We're Swimming in Liquidity, Aren't We?
by Brian Pretti CFA, Contrary Investor. February 2, 2007
Although I'm pretty darn guilty of this personally, I can’tturn around these days without hearing the words, "it’s a liquidity driven market." Trust me, this is not about to go off into yet another discussion of the macro credit cycle. Collectively, we know global central bankers are "sponsoring" excess liquidity. We know Wall Street is capable of the same and is fully in gear at this point. We know the derivatives markets underpin excessive risk taking on the part of investors. We know private equity is the new fountain of youth for the institutional investment community. And we know leveraged hedge funds are not about to change their collective ways any time soon.
But what we don't know is how households/consumers will react ahead as, very much unlike the financial markets, they are not swimming in liquidity. Not by a long shot. At least not relative to the context of history. Given my fixation on the residential real estate cycle being an asset class capable of behavior modification when it comes to the US consumer, it highlights the need to fully recognize that US household excess liquidity availability has largely been driven by the monetization of asset inflation in both equities late last decade and residential real estate in the current, to say nothing of additional leverage assumption. In literally point blank terms, the following chart documents just how important stock and real estate asset inflation has been to growth in household net worth by the decade over the last half century-plus. As is clear, real estate and equities have never been more meaningful to aggregate household net worth expansion than is the case in the current decade. Hence, incredibly meaningful to consumer behavior.
If indeed we will be seeing a slowing in the growth of household asset inflation ahead, as sure appears to be the case at this point, just where will consumers find their next source of liquidity? Although I sure wish I had an answer to that question, maybe more important is to at least be aware of current circumstances regarding household liquid assets. For if continued household asset inflation is at any point a non-starter anywhere ahead, household liquidity will either be what's on the books of household balance sheets right now, or ever more leverage assumption. It's either one of the two. As you know, God forbid there is any deflation in either household residential real estate holdings or equity values.
I'll try to make this relatively quick. The pictures tell the story in a big way. Before getting started, a very brief comment on data calculations. In the following charts I'm looking at household liquidity or cash, as I term it. They are synonymous in terms of calculation. For this number I'm adding together all household bank deposits, CD's, money funds, checking accounts, savings, and other bank-like products together with all household bond holdings inclusive of Treasuries, corporates, muni's, agencies, etc. Long time readers know I try to apply the most broad measure of liquidity to the household picture when examining these trends. Implicitly I'm assuming bond investments could be converted to cash with ease. Not included is real estate, stock holdings and private business equity ownership, but that's about it. In other words, simply trying to give households the most broad benefit of the doubt when reviewing their liquidity circumstances. Here we go.
The following is household liquidity as a percentage of household liabilities. As of 3Q 2006, we're at a level never seen before in the last half century at least. The declining trend simply continues unabated, all starting as the baby boom generation came of age in the late 1970's.
Certainly what you see above is a ratio. Pretty simple stuff. A bit more dramatic is what lies below. It's the same concept as above, just expressed in nominal dollar terms. This time we're looking back six decades. As detailed in the chart, never prior to 1997 was household liquidity less than total household liabilities. But as you know, also since that time the household savings rate has plunged and household liabilities have mushroomed. All part of greater credit cycle dynamics playing out before our eyes.
As mentioned many a time, what we are seeing in these charts is an intergenerational change in attitudes toward leverage. It's a change in comfort with leverage. But I'll be the first to admit, in nominal dollar terms, the magnitude of the change you see above is more than a bit striking. Much more, as a matter of fact.
In the next set of charts you get a look at household liquidity circumstances expressed as a percentage of household real estate values and household ownership of equities. It's simply perspective on the relationship between cash and alternative asset class ownership at the household level. In terms of liquidity set against real estate values, it should be no surprise at all that we are bumping along historical lows right here. Certainly half the story is contracting household liquidity in recent years, but the larger issue is the explosion in real estate values driving this ratio in recent periods. Not THAT big a deal, correct?
Well, it probably would not be THAT big a deal except for the fact that the following chart appears as it does. It's owners equity as a percentage of the market value of residential real estate directly from the Fed Flow of Fund data. Thank you Fed. Very simple question that really reflects on household net worth and prompts a few questions about household leverage. In one of the greatest residential real estate price acceleration periods of a lifetime, how come there has been absolutely no increase in relative owners equity as a percentage of market values since the real estate mania's inception early this decade? With the type of price increases we have seen just this decade, I would have expected this to perhaps have turned up a bit vertical. As you know, there's only one explanation. Household residential real estate leverage in aggregate accelerated at a greater rate than did prices during the current cycle. And here you thought nothing could have moved faster than real estate prices in recent years. Wrong. This shows us just how meaningful "liquidity extraction" has been in the land of residential real estate for households this decade. Again, what's next in terms of a meaningful household asset that can be inflated and borrowed against? At least for real estate, it's now a "been there, done that" asset class, isn't it?
Following along with the concept, below is household liquidity as a percentage of common stock ownership. As you know, at least the last time we checked, stocks are most usually purchased with cash. Sure, there are plenty of leveraged equity purchases among the so-called investment pros, but for mom and pop US households, very few are margined in any big way. Again, it's simply perspective. For now, cash levels are off of their most recent lows (which was really skewed by the stock bubble of the late 1990's/early 2000's). But interesting is the fact that this ratio is quite near what was seen in the mid-1960's. For history buffs, you know that the Dow in 1982 was almost exactly where it stood in the mid-1960's. As is also clear, powerful bull markets as began in the early 1980's saw household cash levels relative to stock values more than three times higher than is the case today. Again, just perspective on alternative asset classes and their relative magnitude at the household level over time.
This is where we can draw this little look at household liquidity to a dramatic close. Final simple look at household liquidity relative to total household assets. After seeing the above charts, what lies below is no surprise at all. It's simply an amalgamation of much of what was covered above. Up from the lows, but just barely. The real change began in the early 1990's, just about the time the credit cycle in the US was set to move into full swing.
Boom, Boom, Out Go The Lights?
So why is all of this discussion about household liquidity important? What does it mean to our investing activities ahead and the broad economy in general? Although this is somewhat of a generic comment, I believe the significance of these trends find their meaning in demographics. In very simple terms, we know that the baby boom generation is moving full speed ahead into retirement years. Point blank, assuming the boomers in aggregate actually do retire, their need for real liquidity will be meaningful. Very meaningful. Remember, I'm referring to a baby boom generation who has "learned" to become relatively dependent on asset inflation for a good many years now to generate household "liquidity;" asset inflation that has truly acted to underpin consumption. Unless we can bank on asset inflation continuing, implying that asset inflation will "fund" boomer retirements as it has clearly funded their lifestyles for at least a good decade now, just where will retirement funds/liquidity come from? This is the issue, and it's clearly of longer-term importance as opposed to being something influencing the open of trading tomorrow morning. Can the Fed fund boomer retirements by simply printing money and inciting ever-greater household asset inflation? Can the boomers "borrow" their retirement lifestyles as they have done up to this point by taking on ever greater household leverage?
As of the 3Q Flow of Funds report, 47% of total household assets were comprised of real estate and equities. Another 16% were comprised of what is termed tangible assets and consumer durables. What are these? Cars, boats, furniture, appliances, art work, jewelry, etc. Not exactly the stuff the local grocer will take in trade for food or the local utility will accept for heat and electric service. Another 15% was the "cash" we described above (all bank vehicles and all bond holdings). The remaining big household asset item was pension fund reserves. As you know, as time passes, less and less households will be covered by traditional pension plans. Given that we are looking at over 75% of household assets in real estate, tangibles and bond/cash assets, again, where does future liquidity come from for the boomers ahead? Of course the most obvious answer is the sale of financial assets. Not necessarily proactively, but by sheer default. It's no wonder demographers such as Harry Dent are painting an outright nightmare economic/financial market outcome starting literally in five years. (For any familiar with Dent's work, you already know he has very quietly mentioned the word depression a time or two in his outlook).
Incredibly enough, against this backdrop of what has been a relatively dramatic drop in household liquidity in its most broad definition over the last few decades, current and forward financial obligations demanding here and now liquidity service have only gone ever skyward. As of 3Q 2006, the household debt service ratio rests quite near all time highs, up quite meaningfully over the past quarter century as the boomers have borrowed against inflating personal assets.
Perhaps nowhere is this more dramatic than in what you see below. All time highs as of last year's 3Q period end. Remember, the boomers in aggregate are in their peak earning years right now. Depending on the character of the US economy ahead, will boomer earnings and personal income accelerate meaningfully enough to knock down this ratio? Or will the boomers essentially be forced to liquidate a very meaningful portion of their probably most liquid holding - financial assets - to continue to fund the obligations implicit in the chart below as their peak earning years pass? Because what won't pass is the long-term debt service on mortgage obligations that are already on the books of US households.
As you know, the boomers have been funding and accumulating financial assets in their IRA's, 401(k)'s, profit sharing plans, hopefully personal accounts, etc. for decades now. In looking at the historical character of declining household liquidity and coincidental growth in household financial obligations largely due to the explosion in mortgage debt over the past few decades, a concern has to be that somewhere "out there" the boomers will ultimately initiate a period of net distributions in these very same IRA's, 401(k)'s, etc. It's a given that since defined benefit plans are virtually extinct in terms of new plans or employee additions, existing plans will become self liquidating in the decades ahead. Financial assets inside these plans will be under constant and consistent distribution at some point in the not too distant future. Will we basically be looking at this decades long boomer financial asset accumulation experience in reverse, exacerbated by the fact that households have such a surfeit of liquidity at present? Again, it seems no wonder Harry Dent is more than a bit worried.
Although this is clearly a longer-term statement than not, we believe we need to factor this set of circumstances into our investment decision-making. Point blank, at some point ahead, the hunt for liquidity will be on in a big way for the boomers. And this suggests to us that yield will be an enduring investment theme if indeed demographics can and do influence real world economic and financial market outcomes, which I firmly believe. For now, household exposure to yield oriented vehicles such as bonds is just not so far off of all time lows.
Although myself and many others worry that ultimate reconciliation in the US trade imbalance of the moment could indeed remove an important support to the bond market that is currently purchases of US bond assets by the foreign community, are the baby boomers the next buyers in what might become a frantic search for income/yield? Personally, I believe bonds are a terrible investment at present based purely on fundamentals, but it's this potential type of a demographic driven need that may override fundamental considerations for a time. Moreover, and more importantly to our investment activities, I sincerely believe there will be an increasing boomer driven bias for dividend yield. I've been preaching for years that total rate of return investing would be again important ahead. This set of circumstances laid out above simply puts an exclamation point behind this thought. Again, an important set of considerations for the open of the market tomorrow morning? Nope. But perhaps an investment theme of long-term durability? It sure looks that way. And all driven by what has been household reaction to asset inflation, household liquidity diminution of the past few decades and the growing acceptance and apparent complacency regarding ever-increasing leverage of the household balance sheet.
Real long-term wealth is created in the investment process by identifying and participating in long term investment themes. If yield is not a long term and successful macro investment theme ahead, I'd be more than a bit surprised. All one has to do to make the secular case is have a good look at current household balance sheets. Funny, it's the one thing Wall Street doesn't seem to do very often.
© 2007 Brian Pretti