Macro and Credit - Showdown

"In every battle there comes a time when both sides consider themselves beaten, then he who continues the attack wins." -  Ulysses S. Grant

Watching with interest the lingering Brexit saga playing on in conjunction with the much commented trade war between China and the United States, when it came to selecting our title analogy, we decided to go for yet another poker card game reference (previous ones being "Poker tilt", "Le Chiffre", "Optimal bluffing", the "Donk bet", to name a few in no particular order). In the game of poker, the "Showdown" is a situation when, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner or winners. To win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not. Cards speak for themselves: the actual value of a player's hand prevails in the event a player mis-states the value of his hand. Because exposing a losing hand gives information to an opponent, players may be reluctant to expose their hands until after their opponents have done so and will muck their losing hands without exposing them. Robert's Rules of Poker state that the last player to take aggressive action by a bet or raise is the first to show the hand - unless everyone checks (or is all-in) on the last round of betting, then the first player to the left of the dealer button is the first to show the hand. 

If there is a side pot, players involved in the side pot should show their hands before anyone who is all-in for only the main pot. To speed up the game, a player holding a probable winner is encouraged to show the hand without delay (Brexit comes to our mind). Any player who has been dealt in may request to see any hand that is eligible to participate in the showdown, even if the hand has been mucked. This option is generally only used when a player suspects collusion or some other sort of cheating by other players. When the privilege is abused by a player (i.e. the player does not suspect cheating, but asks to see the cards just to get insight on another player's style or betting patterns), he may be warned by the dealer, or even removed from the table. There has been a recent trend in public cardroom rules to limit the ability of players to request to see mucked losing hands at the showdown. One would probably think a similar rule should be applied to Brexit negotiations but we ramble again...

In this week's conversation, we would like to look at US consumption and consumers, following the significant rally in the high beta segment of asset classes as we believe monitoring the state of the US Consumer in the coming months will be paramount. 

Synopsis:

• Macro and Credit - Secular stagnation or secular strangulation? 
• Final charts - Yes, Europe is turning Japanese

• Macro and Credit - Secular stagnation or secular strangulation? 

With U.S. consumer prices increasing by the most in 14 months in March to 1.9% thanks to Energy prices climbing by 3.5% and accounting for about 60% of the increase, in conjunction with The University of Michigan’s preliminary consumer sentiment survey falling to 96.9 in April, from 98.4 the previous month, one might wonder what is the state of the US consumer.

On a side note, given the recent rise of the MMT crowd we read with interest Dr Lacy Hunt's take in his latest 1st Quarter review. We highly recommend you read it, for those of you in the "Deflationista" camp. The Keynesian camp might be somewhat part of the "Inflationista" camp given their preference for 2% inflation and beliefs in the much antiquated "Phillips curve" (we have said enough on this subject on this very blog). It seems to us the MMT crowd, as rightly pointed out by Dr Lacy Hunt, could make us all fall into the "hyperinflationista" camp with their monetary prowess and "promises".

As well we have seen many recent conversations surrounding the fact that in many instances in Developed Markets (DM) the "middle-class" has been hollowed out. This has been discussed at length by the OECD in their recent paper entitled "Under Pressure: The Squeezed Middle Class".

Back in December 2014, in our conversation "The QE MacGuffin" we pointed out the following Societe General's take from their FX outlook on central banks meddling:

"It’s broken, and they don’t know how to fix it. It is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.

Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)."  -source Societe Generale

High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." source Macronomics, December 2014

The central banking "Showdown" is still going on we think. The "Global Savings Glut" (GSG), has been put forward by many defenders of Keynesian policies. 

We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "The disappearance of MS München" on this subject:

"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?":
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016

Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. But, returning to the wise note of Dr Lacy Hunt, he puts another nail in the coffin of this "Savings Glut" theory put forward by Dr Ben Bernanke:

"Secular stagnation is basically the rebirth of the over-saving theory. However, after WWII the U.S. balanced the budget, contrary to Keynes’s recommendation, and the economy boomed, permitting the U.S. to rebuild and open U.S. markets to the world’s exporters. What Keynes missed is that the national saving rate averaged over 10% during WWII, and the U.S. had a strong balance sheet. The private sector drew down their saving, and this propelled the economy higher. In 2018, the national saving rate was 3%, less than half the long-term average since 1929 and one-fifth the level of 1945. There is no excess saving to be drawn down (Chart 5)."

- source Hoisington, Dr Lacy Hunt

Given the worrying trend for the middle-class in DM countries, you probably understand by now our chosen title of "Secular strangulation". For instance the "yellow jackets" (gilets jaunes) movement in France is an illustration of the fear of downgrade for many middle-class families which have been eviscerated by continuous fiscal pressure over the years. End of our parenthesis on the GSG.

Returning to the paramount subject of the state of the US consumer, with the volte-face made by the Fed, mortgages rates have fallen in sympathy giving some much needed respite to the US housing market. Existing-home sales climbed nearly 12% in February from the month before, reaching an annual rate of 5.5 million, according to the National Association of Realtors, which attributed the growth partly to interest rates. Of course lower interest rates for home mortgages buoy the housing market. In 19 weeks since November, the rate on a 30-year mortgage dropped from 4.94% to 4.06%, the most rapid decline since 2008. But, given "Shelter" comprises 40% of the Consumer Price Index, we might see some erratic readings in the coming months. 

As illustrated recently by Bloomberg, an excess of 7 million Americans were at least three months behind on their car payments at the end of 2018:

- graph source Bloomberg

Given the rapid deterioration in financial conjunctions in conjunction with housing headwinds thanks to rising mortgages rates in the final quarter in 2018, we think that this conjunction of factors on top of falling equity prices managed to spook enough the Fed to generate the aforementioned volte-face.

Obviously this welcome respite has managed to trigger an incredible rally for high beta thanks to global dovishness from central banks overall. Yet, we do think that the current housing bounce we are seeing is only temporary and providing some short term relief to the US consumer increasingly using revolving credit aka it's credit card to maintain his consumption. On top of that, rising oil prices might be good news for US High Yield but, should gas prices continue to surge, it might start again to become a slight headwind for US consumers. This would point to overall weaker growth for the remainder of 2019 in the United States we think.

When it comes to the US Housing situation we read with interest Bank of America Merrill Lynch's take from their Housing Watch note from the 12th of April entitled "A brief housing pop":

"Get ready for some good data…for now

All signs are pointing toward a short term boost to housing activity following a difficult end to last year. At the end of last year, mortgage rates were the highest since early 2011, the stock market was selling off and confidence in the economy was declining. Prospective homebuyers sat on the sidelines, uncertain about their future finances and concerned about affordability.

It has all changed since then. Mortgage rates have tumbled, returning to levels last seen in January 2018, the stock market has recovered and confidence has returned. If buyers were hesitant last year, this environment has lured them back into the housing market. Indeed, mortgage purchase applications have climbed, pending home sales have improved and existing home sales in February were very strong. Survey measures, including our own proprietary survey, show more favorable perceptions around housing with people noting that buying conditions have improved (Chart 2, Chart 3).

Similarly, homebuilders feel more confident with the NAHB housing index improving and realtor confidence surveys ticking higher. In our last housing watch in January, we argued that we would see a “brief period of stronger housing data.” We are doubling down on that view and now revising up forecasts for home sales in 2Q (Table 1).

Why are we looking for just a short-term boost to home sales rather than a more persistent recovery? Importantly, affordability challenges still remain. While the drop in mortgage rates provides a jolt to housing, housing is still overvalued given the strong rise in prices over the past several years (Chart 4). In addition, we see evidence that existing home sales have reached an equilibrium level based on the historical relationship between sales and the labor force. Of the people in the work-force, we are
at a historically “normal” rate of existing home sales (Chart 5).

There are greater opportunities for new home sales than for existing given that the recovery for new construction has been lackluster. Builders have been shifting away from the high-end of the market where inventory is higher toward the more affordable part where there is still incremental demand. This can be seen through the average size of a new single family home slipping lower and a drop in new homes sold over $300,000
(Chart 7, Chart 8).

Of course, housing dynamics are going to differ by region. A good way of understanding the relative strength or weakness in housing conditions is to track migration.

We find that people continue to leave Northeast, the Midwest and the California to move to Texas, Colorado as well as other areas in the West and South." - source Bank of America Merrill Lynch

Given affordability is stretched, we agree with Bank of America Merrill Lynch, namely that the recent fall in mortgage rates is only providing some short term respite. When it comes to Main Street  it has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising in recent quarters. Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Housing activity is leading overall economic activity, housing being a sensitive cyclical sector.

The big question was that rising interest rates were starting to choke the US consumer hence the dovish tilt from the Fed following the horrific final quarter of 2018. 

On the state of the US consumer we read with interest Wells Fargo's take from their note from the 2nd of April entitled "U.S. Recession? How Do We Count the Ways?":

"Are Consumer Finances in Good Shape?

Household leverage generally, and mortgage debt specifically, was at the epicenter of the last downturn. Although the severe repercussions of consumers getting over-extended a decade ago may still be fresh in the minds of borrowers, lenders and regulators, overall household leverage has fallen substantially over the past decade (Figure 1). As Mark Twain said, however, history does not repeat, but it often rhymes. Are there other areas in consumer balance sheets that pose a risk to the economy from an extensive build up in debt and deterioration in lending standards?

While mortgage debt has fallen over the past decade, Figure 1 also shows that leverage of other types of consumer debt, including autos, credit cards, and student loans, is at an all-time high.

 - Source: Federal Reserve Board and Wells Fargo Securities

Yet unlike housing debt in the 2000s, the increase has not been exponential. Leverage for consumer credit is also only a quarter of the size of housing-related leverage at the height of the housing bust. What’s more, debt service remains exceptionally low. Historically low interest rates and longer repayment terms have kept households’ monthly financial obligations ratios near levels last seen in the early 1980s (Figure 2).

- Source: Federal Reserve Board and Wells Fargo Securities

Notably, the most significant driver of the increase in consumer credit has been student loans. Given that educational debt is nearly impossible to discharge and primarily backed by the federal government, we view student loans as a sustained, long-term headwind to other types of spending rather than a mass credit event that could cause the financial system to seize up like the subprime mortgage crisis. In short, we do not think that consumer debt problems will trigger a recession in the foreseeable future.

Corporate Sector Debt: Keep an Eye on This Space

Where leverage may be more concerning is in the non-financial corporate (NFC) sector. As measured as a percent of GDP, debt in the NFC sector is at a record high. With corporate profit growth slowing, the ability to service debt likely will deteriorate somewhat over the next few quarters. At the same time, a shift in investor sentiment could weigh on asset values, which up until recently had been keeping pace with debt.

The financial health of the business sector has deteriorated since 2015, and significant further deterioration would be worrisome (Figure 3).

  - Source: Federal Reserve Board and Wells Fargo Securities

Firms that are stretched financially may be more reluctant to invest and hire. In addition, if companies start having trouble servicing their debt due to slower growth and/or higher interest costs, rising charge-offs and loan losses could disrupt credit growth. However, the current health of the non-financial corporate sector does not seem particularly dire at present when compared to the late 1980s or ahead of what we consider to have been the business-led recession of 2001.3 Interest rates have been rising from a historically low level and are unlikely to rise much further this cycle, while companies have locked in historically low interest rates by holding more long-term debt.

One segment of business sector debt that bears particularly close watch is the leveraged loan market.

  - Source: Federal Reserve Board and Wells Fargo Securities

Leveraged loans are made to companies with high debt-to-cash flow ratios that are typically rated less than investment grade. Loans outstanding in this sector have grown 35% since 2016, twice as fast as total NFC debt. Slower economic growth this year could make servicing that debt more difficult and lead to weaker demand from investors, which would weigh on credit growth to the business sector and therefore the broader economy. Yet leveraged loans are floating-rate instruments, and, with the Fed currently on hold, interest costs are not expected to shoot markedly higher. As a result, we do not see the leveraged loan market as an immediate threat to the economy.

Is There Overbuilding in Construction?

The bursting of the U.S. housing market bubble precipitated the Great Recession but it does not seem that lightning will strike twice, at least not in the current cycle. As noted above, households have de-levered over the past ten years. The value of mortgage debt outstanding among households is down 4% relative to its peak in early 2008. But disposable personal income is up 50% over the past ten years, giving households better ability to service that mortgage debt than they had at the height of the housing bubble. Furthermore, single-family housing starts are roughly 50% lower than they were at the height of the housing boom (Figure 5).

  - Source: Federal Reserve Board and Wells Fargo Securities

Although the level of multifamily starts is a bit higher today than it was a decade ago, apartment vacancy rates are low and rent growth remains solid.

Despite indications of robust activity in commercial construction, we do not think that commercial real estate (CRE) is an accident waiting to happen, at least not in the foreseeable future. As we wrote last autumn, the underlying fundamentals in the CRE market appear to be strong. Despite appearances of robust construction activity, the level of real non-residential construction spending is only 16% higher today than it was before the economy tumbled into recession in late 2007. At the end of the expansion in the 1980s, real non-residential construction spending was more than 60% higher than its previous peak. Commercial banks hold nearly $1.7 trillion worth of commercial mortgages, an all-time high. However, this amount represents less than 11% of their total financial assets, which is not out of line in a historical context (Figure 6).

  - Source: Federal Reserve Board and Wells Fargo Securities

Whereas it might be a little premature to call for a decisive turn of the credit cycle, to repeat ourselves, the next Fed Quarterly publication of the Senior Loan Officer Survey will be extremely important to monitor.

For now the US consumer is still holding on apparently. This is indicated by Bank of America Merrill Lynch in their BofA on USA report from the 11th of April entitled "The consumer spring into Spring":

"Strong consumer spending in March

The long-awaited rebound in consumer spending has arrived. According to BAC aggregated credit and debit card data, retail sales ex-autos jumped 1.5% month-over-month (mom) seasonally adjusted in March, partly reversing the decline over the prior three months. This recovery supports our view that the recent drop was largely due to temporary distortions rather than a fundamental weakening in consumer spending.

We see evidence that the timing of tax refunds pushed spending from February into March, specifically for lower income households. Those households receiving the Earned Income Tax Credit saw a significant delay in tax refunds, resulting in lower spending in February. Once tax refunds were received at the end of February, these households were able to spend, boosting activity in March. We see this notable swing in the data in the Chart of the Month.

It was the most apparent in the “discretionary” spending categories such as clothing, furniture and lodging. Interestingly, we did not see a big gyration in spending in restaurants which is typically sensitive to income changes. To be expected, spending at grocery stores was fairly steady over the prior two months (Chart 2).

We examine our tax refund data to see if the tax legislation, which capped state and local tax (SALT) deductions, altered refunds across the different states and income tiers. We focused on the top 10 states in terms of the SALT deduction and found that tax refunds were indeed down sharply for upper income households in these states – down 10% year-over-year (yoy) vs. an average of 1.7% increase over the three years prior (Chart 4).

In contrast, upper income households in the states with the most favorable tax laws saw little change in tax refunds relative to prior years. How does the decline in tax refunds among the upper income population in high SALT states impact spending? It isn’t obvious that it will have much of an impact since the upper income population tends to have more disposable income and are therefore less dependent on tax refunds to finance expenditures. Nonetheless, it could possibly weigh on confidence and curb purchases of bigger ticket items.

Bottom line: the consumer finally showed up in March, offsetting part of the decline at the turn of the year. We think we should see further improvement in spend going forward as consumers respond to higher wage growth amid solid job creation.

- source Bank of America Merrill Lynch 

While it's difficult to validate yet a bounce as per Bank of America Merrill Lynch's internal data, while University of Michigan Consumer Confidence remains high, it remains to be seen if there is indeed a change in the narrative:

- source IBT - University of Michigan

Something as well worth of interest when it comes to US Consumers given they make 70% of US GDP, has been the rise of Millenials and change of consumer habits as pointed out by another interesting report from Bank of America Merrill Lynch BofA on USA from the 17th of April entitled "Consumer, my how you have changed":

"Two numbers: age and income

The Millennials - who are currently aged 23 to 38 – make up 28% of retail sales ex-autos based on BAC internal card data, slightly outpacing the 26% from Baby Boomers. The wallet of Millennials is growing, with the average number of monthly transactions up 16% from 2012 vs. the 5% increase of Boomers. Millennials also live differently, with 51% of food consumption done at restaurants vs. Boomers at 34%.

There are also differences by income, as we find that 30% of spending is made by the >$125k income cohort while the <$20k group only constitute 10% of total retail ex-auto spending." - source Bank of America Merrill Lynch

Overall, while it is too early to turn negative on US consumers, in the coming months ahead it will be essential to monitor closely the situation we think.

We have long posited that Europe was becoming more and more "Japanese" hence our frequent use of the word "Japanification". Our final charts below goes more into the similarities.

• Final charts - Yes, Europe is turning Japanese

Looking at the trajectory of policy rates and government bond yields in Japan, it looks to us more and more that Europe is becoming more Japanese and we are not even mentioning the slow pace of resolving the issue of nonperforming loans plaguing the European Banking system. Our final charts come from Deutsche Bank Thematic Research report from the 9th of April entitled "How Europe is looking like the next Japan":

"In February this year, the Bank of Japan celebrated an ominous anniversary: 20 years since it first cut interest rates to zero. Despite a few abortive attempts to raise policy rates, they have never again exceeded 1% and remain stubbornly stuck around zero. Likewise, Europe has seen a few false dawns but again looks set for a long period of short-term rates being stuck at or below zero. More recently, long-term bond yields have fallen as well, with ten-year bund yields dipping into negative territory again over the last month. As such there are ever-growing similarities between the Europe of today and the Japan of the past two to three decades.

The consensus forecast is for the ECB to hike its policy rate from zero by the end of next year but this forecast has been repeatedly pushed back and markets are increasingly sceptical. Much like in Japan, there are now increasing concerns that ‘lift-off’ will never actually happen and Europe will be stuck in a world of ultra low growth and negative yields for years to come. Is this realistic? Well, as we know, it happened in Japan and it is therefore worthwhile examining in more detail the similarities and differences between the two economies with a suitable lag." - source Deutsche Bank

Given in a "Showdown", to win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not and that Cards speak for themselves, it is clear to us that any form of normalization by the ECB will be repeatedly pushed back à la Japan.

"In battle it is the cowards who run the most risk; bravery is a rampart of defense." - Sallust

Stay tuned !

Macro and Credit - Intermezzo

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens

Looking at the pyrrhic victory for the European technocrats in Brussels thanks the consolidation of Germany's Merkel coalition and the results of the Italian elections (which amounts to "Hunga Hunga"), and given the "regime change" put forward by many pundits thanks to the return of volatility after years of central banking repression, when it came to selecting our title analogy we reminded ourselves of the musical term "Intermezzo". In music, an intermezzo is a composition which fits between other musical or dramatic entities, such as acts of a play or movements of a larger musical work. In music history, the term has had several different usages, which fit into two general categories: the opera intermezzo and the instrumental intermezzo. In the 19th century, the intermezzo acquired another meaning: an instrumental piece which was either a movement between two others in a larger work, or a character piece which could stand on its own. As CITI's Chuck Prince said nicely in July 2007:

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing" - Chuck Prince

To some extent, early market jitters such as the ones caused by the explosion of the pig's "short-vol" house of straw amounted to an "intermezzo" we think. A larger musical work is at play and it is the evolution of the credit cycle. It is slowly and gradually turning, with macro hard data erring on the soft side recently (US durable goods orders falling 3.7% in Jan, vs 2.0% drop expected) while consumer confidence, being soft data, printing on the strong side. When it comes to liquidity, it is being withdrawn by the Fed through its "Quantitative Tightening" (QT). While we have already seen some casualties such as the short-vol ETN complex amounting to the equity tranche in the capital structure, it remains to be seen where and when will the next larger fishes will show belly up at some point down the tightening road, but, we think the time has not yet arrived.

In this week's conversation, we would like to look at the situation of the US Consumer, given in various recent musings we were asking ourselves if he had been "maxed out" and rely heavily these days on credit card use to sustain his consumption habits. As pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see particularly in a country boasting a very high Gini coefficient such as the United States. 

Synopsis:

• Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see
• Finals chart - Let the good times roll?

• Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see

Back in March 2017 in our conversation "The Endless Summer" we concluded our long conversation asking ourselves if the US consumer was somewhat "maxed out". We indicated as well that this on-going "Endless Summer" had created a significant windfall for the holders of financial asset. The "wealth effect" has globally lifted all "financial" boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. In January 2018, in our conversation "The Lindemann criterion", we indicated that measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit:

"US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think." - source Macronomics, January 2018

Another sign that caught our attention as of late has been the article in the WSJ pointing towards mounting credit card losses in their article from the 4th of March entitled "Credit-Card Losses Surge at Small Banks":

"Small banks have been fighting for a bigger piece of the credit-card market in search of higher returns. Now, they’re contending with rising losses.

Missed payments on credit cards at small banks have risen sharply over the past year, a sign that their cardholders are taking on more debt than they can handle. Their charge-off rate, or the share of outstanding card balances written off as a loss after consumers failed to pay, hit 7.2% in the fourth quarter, up from 4.5% a year ago, according to Federal Reserve data.

Concerns have been mounting in the broader credit-card industry about the recent trend of rising delinquencies. While overall card losses are still relatively low—below the historical average of the last 30 years, for instance—they’ve been slowly climbing in the last two years.

But they’ve especially surged at smaller banks, those outside the 100 largest by assets that have less than around $10.4 billion in assets. There, the average charge-off rate is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010." - source WSJ

The US savings rate has been falling while consumer credit has been on the rise with a significant usage of the credit card in recent months it seems. This is something to be mindful about, particularly when as we will see in our conversation that when it comes to consumer leverage in the US all is not what it seems. Monitoring Fed Senior Loan Officer and Opinion Survey (SLOOS) will be paramount this year.

There were as well some additional interesting points in the WSJ article:

"The small banks’ experience is “simply a leading indicator of a downturn to come,” said Robert Hammer, founder and chief executive of credit-card industry consultant R.K. Hammer. In the run-up to the last recession, he noted, losses accelerated for small banks before they did for big ones.

Some small banks have viewed credit cards as a way to cross sell their customers and to bring in new creditworthy customers. That became a challenge as big banks pursued the same set of borrowers by charging low interest rates for promotional periods. Personal loans offered by a growing number of lenders provided even more competition.

That left many small banks with card applicants who had lower credit scores." - source WSJ

Is it a worrying sign? You would have to take into account the impact on "millenials" into the equation we think. Since the Great Financial Crisis (GFC), Congress passed the CARD Act of 2009, a comprehensive credit card reform legislation to protect consumers. Under the bill, lenders cannot issue credit cards to a consumer under the age of 21 unless they prove they have independent income or obtain a cosigner. Also, many millennials are clearly "credit mature" in their 20s compared to the previous generations. As millennials come of prime working age, many are having a hard time obtaining credit cards because lenders are unwilling to extend credit to individuals that have a short or no credit history (yes dear readers in your FICO score, credit history is the most important factor!). This is indeed slowing credit creation somewhat for them. Due to the experience of the GFC, millennials could be less inclined to "buy" using credit or are "convenience users" who pay off their entire credit card balance every month, limiting the need for multiple credit cards.

But the "millenials" are only part of the story. There is much more to it and necessitate a bigger dive into the US consumer credit market. On that very subject we read with interest Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon".

One of the most important points made in this report was the Employment Cost Index (ECI) pointing towards rising inflation:

"One measure of wage inflation is the Employment Cost Index. The ECI measures total labor costs for companies, including wages, salaries, and benefits. Historically, labor costs have been predicted with a nine month lead by companies’ plans to raise worker compensation, see chart below. Both series have trended higher since 2010 but are now beginning to reach levels at or above previous peaks, signs that the labor market could start to overheat and bring higher inflation." - source Deutsche Bank

From the above, there is indeed a potential for a surge in inflation particularly with trade war rhetoric heating up which could add to inflationary pressures building up in the near term (and that's bullish gold by the way). A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off. Also, corporations have spread their supply chains across the world in the last ten years and they could be impacted seriously via a rising cost bases due to protectionism and trade war on top of a surging ECI index.

Returning to consumer credit, more concerning and well documented has been the rise in student loans since 2007 as indicated by Deutsche Bank in their report:

"Federal student loan performance worth monitoring

Average student loan balances continue to rise, despite the leveling of the number of consumers with student loans, as outstanding balances have more than doubled since 2010. Since 2007, student loans have risen from 15% to now over a third of the entire consumer debt complex (ex- mortgage).

With the rise of student balances, student debt leverage has also continued to rise steadily since 2003. Among the bottom 60% of income households, DTI from student loans has seen an average increase of +10% pts since 2007.

While the leverage within student lending may have a spillover effect for other consumer loan categories, we note nearly ~20% are deferred or in forbearance (i.e. the impact is being pushed out). Although defaults are currently at ~15% of total recipients, the highest % of defaulted accounts are for the lowest average loans (~2/3 of defaults are for loans & $10k) with defaults usually relating to noncompletion of school.

- source Deutsche Bank

So yes Student Loans have been rising significantly since 2007 and the onset of the Great Financial Crisis (GFC) but it is part of a significant increase in overall leverage of the US consumer. Again, there is what you see and what you don't see as pointed out by Deutsche Bank in their thorough report:

"Items to watch

Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt.

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).

Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge.

Monitoring FICO score inflation: Consumers with a FICO score below 600 have declined from 25.5% in 2010 to ~20% (40m consumers) in April 2017, while aggregate FICO scores have increased from 680 in 1999 to 703 in 2Q17. FICO score inflation has been driven by a robust macro environment, extension of a steady business cycle, demographic aging, and methodology changes. Additionally, non-prime consumers with the same FICO score is more risky today than coming out of the recession as the long business cycle helped bankruptcies off the credit report and solid job market has enabled consumers to pay their bills." - source Deutsche Bank

Indeed as per the above, some credit cracks are starting to show, particularly within the lower credit tier borrower which had been saved by the bell thanks to central banks stepping in with its ZIRP policies and QE to stave off defaults and bankruptcies.

Of course the missing part so far of the "inflation equation" has been wage growth. Over time there has been a stable relationship between wage growth and total consumer debt but it seems that since 2013, there has been a change in the narrative as per Deutsche Bank's report:

"Modestly widening gap between wage growth and debt growth

Wage growth and total consumer debt growth have been relatively stable in the low- to mid-single digit range since 2013; however, the gap between wage growth and debt growth has widened modestly in 2017, with non-mortgage consumer debt now growing at a faster clip than wage growth (with the gap narrowing tightly in 4Q17).

Aggregate non-mortgage consumer debt expansion has come in at +5.5% Y/Y vs. 7% to start the year, and other than the pullback in 2016, has been running at 6% to 6.5% since 2013. The current 5.5% rate is ~150bps lower than the median growth rate since 1965, suggesting non-mortgage consumer debt still has room for growth heading into 2018.

- source Deutsche Bank

The rapid pace in credit card growth aka non-mortgage consumer debt expansion is running hot currently and needs to be closely monitored in the months ahead, particularly if it is starting to bite the lower tier credit borrower with already strains showing up within small banks. No surprise in the above quoted article from the WSJ that smaller banks are experiencing rising defaults given the acceleration seen in credit growth from small issuers aka small banks but also non-banks have been playing the game at an accelerating pace as well.

We pointed out the importance of tracking the quarterly Fed SLOOs for additional signs of tightening lending standards which are still quite loose. The trend though is pretty clear for auto and card, banks are starting to tighten their credit standards in these areas as indicated by Deutsche Bank:

"Banks continue to tighten credit standards on auto and card

As the credit cycle continues to slowly normalize, 4Q17 saw a continuation of a net percentage of banks starting to tighten credit card and auto lending standards, with ~10% of banks reporting tightening card standards on average so far through 2017. We believe it will take a couple years of tightened originations to reflect into total outstanding balances.

Why tightening consumer lending standards should not hurt the economy yet. 

The tightening has been driven in large part by prime/subprime auto (which is needed) and by the smaller banks in card (which does not matter as much, and given small issuers have recently returned to ~11% growth). The Fed’s senior loan officer survey includes 60 banks, but does not adjust for size, which will likely distort results. For example, in credit card, the Top 10 banks control 70% + of card balances and many are actually loosening lending standards (ie Chase and Discover, for example). Furthermore, non-banks have become a larger driver of consumer credit post-Crisis. For example, banks are only 30% of auto and personal lending. TransUnion credit bureau data shows that while banks in net aggregate have started to tighten lending standards, consumer participation across all products outside of HELOCs continues to grow at a healthy clip in 4Q17.

2017 bankcard originations tracking just slightly below highs set in 2016

With data provided by Equifax, total bankcard originations FY17 are tracking just below 2016 levels (through 3Q17) with a slight tightening in originations coming from subprime credit tiers giving prime and near-prime originations a slightly higher percent of total bankcard originations. Interestingly, private label retail cards have actually seen a slight increase of subprime consumers percent of total originations increase at the expense of prime borrowers (likely as retailer woes leave retailers looking to loosen credit standards in order to boost sales).

Card delinquencies and charge-offs are rising, but still well below 30-year averages

Concerns over credit deterioration had been worrisome in 2017, with delinquency rates starting to rise in auto and card products. While card losses have been on the rise from post-crisis lows set in 2015, they still remain ~70bps below precrisis averages and are exhibiting a steady normalization path, considering recent industry growth and the seasoning of these vintages. Outside of auto and card, other financial products are actually either improving in performance or remaining flat in 1Q18.

Within card, normalization occurring across all credit quality

Delinquencies have seen an uptick across credit tiers, however still remain below pre-crisis levels, in aggregate. Score inflation masking the underlying credit quality of the consumer, a change in the mix with newer vintages, and outsized growth for newer vintages (growth math) are contributing to higher delinquencies across these credit tiers.

Retail card delinquencies peaking faster and higher

Retail private label cards (specifically the 2015 and 2016 vintage) are exhibiting a shorter time to delinquency and a higher DQ rate than even pre-crisis vintages. We see a combination of mix shift towards lower FICO score customers, potential retail bankruptcies, and FICO score inflation as contributing factors. Regarding retailer bankruptcies, an analysis by Moody's suggests that increased charge-offs for the retailer ahead of a bankruptcy filing are more common, as these retailers start to loosen their credit standards and aggressively market to lower end consumers in order to bolster sales. Whether consumers also feel less inclined to pay off a card for a retailer that has recently gone bankrupt could be another factor to monitor." - source Deutsche Bank

It certainly feels that we are in 2007ish environment at the moment, hence our "intermezzo" title, yet given the lateness in the credit cycle as indicated by more M&A deals, a flattening of the US yield curve and a continuation of buybacks. As per our prognosis and Deutsche Bank thorough analysis, there is what you see, and what you don't see when it comes to the US consumer. As pointed out by the Kansas City Fed, 43% of the increase in average FICO scores from 1999 to 2007 is attributable to the aging of the US population. Demography is indeed "destiny" and if it looks like credit scores are higher thanks to demographics, leverage as we have seen is much higher than anticipated. This is a continuation as well from the theme we tackled back in March 2017 as well in our conversation "The Endless Summer" when we asked ourselves if "boomers" were bust, given that they are more leveraged than previous generations were ahead of retirement. Sure most of them have a relatively small exposure to student debt as their enter their golden years, but their retirement "preparedness" remains a very big issue. During the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day...

For now soft data in the US is strong whereas hard data is somewhat weaker, and it seems Wall Street is more pessimistic than Main Street. In our final charts below we will look at consumer confidence which seems diverging to the prevalent mood in Wall Street thanks to trade war rhetoric as of late.

• Finals chart - Let the good times roll?

Whereas there has been a change in the narrative in Wall Street with the returns of higher volatility and more gyrations in financial markets, it seems that the US consumer has remained more unfazed and upbeat as per the rise seen in consumer sentiment. Our final charts come from Wells Fargo Economics Group from the 2nd of March entitled "Consumers Remain Unfazed By Market Volatility" and displays not only Consumer Sentiment Survey but more importantly expectations of higher income to come as well as a very interesting chart displaying the US consumer uncanny ability in calling a market top in the housing market, or to put it simply, when Main Street is better at forecasting than Wall Street:

"Consumers Remain Upbeat About the Economy and Incomes

Consumer sentiment rose 4 points in February to 99.7 and is just 1 point below its recent high hit in October of last year. Consumers appear to be unfazed by the recent volatility on Wall Street. Relatively few consumers cited the stock market as a factor influencing their views on the economy and, surprisingly and reassuringly, a larger proportion of those that cited it as having an impact said it was positive for the economy rather than negative.
Consumers are clearly more focused on the underlying fundamentals. Our below chart shows consumers’ assessment of current economic conditions, which rose 4.4 points in February to 114.9.

The University of Michigan noted that more consumers reported they had recently heard favorable news about the economy in February than any other time since 1984. Two-thirds of consumers reported their attitudes were influenced by the recently enacted tax cuts and stronger overall employment growth.
The persistent improvement in consumer sentiment provides some relief for folks concerned about ballyhooed threats, such as rising interest rates or steel tariffs. Consumers are not turning a blind eye towards the threats, but appear to be balancing them against expectations for stronger job and income growth. Consumers’ assessment of their finances has improved greatly over the past year. Fifty-four percent of consumers said that their finances had improved over the past year, which is the highest share since January 2000.
Consumers are also optimistic about the labor market and income growth going forward, with a significantly larger share of consumers expecting the unemployment rate to fall over the next year (35 percent) than expecting it to rise (23 percent). The percentage of consumers expecting their income to rise over this year rose 3.8 percentage points to 55.3 percent. An even larger share (57 percent) of consumers stated that they expect the country will have continuous good times over the next 12 months, up 3 percentage points from January.

The increased confidence in job and income prospects should be good news for consumer discretionary spending, which has recently shown some signs of cooling off following a strong holiday shopping season.
While consumers are remarkably upbeat, they are still aware of many of the key risks present today. An overwhelming 77 percent of consumers said that they expect interest rates to rise over the next 12 months and 48 percent expect gasoline prices to increase. Consumers just seem to be doing a better job than the financial markets in putting these risks into perspective. Stronger economic growth and increased job security are far more important to consumers and that is apparent in buy plans for major household items, which rose 6 points in February. On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent."

- source Wells Fargo

In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again...

"Pessimism of the spirit; optimism of the will." - Antonio Gramsci, Italian politician

Stay tuned!

Guest Post - US Corporate Profits Under Threat

"Human behavior flows from three main sources: desire, emotion, and knowledge."- Plato

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards corporate profits in the United States surprising on the downside in coming quarters:

Michal Kalecki was a Polish neo‐Marxist economist who, during the mid‐30s, undertook the difficult task of explaining why, contrary to Marx’ predictions, corporate profit rates in capitalist societies were not converging towards zero.

The starting point of his argument lies in the fact that an economy can only save (i.e. increase its aggregate wealth) by investing. Kalecki’s profit equation therefore begins with the following equation:

Saving = Investment

If we divide saving into Business Saving (= Profits after taxes and dividends) and Non‐business saving (Personal saving + Foreign saving + Government saving), the equation becomes:

Profit after taxes and dividends = Investment ‐ (Household + Foreign +

Government) savings

=> Profit after taxes = Investment + Dividends ‐ (Household + Foreign + Government) savings

The Kalecki profit equation is not a mere macroeconomic model. It is an accounting identity that remains true at all times. One can always verify its validity by checking the following items in the National Income and Product account.

Interestingly, the Kalecki equation implies the following paradox: although the business sector often advocates for balancing governments’ budgets, the Kalecki equation undeniably shows that a large part of corporate profits actually derives from budget deficits. It has certainly been true over the last 70 years.

Following Kalecki’s equation, the fiscal cycle can be used as a lead indicator for corporate profits and the business cycle.

In a recently published piece, John Hussmann explains that because in the US, investment,dividends and foreign savings usually cancel each other, the Kalecki equation can be reduced to:

Corporate profits = ‐ (government + household savings).

In recent years, this has however not been the case. Investment rose while the current account improved (imports‐ exports= foreign savings). Therefore, as the chart from Hussman’s blog shows, the relationship broke down over the last 5 years.

- source Hussman funds

This explains why, despite reduced savings from the combined government and household sectors, profits have held up quite well. Part of the answer comes from quantitative easing. Debt issuance to repurchase shares has artificially lifted profits. Additionally, the last few years also correspond to the shale oil revolution. It is therefore possible that with a lower energy bill, the US was able to “self‐finance” investments without the usual help of imported foreign savings. The question is, can that last now that QE is over and with the FED about to lift interest rates? Given the strength of the dollar and the weakness of the global economy, the most likely scenarios are that investment weakens and/or that the current account improvement goes into reverse. Already, capital goods’ spending is weakening, and the oil crash has increased the odds that it will weaken substantially more.

Furthermore, over the last 3 years, consumers have tapped into their savings. The saving rate went from a high of 8.5% in 2012 to 4.5% today. It is unlikely that the saving rate will drop further given 1/ the close memory of 2008 2/ demographics 3/ current households behavior (consumer are using their strong cash flows to pay down debt).

At more than 600% of GDP, the US government + unfunded off balance sheet debt leaves no options on the fiscal side of the Kalecki equation when the cycle turns.

As a result the boost to private consumption from consumers is unlikely to be repeated. And since government dissaving has more than offset consumer spending it is likely that profits will surprise on the downside in coming quarters. Even more so, if investment weakens on top.

We can also observe a strong link (with a lead) on both corporate credit spreads….

and thus equity volatility.

As we have shown recently, the strength of the US currency is another threat to corporate profits and forward earnings estimates. When the supply of dollars globally shrinks (budget and current account improve together) overseas earnings tend to crash, hence the relationship below.

Current consensus believes that extremely low yields and energy prices will more than offset these threats.

With US equity volatility as mispriced as it was back in 2007 according to our model, now is not the time to be overly complacent.

Finally we would like to also add an important point made by David Goldman which can be found on Reorient Group's website from his note from 31st of March entitled "US Corporate Profits Inflated by Undersestimated Depreciation":

"If the United States wants to attract Chinese investors, it had better improve accounting standards. That sounds like the beginning of a joke, but it’s not. There have been isolated cases of accounting fraud in Chinese companies listed on US exchanges, but there appears to be systematic distortion of US corporate profits across the board. The issue is depreciation of plant and equipment. This is another reason we don’t like US stocks at present valuations.

Before-tax earnings of US companies in the GDP accounts are reported two ways: with Inventory Valuation Adjustment (IVA) and Capital Consumption Allowance, and without. The two measures have diverged by about 25%, or US$500 bn, since 2012. That’s a big divergence. The stricter measure (based on the Commerce Department’s depreciation model) shows that Q4 corporate profits in 2015 were lower than in Q4 2011; the looser measure shows substantial growth. Note that the S&P 500’s earnings per share track the higher, not the lower number."

- source Reorient Group

"When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up." - Ray Dalio

Stay tuned!