Going With the Flow
by Brian Pretti CFA, Contrary Investor. July 10, 2009
The Fed Flow of Funds report for 1Q 2009 hit the Street a while back. And there has already been plenty of coverage concerning consumer net worth (which is simply out of date at this point), the character of systemic leverage, etc. Let’s skip the generic views of life and highlight key data points which importantly relate directly to bigger picture equity and fixed income market themes and potential outcomes of the moment, as well as important benchmarks against which we hope to assess the forward progress, or otherwise, of the US economy itself. Probably too many graphic views of life to come, so I’ll try to keep the commentary very short and directly on point.
First major macro theme that will influence economic outcomes ahead is the continued contraction of the asset backed securities markets. Not surprisingly, 1Q 2009 experienced the deepest nominal dollar contraction in the asset-backed markets both on record and so far in the current cycle. You already know that it was largely the shadow banking system that both defined the character of and drove the prior economic expansion in the US post the 2001 recession. It was not a typical business cycle upon which the US (and really the global economy) was running, but rather a credit cycle. The asset backed securities markets were the key underpinning to the character of the prior economic cycle. Over the last six quarters, contraction in the ABS markets has been close to $600 billion. It's no wonder residential mortgage markets have been gasping for breath and the Fed has so obligingly agreed to spend a generational magnitude of taxpayer dollars compensating for the implosion you see below.
In an environment in which the asset backed securities markets continue to contract, commercial bank lending is the key watch point in terms of the ability of broader credit markets to facilitate forward economic expansion. The coincidental historical directional nature of the rate of change in bank lending and the rate of change in GDP growth is unmistakable. All eyes on the banks ahead and the rate of change in lending as the ABS markets are clearly down for the count and will not be a factor facilitating broader US credit expansion. The deleveraging in the non-bank financial sector continues. A key theme that has been enduring for over a year now that shows no sign of trend change.
Although not in outright deleveraging mode in academic or specific terms, non-financial corporate leverage growth has slowed meaningfully over the last year plus, falling from approximately 14% year over year to near 4%. It’s pretty simple, during economic downturns non-financial sector borrowing and spending slows. Capital spending ex-government defense spending has been very weak as of late. It’s a good bet this continues into the second half of the year at best, and perhaps longer dependent on whether the inventory rebuild cycle to come engenders broader economic firming. The important point here is that this ongoing rate of change decline in corporate borrowing tells us to watch the industrial and cap spending sectors closely. Yes, they bolted out of the gate as representing high beta equity sectors post the March lows, but an extended lack of corporate capital spending ahead will leave them vulnerable. Watch management comments about forward outlook in upcoming earnings releases for these sectors.
And although this is much more macro and long term in nature, staying aware of and in tune with the year over year rate of change in non-financial sector corporate debt levels is very important in terms of validating broader equity market direction. The following chart makes the point quite elegantly. Yes, equity markets lead rate of change improvement in economic cycles and by inference non-financial corporate debt acceleration. But for an equity market to be correct in attempting to discount a turn up in economic fortunes, the chart below tells us corporate borrowing (and spending) must turn up not too far after the turn in equities to validate the direction change in financial asset prices. It only seems common sense as corporations engage in borrowing (and spending) when they see forward return (economic) opportunities greater than their cost of capital. As of 1Q 2009, no turn up yet in corporate leverage.
It should be no surprise to anyone that household leverage contracted again in 1Q. We now have the two largest quarters of back-to-back contraction in nominal dollar household leverage on record. In fact, at least over the near six decades shown in the chart below, this has never happened two quarters in a row. THE most important watch point in the current cycle is the character of the household balance sheet recession. The household deleveraging cycle is still in its early stages. Unfortunately labor market and wage pressure of the moment make it very tough for households to "hurry" the needed deleveraging process. The longer the labor markets remain weak, the more drawn out will be the household deleveraging process, and by default the longer it will take for the rate of change in consumption to recover adequately to spur self-sustaining macro economic growth. Throwing in an increased household savings rate does nothing to brighten the consumption picture.
As marked in the bottom clip of the above chart, never in the history of the data have we seen the year over year change in household debt fall into negative territory. 1Q was a record breaker on that front. This is completely unique to post war US economic experience.
I’ve asked the question a number of times in the recent past as to whether the US has encountered a point of secular change in US consumption patterns. The bottom clip of the above chart simply reinforces this curiosity. Consumption that quite necessarily has been intertwined with and dependent on household leverage. The retail sales increase for May at the headline level was completely driven by rising gasoline sales due almost entirely to price. Core non-auto and gas retail sales did not look good. The discretionary components of the retail report were collectively weak at best. We need to keep a very sharp eye on the following relationships as we move into 2H 2009. Historically consumer confidence has led rate of change improvement in core retail sales by literally a month or two. We have the upturn in confidence. The rate of change upturn in retail must come now, or we are looking at perhaps what would be one of the most important divergences I can think of in terms of implication for forward US macro economic expansion. You already know personal consumption expenditures account for 70% of recent GDP.
Likewise another corroborative relationship of importance is between that of the year over year change in non-auto and gas retail sales and monthly nominal body count payroll employment trends. The two have moved in directional harmony over time. For now, headline payrolls have been getting less bad, but we have not yet seen the character of less bad in core retail sales trends. Again, this needs to improve now or the divergence relative to historical experience will be all too apparent. (We know that June payroll experience was another drop to near 450,000 of losses – not a great leading indicator for retail outcomes ahead.)
Just a quick very long-term picture of life update below. We’ve never seen anything like current experience over the past six decades. A secular demarcation line? We'll see.
You’ll remember that above I mentioned the importance of the inventory rebuild issue. Sorry to drag you through the household debt and retail sales trends above, but this is what I have been leading up to. First, it’s the underpinning to the “green shoots” concept and the bedrock upon which the “second half recovery” hopes have been pinned upon by a good number of Street cheerleaders for a number of months now. But more importantly, it’s a fundamental driving force for emerging market equity performance. Let’s face it, who would benefit most from a macro domestic and really global inventory rebuild cycle? The emerging market manufacturing community. Emerging market equities were blown from the sky last year anticipating and discounting an inventory cleansing cycle of meaning. This year they have risen from the ashes trying to strongly discount a global inventory rebuild cycle of substance. Although this is a pretty darn simple statement, emerging equities and commodity sectors in general are dependent fundamentally on the whole issue of an inventory rebuild. So, as we all look into the second half and try to assess potential change in equity sector leadership, or reinforcement of what is existing leadership, following the character of inventories and sales becomes critical.
As you can see in the bottom clip of the chart below, yes, inventories have been and continue to be drawn down meaningfully by the month over the last seven months. The ultimate reversal of this is the case for the inventory rebuild so widely anticipated by investors as of late. But the top clip suggests the potential for a different outcome that relates directly back to household deleveraging. Yes, inventories are falling, but sales are falling right alongside inventories, leaving the inventory to sales ratio to this day quite near the highs of the current decade and not far off the recent spike peak.
Moving into the second half of the year it all comes down to the US consumer and the forward character of household balance sheets. The Flow of Funds report is showing us household balance sheets continue to contract. The monthly consumer credit numbers are showing us the same thing on a more high frequency basis. Alongside this household balance sheet contraction we see retail sales remaining very weak for now, in spite of the fact that consumer confidence has turned up sharply and monthly payroll losses have gotten “less bad.” The reconciliation of household balance sheets is weighing upon retail sales. And it’s this continued weakness in sales that is keeping the inventory to sales ratio aloft, despite the ongoing contraction in nominal inventories. IF sales remain weak and households continue to contract their balance sheets ahead, the process of drawing down inventories to the point where a meaningful inventory rebuild cycle will take hold will be drawn out relative to current consensus expectations. This is the important linkage between the Flow of Funds data and the reality of the current economy itself. Moreover, these relationships have direct meaning for equity prices and sector character near term.
And as I’ve mentioned, in terms of equity sector price performance the emerging markets, commodity representation broadly, and high beta sectors such as materials, industrials and consumer discretionary are very much dependent on this inventory rebuild theme. But the linkages shown and discussed above leave me with meaningful question marks concerning the magnitude and character of any near term inventory rebuild cycle. If this inventory rebuild theme is derailed anywhere in the second half, these sectors are at risk. Under the assumption of a theoretically efficient market, we need to continue monitoring these sectors for relative performance strength. If they break down collectively, the markets will be discounting a weaker than hoped for inventory cycle. If this occurs, defensive sectors will once again be repositories for equity money that must remain invested. I’m just hoping to look at the right markers ahead. In summation it all comes down to the rhythm of household balance sheet delaveraging.
Final stop in this short review is Federal debt. We already know leveraging up is the issue of the moment for the US government set against the deleveraging that continues in the private sector. That's not new news. Over the past three quarters we are looking at an additional $1.5 trillion in new US government debt. The government is virtually single handedly responsible for the total credit market debt-to-GDP ratio vaulting to 375% in 1Q from 370% in 4Q of last year. No precedent for this number in US history. The important note of the moment is that on a year over year rate of change basis for US Government debt, we’ve never seen a higher number in US post war history. Without question, one of the issues centrally important to our investment decision-making ahead will be the unintended consequences of this action.
But as I look forward in terms of big picture themes I need to keep top of mind, I feel the following picture tells a very big story. This is a little compare and contrast between the rate of change rhythm in bank lending and government borrowing. Very simply, it’s the interplay between public and private debt growth. Have a look.
A few observations I hope are germane to our current circumstances and the current economic and financial market cycle. First, historically the year over year rate of change in bank lending and Federal borrowing has been negatively correlated. It has been an inverse relationship. Not too hard to understand as the government has stepped up stimulus efforts (borrowed stimulus efforts) when the private sector pulls back during economic periods of slowing. The top clip of the chart above is clear in that bank lending (private sector borrowing) has slowed on a rate of change basis during or very near all US recessions of the last four decades at least. Simultaneously, as the bottom clip of the chart reveals, the annual rate of change in government spending (federal Government borrowing) has expanded during recessions. I get it. We’re just now in the current cycle looking at one of the greatest rate of change increases in government spending/borrowing on record. Again, no wild revelation here by any means.
You can see the colored red bars in the chart above. As I look at the chart what I believe we are looking at was a period of secular decline in the rate of change in government borrowing that is now in the midst of dramatic upward change. Of course that period colored in red coincides almost perfectly with what was one of the greatest and most long lived equity bull markets and economic expansions in US history. What did that decline in Federal borrowing really represent and why did it coincide with the equity bull? It represented a period where the Government stopped “crowding out” the private sector in the US. The less the government competed for funds with the private sector (on a rate of change basis), the better the macro US economic outcomes that were achieved and the better the stock market reward for an increasingly private sector centric economy. As I said, big picture stuff.
Of course all of this has been changing and now that trend change is accelerating as government borrowing skyrockets. To the point, this relationship suggests a few very important issues. First, the more the government crowds out the private sector, we have to seriously ask ourselves just what type of appropriate valuation multiple do equities deserve? The 1980-2000 period was all about multiple valuation expansion in terms of equity performance. More government involvement in the economy suggests to us macro multiple valuation contraction tendencies. Exactly the opposite of economic and financial market circumstances and character experienced during the 1980’s and 1990’s.
Secondly, as we look forward, I believe it will be very hard to make the case that government borrowing will wind down any time soon. Above and beyond the stimulus initiatives of the moment, the US is facing wildly rising social transfer payment obligations (SSI and Medicare). So here’s the important point. IF the US economy can recover and private sector borrowing (bank lending) turns north while US government borrowing needs remain high, then we will really see the private and public sectors compete for funds. We're not there yet. Absent the influence of global capital flows, this is a scenario where we would expect domestic interest rates to really be pressured upward. Yes, government borrowing of a magnitude we now see is not warming my heart and it sure seems to be awakening the long asleep bond market vigilantes. But I promise you that if private sector borrowing picks up any time soon and government borrowing does not subside virtually immediately, you ain’t seen nothin’ yet from the proverbial vigilantes. A certain outcome? Far from it. Using the relationships from the Flow of Funds report, I’m simply hoping to anticipate and then benchmark potential forward outcomes, of which higher interest rates due to increased and real “crowding out” by the government is one. If the year over year rate of change in Federal borrowing AND bank lending (private sector borrowing) rise together, the fixed income markets will be in real hot water. For now, they are just luke warm.
So there you have it. Hopefully not the run of the mill look at a few highlights of the Flow of Funds report. In summation, bank lending is the key to credit cycle benevolence ahead in support of economic recovery as the asset-backed markets continue to contract at a record pace. An acceleration in corporate borrowing has historically been associated with both US economic growth and periods of very favorable US domestic stock price performance. We’re not seeing that upward acceleration in corporate leverage as of yet. As household balance sheets continue to contract we need to carefully watch the interplay between inventories and weak sales driven by this household reconciliation. IF the inventory rebuild cycle is quite weak ahead, then equities and sectors that have more than anticipated a strong outcome will be at risk. That's the proverbial reflation trade. Finally, although government borrowing has accelerated at an unprecedented rate, I’m not yet ready to suggest domestic interest rates are ready for a moon shot. But if bank lending/corporate borrowing recovers strongly AND the government borrowing continues apace, the fixed income markets will have a reckoning. This is what I see when I look at the initial FOF data. The implications of this data are far beyond simple leverage and household net worth measures.
© 2009 Brian Pretti