing in U.S. dollars, the bulk of which came from emerging markets. Rising interest rates on record debts cause those that have to roll them over to pay higher rates. Record dollar borrowing, which is now even bigger than in 2018, as it grew another 6% to reach a new record of $12.2 trillion at the end of 2019, is the same as a record short position gains the U.S. dollar.

Borrowing dollars is the same as shorting dollars for non-dollar denominated corporate or government entities. When those dollars are borrowed, they are sold in exchange for local currency to be used. When the loans are repaid, dollars have to be bought back. Back in 2018, rising interest rates were the problem; now it’s disappearing cash flows as can be seen in the collapse in global trade and commodity prices.

Commodities Research Bureau Index versus Brazilian Real Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In 2018, I identified the Turkish lira, the Argentine peso, and the Chinese yuan as problematic and at high risk to suffer damage. Two out of three blew up in 2018 – the Argentine peso and the Turkish lira. The big one, the Chinese yuan, managed to survive irreparable damage due to the grip Chinese authorities had over their financial system, which is unlike anything we have seen in any large economy in the world.

In 2020, both the Turkish lira and the Argentine peso have already made new lows – lower than the lowest levels they saw in 2018. In fact, if one were to look at a currency index for emerging markets, you would see it making fresh all-time lows. I think the situation is much worse for emerging markets than it was in 2018, as the effects from disappearing cash flows to service those record dollar debts right now are much bigger than the effects of rising U.S. interest rates at the time.

For emerging markets, the worst is yet to come as they run up record-high deficits, enact complicated central banking operations, and deliver fast and record-high unemployment benefits. Therefore, many emerging economies will have a harder time ahead before they reach their economic trough.

All content above represents the opinion of Ivan Martchev of Navellier & Associates, Inc.

Please see important disclosures below.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. All content of “Global Mail” represents the opinion of Ivan Martchev

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