We've Only Just Begun?
by Brian Pretti CFA, Contrary Investor. February 13, 2009
Yeah, that’s pretty much how we see it at this point. We’re referring to the process that is macro or systemic deleveraging. It was way back in March of 2007 that we penned a discussion entitled, “It’s Delightful, It’s Delovely, It’s Deleverage”. At that time very few folks were talking about deleveraging as a concept and economic force to come. Fast forward to the present and it’s now consensus thinking. Although the theme has been very much popularized in the mainstream press, we see very little attention to specific detail. So, in that spirit, this discussion is all about a check in on the concept and detail as to where we now stand. Nothing like the facts to illuminate the true picture, no?
To the point, deleveraging is not an event, but a process. As we've explained in the past, the multi-decade credit cycle phenomenon was key to economic and financial market outcomes in the US, as well as globally for close to three decades. The whole concept of deleveraging dramatically interrupts, or really derails that cycle. Coincidentally, the Fed/Treasury/Administration are in do or die reflation mode at present. Reflation really meaning an attempt to restart what is a critically wounded credit cycle. Mortally wounded? We’re going to find out. In this light, monitoring the process that is deleveraging becomes very meaningful in terms of trying to interpret just what the financial markets are pricing in at any point in time. We believe it's also helpful in terms of trying to monitor the economic slowdown magnitude and duration issues so key to near term investment outcomes.
Looking at the hard data, it's our interpretation that deleveraging has barely begun when looking at the economy and financial market broadly. Below are a number of highlight data points. Through the third quarter of last year, US consumers have not yet gone into a net debt contraction mode, but have slowed their borrowing dramatically YTD. It's a darn good bet net debt contraction is here now and will show up in quarterly numbers very shortly as official 4Q numbers are published. Below is the near half-century history of the quarter over quarter nominal dollar change in household debt obligations. In this and all like charts that follow we are not using seasonally adjusted, so we're pretty much looking at the real thing. For perspective we've included the 12-month rate of change which smoothes an incredible amount of monthly volatility. To suggest what has transpired at the household level is dramatic both on the upside and downside is an understatement.
From taking on close to $350 billion quarterly in new leverage some years back, household debt grew by only $14 billion in the last quarter (3Q 2008) for which info is available. That’s absolutely a rounding error set against a $14 trillion+ economy. As we stated in the chart, the last time households actually paid down debt on a quarterly basis was 1975. We’re convinced net debt reduction at the household level lies ahead. Although we will not drag you through another chart, both revolving and non-revolving consumer credit balances have contracted with 4Q data available as of now. Bottom line being, for households the deleveraging process has just begun despite all the sound and fury over deleveraging as a concept last year. As with the macro economy, magnitude and duration of the deleveraging to come at the household level will be a key data point for 2009. The Fed/Treasury/Administration (the F/T/A) may be begging the banks who’ve received TARP money to lend, but households are telling us by the trend in these numbers that they are not necessarily willing borrowers, regardless of cost and availability of credit.
As we see it, the financial markets have priced in the F/T/A response to the credit market freeze/economic slowing, but as of now the household response to borrowing inducement remains a question mark. Maybe the key question mark of the moment. If households begin a process of net debt contraction (which we believe they will), then financial markets trying to anticipate a turn in the US economy by the second half of this year will be jumping the gun in a big way. Moreover, existing 2H 2009 bottom up analyst earnings estimates are a good bet to be far too high at the moment. For now, we believe the markets have not priced in household indifference to monetary stimulus.
The chart below tangentially documents the rhythm of household balance sheet cycle reconciliation over the prior half century. As is clear, never in the half-century plus period that is covered has the year over year change in household debt growth been at the record low level we see today. Does this trend dip into negative territory before the current cycle is over? We think so, which will be unprecedented, but we’ll just have to see what happens. From our perspective, equities have not yet fully priced in the ramifications of actual household debt contraction. Remember, the reality of prior half year auto sales, retail sales and residential property activity all occurred during a period characterized by slowing in household debt assumption, not net debt contraction. And in this environment we already see the year over year change in headline retail sales as the lowest level in the history of the data (dating back to the late 1940’s).
As we have stated in the past, actual deleveraging has been occurring in the financial sector during 2008. THE poster child example for this phenomenon is the asset backed securities markets. The following chart is self-explanatory. Since the dawn of the asset backed markets in the mid-1980’s, there had never been a quarter over quarter decline in asset backed securities market leverage until 4Q of 2007. We already know that it’s the non-bank credit creation arena (the shadow banking system necessarily inclusive of Wall Street) that has been ground zero for broader credit cycle reconciliation in the current period. Have the markets already priced in contraction/deleveraging in the non-bank financial sector? To a large extent, you bet. Yet confidence in the sector will never be restored until investors can truly assess balance sheet risk. Given the revelations of companies like Citi, State Street and BofA lately, it’s clearly what we don’t know that’s the issue. And we’re miles away from confidence restoration. Miles.
In terms of specifics, and we will not drag you through a myriad of long term charts as within the financial sector actual deleveraging (net debt contraction) is evident as we look at the REITs, funding corporations and the asset backed markets, but outside of that continued leverage acceleration is still evident looking at the banks, insurance companies, GSEs, the broker/dealer community and credit unions. As such, this data and the trends underpinning recent experience suggests there is still a good deal of deleveraging potential within the broad US financial sector itself. Although the financial sector stocks have been resoundingly hit over the past year and one half, true recovery seems a long way off given that actual deleveraging in the sector has been meaningful, but isolated as opposed to broad based. Further potential deleveraging in the US financial sector remains a high probability outcome well into 2009. The importance of this will be its ramifications for the broader economy as a whole.
The non-financial corporate sector, much like its household sector counterpart, has only experienced a slowing in leverage assumption as opposed to outright contraction through 3Q of last year. As you can see in the chart, in the prior two recessions the non-financial corporate sector actually engaged in net debt reduction/deleveraging. We think it’s a very safe bet that occurs again in the current cycle. The dramatic drop in debt assumption is occurring now. The markets know this and we believe have priced this in. What remains to be discounted is once again magnitude and duration of net debt contraction that we believe lies dead ahead.
Collectively the data points we have briefly reviewed above are strongly suggesting that a broad based deleveraging process has not yet gained maximum wind speed. In fact in strict definitional terms the real deleveraging process has not even yet begun outside of the asset backed securities markets as a component of the financial sector. As of 3Q 2008, quarter over quarter total US credit market debt grew by almost $730 billion. YTD that number is just shy of $2 trillion in growth. Of these numbers, federal debt grew $525 billion in 3Q of last year (accounting for 72% of total US credit market growth) and $675 billion YTD (accounting for a third of total credit market growth) at that time. We will not belabor the point as we discussed it many a time last year, but we all know Federal debt is set to mushroom ahead. A little preview of what may be to come in comparison to past experience lies below. Talk about the antithesis of deleveraging.
In summation, debt growth throughout the broad US economy, exclusive of the asset backed securities markets (that is in clear deleveraging mode) and the Federal government (that is in clear leverage acceleration mode), has only slowed, but not gone into net contraction. As per the nearer term directional trends seen in the charts above, it appears households and the non-financial corporate sector are either in or will enter the process of net leverage contraction (deleveraging) very soon. Consumption, production and price deflation trends in a number of asset classes (primarily residential real estate and equities) has occurred up to this point against a backdrop of only slowing household and corporate debt growth. Just what will happen if/when household and non-financial corporate leverage begins to actually contract in nominal terms? THAT’s the key question for us as investors over the quarters directly ahead. The markets have priced in sector implosion (financial sector) and the potential for a recession of a mid-1970’s/early 1980’s magnitude. But, the broad deleveraging process has really just begun. We have a very hard time seeing this process truncated in the quarters ahead. The potential clearly exists for a multi-year reconciliation process. Have the markets already priced in a multi-year deleveraging process, with specific emphasis and implications as per consumers? That we do not believe has happened, except maybe in the Treasury market. You already know we will be monitoring and discussing these very issues as we move forward. Deleveraging is not done. As you can see, it has barely begun.
Moving Toward A New Normal?
We all know by now that Microsoft missed its 4Q 2008 earnings a few weeks back. Moreover, for the first time in their history they are beginning to reconcile labor costs, as are so many firms domestically. But probably THE most important aspect of the Microsoft announcement we believe simply did not receive enough headline attention, and it had absolutely nothing to do with earnings or layoffs.
Getting to the point, we want to quickly cover a very brief comment made by Microsoft big cheese Steve Ballmer with the earnings report. Without sounding melodramatic, we have to hand it to Ballmer in a big way. As we see it, his comments were absolutely spot on regarding what we believe is one of the key macro themes of the moment. We’re convinced by these simple comments that he gets it in a very big way. Sorry if you have already seen these comments, they are just so dead on we had to reprint them.
“We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to a lower level of business and consumer spending based largely on the reduced leverage in the economy.”
We never thought we’d say it, but BRAVO Mr. Ballmer. You hit it right on the head thematically, baby. We're moving to a "new normal" for the economy and corporate profits. That’s EXACTLY what is occurring, as far as we are concerned, and this is the exact set of circumstances the equity markets are in the process of adjusting to and discounting right now. Late last year we ran a series of charts comparing the longer cycle of total credit market debt growth in the US relative to the like period directional movement in after-tax US corporate profits. A snippet is seen below. Apparently like Ballmer, we are convinced the credit cycle clearly enhanced corporate profits and lifted asset values, both physical and financial. Our question at the time that still stands today is, “what happens to profits, and by extension US GDP, in a credit reconciliation process of perhaps generational magnitude?” Wouldn’t ya know it, Ballmer seems to be asking the same question. We have the distinct feeling this theme will be one of the most important to investment decision making and economic outcomes in the year ahead, and will gain in popularity as it works its way into consensus thinking.
Hopefully expressed in simple terms, the prior period credit cycle was a massive anomaly. That anomaly raised US nominal GDP, corporate profits and asset values to levels they never would have experienced in the absence of maniacal credit creation. Now that the meaningful deleveraging process we have been ranting and raving about is evidenced all around us and is really still in its infancy, we believe the US economy, corporate profits and asset values are in the process of shifting downward to a “new normal.” THIS is what the current equity bear market is all about. Corporations are adjusting to this new normal by cutting costs as their revenues shift downward. Households are adjusting to this by massively lowering their intake of leverage, and we believe soon to be paying it down. Even Ballmer recognizes the anomaly is over and is acting appropriately as far as Microsoft is concerned. When will this most important of messages and conceptual thinking make it to Washington? Answer: Don’t hold your breath, okay? After all, everything we've seen from the powers that be so far suggests to us they have absolutely no intention of adjusting to a new normal, but rather are doing everything in their power to recreate the old anomaly.
© 2009 Brian Pretti