Running Out of Fuel
By Chris Puplava, July 26, 2006
After Nixon abandoned the Bretton Woods gold-exchange standard on August 15th, 1971, an era of liquidity and rampant money creation began. With the rampant money creation by the Federal Reserve consumers sopped up the newly created money in the form of taking on debt. Lenders benefited from the cheap money created by receiving interest payments and the economy benefited from that money being poured into the economy.
Consumers took on more debt at increasing levels in the 1980s. Personal consumption expenditures as a share of GDP have risen from less than 63% in the early 1980s to over 70% in recent years. Spending growth has outpaced GDP growth in seven of the last eight years, with 2004 the only exception. Taking on increasing amounts of debt wasn't the only way that U.S. consumers fueled their consumption. The U.S. savings rate plummeted from a high of nearly 12% in 1984 to a current -2% savings rate. The U.S. consumer saved less, acquired more debt and then poured this into the economy.
The rapid growth in GDP during the 1990s as well as the great bull market of the 1990s came on the back of increasing U.S. consumption. Consumer credit rose from roughly $800 billion to $1800 billion by the recession of 2001, an increase of 125% in consumer debt!
What also occurred beyond a more than doubling of consumer debt was a 75% drop in the U.S. savings rate, falling from 8% to 2% during the 1990s. Figure 4 below shows a sharp increase in consumer credit in the early 1990s when looking at the year over year (YOY) percent increase, which then moderated back down to a 5% YOY rate.
Note: Shaded regions represent recessionary periods
Money creation (M3) by the Federal Reserve exploded to prevent the 1994-1995 mid-cycle slow down from turning into a possible recession. The massive amount of money created during the 1990s found its home in the stock market driving up the S&P 500 and the Dow Jones Industrial Average to record levels. The correlation seen in the chart below is pretty self evident.
As the recession of 2001 took hold the U.S. savings rate stabilized at 2%. (See figures below.)
To bring us out of the recession the Federal Reserve chopped down every tree in sight to print money as seen by the M3 money supply. M3 increased at a 20-25% annual rate, with spikes of 20% annual rate increases in 2002.
Rampant money creation wasn't the only weapon the Federal Reserve used. The Fed took the Fed Funds rate down to decade lows of 1%, which was an irresistible rate to consumers who took out loans to purchase homes at a record rate. Mortgage debt rose with mortgage obligations as a percentage of disposable income rising from 9% in 2000-2001 to current levels of 11.5%.
The newly created money from the Federal Reserve from 2000 onward didn't find its home in the stock market as the indexes plummeted in value before stabilizing in 2003. Instead the money poured into houses and housing prices began to increase rapidly like the stock market did in the later half of the 1990s. As consumers saw their homes appreciate dramatically in value they borrowed against their homes and used them as ATM machines by extracting equity from them to fuel their consumption.
Source: The Northern Trust Company
Net home equity withdrawal was non-existent in 2000 but subsequently went through the moon, rising up to $452 billion by early 2005. The U.S. consumer took their equity from their homes to pay principal and interest on non-mortgage debt by an annualized record amount of a $132.9 billion in excess of what they earned after taxes.
As consumers took on more debt their ability to service that debt decreased. The household debt-service ratio, debt service payments relative to disposable personal income, rose to all-time highs (Figure 10).
Figure 10. YOY Rate % Change
Source: The Northern Trust Company
Data: Federal Reserve Board/Haver Analytics
Even though many consumers saw their homes appreciate dramatically, their liabilities rose at an even greater rate causing the liability to net worth ratio to rise to all-time highs (Figure 12). Household liabilities rose from $359.8 billion in 2000 to $1181.5 billion in the first quarter of 2006, up 228% for a greater than 3-fold increase in debt!
Source: The Northern Trust Company
Source: The Northern Trust Company
As the U.S. consumer took out record levels of equity from their homes (Figure 9) which poured into the economy, the percentage of GDP coming directly from this source of U.S. consumption fuel increased in importance.
I've shown this chart before but the information contained within speaks volumes for the state we are in currently.
The primary source of gains in U.S. cash flow has been borrowing against rapidly rising home equity. Low interest rates have facilitated this borrowing, with the U.S. consumer pouring their extracted home equity into the economy. Prior to 2000, the percentage of GDP due to mortgage equity withdrawal (MEW) added roughly 0.5% growth to GDP. When MEW is taken out, GDP was negative in 2001 and 2002 and only slightly positive in 2003. MEW now makes up nearly most of GDP pointing to the importance of housing to pull us out of the last recession.
Interest rates have been on the rise and have slowed down applications to refinance mortgages, which are currently at one fifth their 2003 peak and down 20% from 2005. In addition, smaller gains in household wealth will provide added impetus to saving, weighing on borrowing and spending. With interest rates rising leading to a housing slow down and inflation eating into U.S. consumer pockets, the source of continued U.S. consumption looks bleak.
Current State of Affairs
The economy is clearly slowing down and the question is now whether this will be a mid-cycle slow down as seen in 1994-1995 or a recession seen in 1991 and 2001. Mark Zandi, Moody's Economy.com's Chief Economist and co-founder believes we are heading towards a mid-cycle slow down (Click here for article link).
The economy's performance during the coming year will feel a bit uncomfortable, and stagflation fears will at times even intensify, but by the standards of mid-business cycle transitions, this one is shaping up to be rather graceful. There are some obvious risks and the Fed could still make a misstep, but the economy's fundamental strengths seem likely to prevail.
Economists from BCA Research are also calling for a mid-cycle slow down. Comments from a recent BCA Research article ("Are The Conditions In Place For a Fed Pause?") are given below along with an accompanying chart.
Economic conditions are only partly in place for a Fed pause, based on past cycles. Nonetheless, policymakers are fearful of going too far. The chart shows why. Even if the Fed stops now and bond yields stabilize, the interest burden for U.S. consumers will continue to rise sharply as ARMs (adjustable rate mortgages) and other short-term loans are rolled over at higher interest rates (shown inverted in the chart). The total rise in the interest burden will be much larger than occurred during the 1990s soft landing and could approach levels that preceded the 1990 recession. We are not calling for a recession, but the chart highlights the growing headwind for U.S. consumers. Bottom line: There is a good chance that the tightening cycle is over.
I personally am a little more pessimistic on the U.S. economic outlook and believe we are quite possibly heading towards a recession. My reason behind this thinking is the state of the U.S. consumer. The U.S. consumer used low interest rates over the last several years to take on more debt for more consumption instead of using the cheaper debt (lower interest rates) to reduce their more expensive debt (higher interest rates) like U.S. companies did. Because of this the U.S. consumer is in a weaker state then they were heading into the 2001 recession (Figures 10-12), having a record high debt-service ratio and also a record high in their liabilities/net worth ratio. Compounding this problem is the current -2% savings rate (Figure 6). The fuel to bring us out of the 1991 recession came from consumers decreasing their savings rate from 8% to 2% and taking on massive amounts of debt. Consumers used part of their increased debt to invest in the stock market and used the capital gains from strong equity market returns to pour back into the economy through consumption. The fuel for bringing us out of the 2001 recession came from using MEW as homes were the new bubble instead of the stock market, with home prices appreciating in the wash of liquidity from the surge in M3 money supply.
Where is the fuel for further U.S. consumption going to come from with a current -2% savings rate, a housing slow down and MEW on the decline, along with higher energy prices?
Source: Dismal Scientist
Source: The Chart Store: Weekly Chart Blog, July 21, 2006
Inventories for new and existing homes as well as condos have been rising sharply since 2005. The inventory of new homes is at 5.8 months. The last time the new home I/S ratio hit this range was in early 1996. This ratio is likely to rise even further as a growing number of homebuilders, including the Ryland Group, Toll Brothers, and KB Homes, are reporting sharp drops in orders, rising cancellations, and mounting inventories.
Some point out as I mentioned above the U.S. companies are in excellent shape as they used the low interest rates to reduce debt and improve their balance sheets, and that increased business investment will supplement dwindling consumer spending. Business CEOs say otherwise when looking at the National Federation of Independent Business (NFIB). Brian Pretti from ContraryInvestor.com provides the following commentary:
The top dawg CEO's have not quite yet descended into the depths of emotional blackness, but we are currently resting on survey level lows dating back to 2002. As is self obvious in the chart below, the track record of the CEO business confidence survey in anticipating real world US economic downturns is simply sterling. At least since the late 1970's (the inception of this report), CEO optimism fell rather meaningfully directly in front of each and every official US recession. The track record here is 100%. Fade these folks at your own peril. If for some reason this index gets anywhere near the 40-45 level, until proven otherwise, CEO's would be "telling us" an official recession lies in our rather immediate future. In fact, we'd seriously consider any further weakening from here to be a big red flag in terms of investment risk management as it relates to macro US economic softening ahead.
Current jobless claims are at cyclical lows, with jobless claims at the same level prior to the 1991 and 2001 recessions.
The crossing of the 6 month moving average with the 18 month moving average of initial claims signaled the 90-91 recession, 94-95 mid-cycle slow down and the 2001 recession. The 6 month moving average has turned up over the last few months and will have to be watched closely especially with the inversion of the yield curve that has accurately predicted every recession over the last 50 years.
Source: Dismal Scientist
The inversion of the yield curve has historically been a strong signal that the Federal Reserve has pushed rates too far. Rising interest rates are a break on the economy, and the start of the current Fed Rate raising cycle in 2004 put a cap on employment growth which peaked in 2004 at roughly 1.5% YOY growth rate. The employment growth rate of the recent economic expansion is weaker than the expansion seen in the 1990s where the bottom of the mid-cycle slow down in 1994-1995 was roughly the current expansion's peak! Employment growth dropped sharply in late 2000 into 2001 as the recession took hold. We are heading into an economic slow down at an employment growth rate below that of the peak before the 1994-1995 mid-cycle slow down and that of the 2001 recession!
Not only are jobless claims at expansionary cyclical levels but so are retail sales. Retail sales typically peak at 10% YOY gains and can fall below 0% during recessionary troughs. Turning points in economic growth can be seen when the 1-year retail sales YOY growth rate moving average crosses the 2-year average.
The greatest drag on retail sales currently is motor vehicle & parts dealers with the greatest support coming from gasoline stations, with YOY sales growth of -3.5% and 20.4% respectively. The greatest support in retail sales coming from gasoline stations can not be an encouraging sign and makes the current retail sales level in the chart above look more positive than it is as rising energy prices are akin to an energy tax, reducing consumers' discretionary income.
To make matters worse for the housing market and the economy is roughly $2 trillion in floating rate debt that is scheduled to "reset" in the next 12 to 24 months. From here, if the yield curve remains flat and continues to shift higher following the lead of rising short term rates, the entire US Financial System would be at great risk as home owner interest payments may double, some of which will lead to increasing bankruptcies and foreclosures.
Source: New York Times, posted in The Big Picture
Adding to the strain of rising interest rates leading to increased mortgage payments is persistent and rising inflation. Current inflation is running at over 4% using the CPI index methodology that was changed during the Clinton Administration. Economist John Williams measures the CPI using the pre-Clinton era methodology which shows that the current CPI (orange line below) greatly understates the current inflationary picture had the government not tinkered with the CPI calculation method.
The pre-Clinton era CPI (blue line above) appears to reflect the current picture far greater than the current core CPI index, which excludes food and energy. Food and energy historically oscillate dramatically which is the reason given us as to why it is removed from the "core" CPI, yet food and energy are two of the greatest areas eating away at consumers discretionary income. A few months back Financial Sense Online (FSO) received the following e-mail from a follower of the website which is presented below.
We are seniors, me 77 and wife 64. Our income is FIXED at about $4,600 per month. It consists of 2 pensions, 2 Social Security (SS) checks and a small annuity. Other than the minute increases in SS, our income has not changed since we were married in 1995. We cannot understand why food and fuel are not included in this calculation. These are two major factors in our cost of living. The fuel prices hurt us as we live full time in a motorhome, (no house) and the thousands of 18 wheelers we meet in the fuel stops are hurting and the surcharges they add on are carrying right on through to our food costs.
The PPI and CPI were released last week and the following key tables are given below highlighting the dramatic rise in inflation seen in many industries and goods.
Table 1. PPI Annual Data for Stages of Production
Table 2. PPI Data for Crude Materials
Table 3. PPI Data for Intermediate Materials
Table 4. PPI Data for Crude Materials
Table 5. PPI Data for Industries
PPI Data Link: Source: Bureau of Labor Statistics
Tables 1-5 show a strong rise in inflation from crude inputs in the manufacturing process through finished goods with an annual rate of inflation for 2005 of 21.1% to 5.4% respectively. The largest drag on inflation has continued to be computers and electronics as there has been a supply boom coming from Asian countries driving down prices. Data for the CPI index is given below.
Table 6. CPI Data
Source: Bureau of Labor Statistics
Given near the bottom of page 15 of the 25 page CPI report is the following information:
- Purchasing Power of Consumer Dollar (1982-1984 = $1.00).....$0.493 (50% loss in value)
- Purchasing Power of Consumer Dollar (1967 = $1.00).....$0.165 (84% loss in value)
Based on the CPI index correcting for inflation, the 1967 dollar has lost 84% of its value while the 1982-1984 dollar has lost 50% of its value due to constant infusion of money creation into the economy from the Federal Reserve.
In summary, the 8% savings rate (Figure 2) and lower debt-service ratio (Figure 10) and liability/net worth ratio (Figure 12) were the two sources of fuel allowing the U.S. consumer to increase their consumption and spur economic activity to bring us out of the 1991 recession and prevent the 1994-1995 mid-cycle slow down from turning into a recession. The consumer saved less and borrowed more. The dramatic rise in liquidity (money supply) in 1994-1995 by the Federal Reserve found its way to the consumer who poured the borrowed money into the stock market and economy (Figure 5). The 2% savings rate seen as we headed into the 2001 recession did not provide much fuel for spurring consumption. Instead, the U.S. consumer took on even more debt which ultimately found its home in the housing market instead of the stock market as the stock indexes fell (Figure 11). As rising stock prices allowed U.S. consumers to pour capital gains back into the economy, rising home prices allowed consumers to use their houses as ATM machines by mortgage equity withdrawal (Figure 9).
As we head into another economic slow down we enter with a -2% savings rate unlike the positive 2% savings rate seen entering into the 2001 recession, a complete reversal. More than $2 trillion in ARM's are set to reset over the next two years squeezing more discretionary income from consumers. Mortgage payments as a percent of discretionary income has already taken off to the moon with no sign of slowing in site (Figure 8). If the U.S. consumer can’tlook to their savings rate for fuel, and mortgage debt is already at record levels, and business CEO confidence is rapidly falling, where is the fuel going to come from to prevent the developing economic slow down from turning into an out-right recession?
In economic news, the Mortgage Bankers Association of America released their Applications Survey. Mortgage demand decreased last week, with the market index falling 1.3% in the week ending July 21, currently 29% below its year-ago level. Purchase applications decreased 2.4%, 20% below its year-ago level, while refinance applications increased 0.6%, though 40% below its year-ago level.
Also released today was the Energy Information Administration (EIA) weekly petroleum report for the week of 07/19/2006. Crude oil inventories held steady while a 0.7 million barrel decline was estimated. Gasoline inventories, though, plummeted 3.2 million barrels, well beyond expectations for a 0.2 million draw down that supported energy prices on the day. Brent crude prices rose $0.75 per barrel pushing prices back over $74 a barrel to rest at $74.03.
The EIA provided the following commentary in their release (click here for link):
For baseball players, hitting .300, or averaging 3 hits for every 10 at-bats, is a very significant accomplishment. While hitting .300 may be good for baseball players, having gasoline prices reach $3.00 per gallon is nothing to cheer about for consumers. EIA's latest weekly survey of retail gasoline stations showed that the average price for regular gasoline across the entire country averaged just over $3.00 per gallon as of July 24, only the second time in the history of the survey (which dates back to 1990) that this level has been reached in nominal terms. However, prices in inflation-adjusted terms are still well below the monthly average of about $3.20 per gallon (in 2006 dollars) in March 1981.
The markets were initially down in early morning trading before making a steady advance into positive territory before giving up gains in the final hours of trading. Among the most notable news items Wednesday was a significant upside surprise on the top and bottom line from General Motors, while disappointing Q2 news came from Amazon that weighed on consumer discretionary stocks.
Advancing issues represented 52% and 43% for the NYSE and NASDAQ respectively, with up volume representing 54% and 50% of total volume on the NYSE and NASDAQ.
All of the broad market indices were down, with the DJIA posting a slight loss, down 1.20 points to close at 11,102.51. The S&P 500 posted a meager loss, down 0.48 points to close at 1268.40, and the NASDAQ was also down, falling 3.44 points to close at 2070.46. The 10-year Treasury note yield fell to 5.036%, and the dollar index posted a loss on the day, falling 0.78 points to close at 85.86
Overseas markets were mixed for the day. Japan's Nikkei stock average fell 0.81%. London's FTSE 100 rose 0.44%, Germany's DAX index rose 0.31%, France's CAC-40 rose 0.20%, and Mexico's Bolsa and Brazil's Bovespa Index were both down, falling 0.84% and 0.24% respectively.
Sector performance was mixed on the day with the greatest gains coming from energy, telecommunications, and utilities, posting gains of 1.66%, 1.41%, and 0.37% respectively. The greatest losses came from industrials and consumer discretionary, posting losses of 1.29% and 1.14%.
Spot gold prices rose $4.32 an ounce to close at $623.45 an ounce, West Texas Intermediate Crude (WTIC) oil rose $0.06 a barrel to close at $74.00 a barrel, and Henry Hub spot natural gas prices fell $0.0774 per mBTU to close at $6.7062 per mBTU.
Have a pleasant weekend,
© 2006 Chris Puplava