Field of Uncertainties
If you provide it, will they come?
By Chris Puplava, January 6, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
In the 1989 film, Field of Dreams, an Iowa farmer hears a voice in his corn field that says, “If you build it, he will come,” in which building a baseball field on his farm leads to a visitation by his father who passed on. Fed Chairman Mr. Bernanke is likely hearing the voices of past economic cycles that say, “If you provide it, they will come,” in which lowering interest rates and providing liquidity leads to the consumer and corporate sectors coming to the debt trough to lever up their balance sheets. While this may have worked in the past it is unlikely to prove as successful this time around.
The Federal Reserve conducts a quarterly opinion survey of the banking sector which provides a great snapshot in terms of the availability and demand for credit (Click for link to Fed report). Typically, as the economy slows down banks begin to tighten lending standards which leads to a decrease in the demand for loans. Conversely, as the economy recovers banks ease lending standards which makes credit more affordable and demand for loans increases. As seen in the figure below, lending standards rose leading up to the last three recessions and then decreased as the economy recovered. Currently the net percentage of banks are still tightening lending standards, though well off the highs seen in 2009 when 60% to 80% of banks were tightening standards for various forms of credit.
Source: Federal Reserve
As banks eased on lending standards after the conclusion to the last two recessions, loan demand began to increase with banks showing a net positive reading for loan demand usually within a year or two after the recession ended. Looking at current loan demand shows that the greatest recovery has been in prime mortgages thanks to the tax credit from Uncle Sam. However, given the dramatic decrease in the net percentage of banks tightening standards and given record low interest rates, one would think that demand for the other loan types would be recovering at a much stronger rate than is presently being seen. Will it take more tax credits from Uncle Sam to spur demand for credit cards, commercial and industrial loans (C&I), and commercial real estate? For our children’s sake, let’s hope not as they will foot the bill!
Source: Federal Reserve
As mentioned above, demand for loans increase after banks ease lending standards and a rise in general consumption levels then ensues. While banks may be easing lending standards and interest rates remain low, the consumer has virtually no interest in parting with their savings and/or taking on more debt as their plans to purchase homes and big ticket items over the next six months rests at severely depressed levels.
Source: The Conference Board
It is no surprise then that the most important problem that small businesses are reporting to the National Federation of Independent Business (NFIB) is poor sales. Interestingly, near the bottom of their concerns are financial and interest rates, which is the proverbial “pushing on a string” in which Bernanke’s monetary policy is showing little results for credit growth.
Source: Northern Trust, The Econotrarian: Airplane Thoughts (12/10/2009)
There is a clear trend of deleveraging in the private sector that really has taken on steam in the past two years. For the first time in more than a half century we have both the household and corporate sectors deleveraging at the same time, making this recession all the more severe with required support from the Fed and US Treasury to keep the economy from falling even further.
Source: Federal Reserve
Consumer credit as a percentage of GDP peaked earlier in the decade and continues to decline with there still being considerable room for it to fall to its long term average of 13% to 14%. Likely to be seen concurrent with the debt deleveraging is a fall in real (inflation-adjusted) stock prices which track the overall pattern of credit growth relative to GDP. As consumer credit relative to GDP has room to fall before reaching its long term average, we have likely not seen the lows in terms of real stock prices. In the 1970s the nominal low came in 1974 after the brutal 74/75 recession, though the inflation-adjusted low for the S&P 500 came in 1982.
Source: Federal Reserve/Standard & Poor's/BLS
The deleveraging cycle will likely continue into the middle the decade according to demographics. Demographics play a key role in terms of the aggregate consumption levels for an economy. The age cohort that has the most discretionary income to spend are those that are in their prime working years (35-49) and the ratio of this cohort relative to the younger (20-34) or older (65+) cohorts contributes to the overall level of consumption relative to economic activity (GDP). As demographics are relatively easy to model, we can assume that given the decline in the higher discretionary income cohort (35-49) relative to the lower wage (20-34) cohort that will continue until about 2014-2015 that consumption levels relative to GDP will also continue to decline for several more years.
Source: U.S. Census Bureau/Bureau of Economic Analysis/Federal Reserve
The deleveraging that has taken place this decade in stocks (2000-2003, 2007-2009) and housing (2006-present) has helped remove some of the excess asset inflation that was a result of excess credit in the system generated over the last few decades. The devastating stock market crash from 2007-2009 along with the decline in housing helped drive the ratio of household net worth to income below its long term average for the first time in more than 15 years.
Source: Federal Reserve
While much asset inflation has been wrung out of the system we are still not near the lows seen in the middle 1970s that marked the price low in the last secular bear market, meaning we still likely have more asset deflation to go relative to income levels over the next few years. While Mr. Bernanke is giving every reason for households and corporations to take on more debt, the desire for more debt from these two groups will likely remain subdued and lead to Uncle Sam to fill the gap.
This type of dynamic is typical during secular bear markets in stocks in which the private sector is often seen deleveraging while the public sector steps up. Secular bear markets are filled with incredible volatility and so it will be key to take profits along the way as a buy-and-hold strategy was devastating in the last secular bear market as seen below. As such, given the dramatic rally off the 2009 lows capital preservation will be paramount in 2010 so that the gains made in the prior year are not surrendered once the bears come out from their caves.
Source: Bloomberg
Chris Puplava
© 2010 Chris Puplava
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