Time of Distress

If banks in this time of distress
Are fine, at least in the US
Then why would the Fed
Stop dividends dead
While buy backs, forever suppress?

In a market that is showing little in the way of price volatility today, arguably the most interesting story is the results of the Fed’s bank stress tests that were released yesterday. There seemed to be a few inconsistencies between the actions and the words, although I guess we should expect that as standard operating procedure these days.

The punchline is the Fed halted share repurchases by banks while capping dividend payouts to no more than their average earnings for the past four quarters. In their tests they explained that, depending on the trajectory of the recovery, banks could lose between $560 billion (V-shaped) and $700 billion (U-shaped) in the coming year from loan losses. It ought not be that surprising that they would want to force banks to preserve capital in this situation, especially as the current Covid economy is far worse than any of their previous stress test parameters. And yet, the Fed explained that the banks were strongly capitalized, nonetheless. It strikes me that if they were so well capitalized, there would be no concerns over rewarding shareholders, but then again, I am just an FX guy.

But let’s take a look at the bigger picture. While the Fed has been doing everything in their power to prevent the equity market from declining, and so far have been doing a pretty good job in that regard, they have just laid out two of what I believe will be three regulations that are in our future. As populism rises worldwide and the 1% remain on the defensive, I expect that we are going to see widespread changes in the way capital markets work. Consider the following:

• Share repurchases are going to be a thing of the past. Now that the Fed has shown the way, I expect that regardless of who is in the White House after the election, one of the key lessons that will have been learned is that companies need to keep bigger rainy day funds, as well as invest more in their own businesses. At least that will be the spin when share repurchases are made illegal.
• Dividend caps are going to be the future as well. Here, too, with a nod toward reducing overall leverage and maintaining greater cash balances, dividends are going to be capped at some percentage of net income, probably averaged over several quarters so a single event will not necessarily disrupt that process, but dividend yields are going to decline as well. Of course, any yield will be better than the ongoing returns from ZIRP!
• Management salary caps. Finally, I think we will be able to look forward (?) to a time when senior management will have their salaries and bonuses capped at a multiple, and not a very large one, of the average employee’s salary.

The real question is, will these regulations apply only to publicly listed companies, or will there be an effort to change the way all businesses are managed in the US? But mark my words, this is the future, at least for a while.

If I am correct, and I truly hope I am not, then I think several other things will play out. First, these regulations will quickly be enacted in most nations. After all, if the US, the largest economy with the most sophisticated capital markets, can change the rules, so can everybody else. Second, this is going to play havoc with the Fed’s ongoing attempts to support equity prices. After all, restricting the ability of investors to earn a return is going to have a severe negative impact on valuations. However, the Fed will find themselves hard-pressed to argue against widespread adoption of these policies as they initiated them with the banks. Needless to say, risk assets are likely to find much reduced demand if there is less prospect of return.

To sum it up, there seems to be a real risk that we are going to see structural changes in capital markets that will result in permanently lower valuations, and the potential for a significant repricing of risk assets. This is not an imminent threat, but especially if there is a change in the White House and the Senate, this will quickly move up the agenda. Risk assets are likely to become far riskier, at least at current valuations.

But enough about my clouded crystal ball. Rather, a quick look at today’s session shows that yesterday afternoon’s US equity rally continued into Asia (Nikkei +1.1%, Sydney +1.5%) and Europe (DAX +1.1%, CAC +1.6%, FTSE 100 +1.55%) although US futures are actually little changed at this hour. Bond markets are edging higher, with yields declining on the order of 1bp-2bps across the haven markets, while oil is continuing to rebound from its sharp fall earlier this week.

FX markets are mixed in direction and have seen limited movement overall. In fact, the leading gainer this morning is the yen, up 0.3%, although despite some commentary that this is a haven asset move, that really doesn’t jive with what we are seeing in the equity space. Perhaps a better explanation is that CPI readings last night from Tokyo continue to show deflationary forces are rampant and, as we have seen for the past twenty years, that is a currency support. Kiwi is up a similar amount, but here, too, there is no news on which to hang our hat. On the flip side, we have seen tiny declines in SEK and GBP, and in truth, beyond yen and kiwi, no currency has moved more than 0.1%.

In the emerging markets, the picture is also mixed, with a similar number of gainers and losers, although magnitudes here are also relatively small. On the downside, RUB and ZAR have both fallen 0.4% while last night KRW managed a 0.35% gain. Both Russia and South Africa reported a jump in new Covid cases which seems to be overshadowing hopes of reopening the economy. As to the won, it was a beneficiary of both the equity risk rally as well as an apparent easing of tensions with North Korea.

On the data front, yesterday’s Initial Claims data was a bit concerning as though the number fell, it fell far less than expected. There are growing concerns that a second wave of layoffs is coming, although we continue to see companies reopening as well. I still believe this is the most relevant number going right now. This morning we get Personal Income (exp -6.0%), Personal Spending (9.2%), Core PCE (0.9% Y/Y) and Michigan Sentiment (79.2). While there will almost certainly be political hay made about the Income and Spending numbers, my sense is none of them will have much market impact. Rather, today is shaping up as a very quiet Friday as traders and investors look forward to a summer weekend.

Good luck, good weekend and stay safe
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