The Service Economy
by Brian Pretti CFA, Contrary Investor. April 24, 2009
You’re darn right the US is a service based economy these days. No two ways about it. I have just a very quick comment about our wonderful US service economy, but probably not relative to what first popped into your head when I characterized the economy as such. Of course I’m talking about debt service. First a few very fast bigger picture comments.
Given the near historic short term rally we’ve had in the equity markets as of late, trust me, I’m not looking to wallow in pessimism. Quite the opposite. The damage done to the equity markets over the last year and one half is generational. You see, it may be once in a lifetime (at least let’s hope so). At the same time, I’ve seen so many bear market rallies in my time that it looks like the fingerprints of the bear are all over this one, but I think it’s important to remain open to any outcome. As always THE key personal characteristics of successful investors are humility, humility and then humility. Lastly, I certainly have to acknowledge the Administration has finally realized its messaging and actions need to be much more sensitive to financial market outcomes. A lesson learned after a terrible January and February. The tone, communication orchestration and sensitivity have changed 180 degrees.
Looking back over the last month and one half, it’s been a whirlwind. Never before has a sitting Fed Chairman shown up on national TV to “give us his thoughts.” Never has a sitting President shown up on a late night talk show and then book ended the week with a visit with the same television coverage Bernanke was showcased in seven days prior. The “surprise” Fed “we’re finally gonna print money big time” monetary announcement came in-between TV cameos for Obama and Bernanke. The Geithner taxpayer giveaway backdoor bank bailout toxic asset plan announcement followed the day after Obama on 60 minutes. And the cherry on top was the massaging of mark-to-market just in time for reported bank earnings. Perfect. Get the picture? And to top it all off, an equity run of near historic proportion with very little backtracking from start to finish, which is very much the rarity in human experience, was the icing on the proverbial cake and clearly the intended target of such Administration “attention.” Look like “the invisible hand of the market” to you? It sure does. Couple the invisible hand with a massive short position, record sideline cash, the need of professionals to perform, and WOW! Big message being, the Administration has finally woken up to the perceptual power of the financial markets, especially equities, and has addressed them as such. I do not expect this to stop any time soon. And the results have been great so far as evidenced by the immediacy of rising optimism, the perception of some better than expected economic stats plus the mandatory “better than expected earnings” announcements from a number of Wall Street’s most fundamentally challenged sectors. The trick being whether this will last.
Back to the issue at hand. Personally I suggest we all remain focused on the facts and bigger picture ideas and trends of the moment. I can assure you that a month+ equity rally is not about to fundamentally change the character of a US macro credit cycle and economy that has been leading up to this period of reconciliation for a good three decades now. As always, to maneuver the financial markets successfully, one must first have an affinity and talent for behavioral psychology, and then have a decent familiarity with numbers. And most of the time the numbers really aren’t the key driver of financial asset prices over shorter periods of time.
Okay, time to finally getting to the point of this discussion after dragging you through my philosophical meanderings for a few minutes. An important issue as I look at the 4Q 2008 Flow of Funds statement is the character of household debt service. Or more correctly, the lack of change in debt service itself given the change in household nominal dollar debt outstanding and the change in consumer borrowing rates in the prior period. Right to the point, in 4Q the quarter over quarter change in household debt outstanding saw a drop in levels of nominal dollar household leverage never seen before in US history. Personally I remain of the opinion that households are just at the beginning of what should be a prolonged deleveraging process. A process the Fed/Treasury/Administration would love to nip in the bud.
Next view of life to set the stage for the point I’m trying to make is what was the very meaningful drop in the cost of conventional mortgage financing in 4Q. You will remember that the Fed initiated their first $600 billion program (followed up with another $750 billion as per the last FOMC meeting a few weeks back) of buying back mortgage backed securities with the expressed purpose of driving down the costs of conventional mortgage financing. As I’ve heard it said somewhere, mission accomplished. At least so far.
So the punch line lies directly below. In a quarter where household debt declined in nominal dollars by the greatest amount ever witnessed in US history AND in a quarter where conventional mortgage rates dropped meaningfully, the household debt service ratio was basically flat. And in the bottom clip of the chart below, the household mortgage debt service ratio actually increased. The world is not coming to an end by any means, but I believe before the current cycle is over, it’s literally a necessity that household debt service ratios measured in any number of different fashions must decline. Not should decline, but must decline. Remember, it’s the stated intention of the Fed/Treasury/Administration to “get credit flowing again.” This while household debt service ratios remain to this day much nearer all time highs than not.
One last and perhaps redundant view of life is the household financial obligations ratio. The financial obligations ratio is a broader measure than the debt service ratio in that it includes automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments. More than just debt service per se, the financial obligations ratio is telling us households are having a bit of a tough time getting their basic non-food and energy infrastructure costs down.
Again, the sun will not rise and set as per this characterization of household financial circumstances, but I suggest that although simplistic, it’s a key data point to monitor ahead. I can’t see any other way for the current cycle to reconcile itself without household debt service ratios AT LEAST falling to the longer-term averages drawn into the charts above. History tells us that these ratios have indeed declined in every recession of the last three decades at least, with the exception of 2001 (where credit cycle acceleration for households never even blinked). Although the Fed/Treasury/Administration would love to forestall this reconciliation as per their current actions, I believe reconciliation is inevitable in the current cycle. The only issue open to question is degree or magnitude of reconciliation, which simply must play out. As per the numbers and relationships above, there is no way the US can start yet another leg of the already maniacal credit cycle. It's not about not being able to take on additional nominal dollar debt, it's about not being able to comfortably service the debt we already have on the books right now. Very simply, I believe this is a key bigger picture point.
What does this have to do with the financial market issues we face in the here and now? First, if indeed I’m anywhere even near correct on this key issue of household debt service reconciliation to come, forward consumption becomes a much larger question mark for the US economy and corporate earnings specifically. Although I personally believe we are experiencing a bear market rally in equities, ultimately the financial markets will need to face the post equity market bottom question of just what type of an economy we face ahead. What type of growth can we expect and when? Will asset values (residential real estate, equities, commercial property, etc) really recover, and to what extent and over what time period will that occur? I strongly suggest watching the totality of household balance sheet and P&L reconciliation will help us answer these questions and frame the context of equity price movements at any point in time. Additionally, and very importantly, I believe this will also help shape equity sector outcomes over the intermediate term as household debt service ratios will not be reconciled next month or next quarter, but most likely over a series of years. Such are the issues of the US service economy, the debt service economy, that is.
© 2009 Brian Pretti