July 2002

Double Trouble

The Fact Of The Matter...For those who have kindly read our discussions for almost the past half decade, you know that we try to deal in facts when approaching financial market and economic analysis.  We hope to leave the ranting and raving to someone else.  At this point in the bear market cycle, the landscape is changing anew.  No longer is the investor of the moment merely faced with the dilemma of assessing whether knowable facts justify an investment opportunity, but now investors must jump the hurdle of whether apparent facts themselves reflect reality.  For years, the bearish underground has been decrying the perceptual presentation of many a corporate earnings report.  Pro forma numbers, operating earnings, earnings devoid of acquisitions costs, write-offs and one time events.  That now appears to be child's play as we move on to a whole new level of questioning what is fact and what is fiction in the financial and economic environment of the here and now.  

For domestic investors already a bit nervous that equity markets have not been traveling the path promised to them by Wall Street and the popular financial media, the investment confidence factor ahead becomes a paramount question mark.  Especially given the fact that there have been no net outflows from equity mutual funds at all over any annual or quarterly period since this bear market began.  (Although the numbers are not yet final, the current June quarter just may become the first quarterly net outflow experience for this cycle.)  For the foreign investment community who has so graciously recycled trade related dollars back into US dollar denominated financial assets, the stakes may be even higher in terms of the maintenance of investment confidence given that they must also deal with currency exchange rates that are such an important overlay in terms of global capital placement.  It sure appears to us that the markets are headed for double trouble dead ahead.  It's no longer just a question of whether the facts justify the investment, but whether one can justify the investment of any trust in the facts.     

Messages in Flow Motion...For now, we can only hope to judiciously approach factual examination of data we simply must accept as trustworthy.  One of those data compilations we routinely plow through is the Fed Flow of Funds report.  Let's put it this way, if the market ever comes to find that Fed publications or data are a fabrication, the whole game is over, isn't it?  It just so happens that the recent Flow of Funds report also suggests a fair amount of potential for factual financial market double trouble on the horizon, completely independent of the accounting landmines that are blowing off in semi-erratic fashion on the Street these days.  The two double trouble data point extremes witnessed in the current Flow of Funds report concern both households and the corporate sector.  Let's get right to the numbers.

During the first quarter of 2002, total credit market debt grew as follows:
            

Just a few tidbits before we get to the household and corporate sectors.  This is the first time in many a moon that the Federal debt has been in a more than benign expansion mode.  Chances are this accelerates possibly significantly ahead.  From a purely longer term macro standpoint, periods where government borrowing and spending has been in a significantly expansionary mode have been periods where common equity P/E multiples have not.  We're in the early innings of government deficit spending for this cycle.  Our second comment is that domestic financial sector debt has been in a meaningful expansionary mode for more than a decade now.  The consistency of financial sector credit expansion has been such that most investors are now numb to the recurring double digit characterization of growth.  Much as the mainstream became numb to equity valuation levels just 24 short months ago.  The good news for now being that the numbness in terms of equity valuation has worn off.  The bad news being that shock has now begun to set in.    

We believe that two of the more important messages of the current Flow of Funds report can be found in household and corporate data.  Corporations appear to be telegraphing their need to pull their own balance sheets into the financial repair shop.  As you know, some more begrudgingly than others.  This may very well be the beginning of an important trend and sends a much broader message about corporate financial flexibility.  Households, alternatively, have simply thrown another quart of oil into the engine and gotten right back on the road in terms of credit expansion.  For households, the facts are truly indicative of the intergenerational change in attitudes toward leverage that have come to characterize the modern era.  A credit expansion the size of which has not been seen since the days of our grandparents.  One key data point really regarding systemic financial flexibility that we will throw into the mix is that of the contextual meaning of the foreign sector to both households and corporations.  

THE CORPORATE SECTOR

Certainly one of the highlights of the 1Q FOF report is corporate debt expansion, or more correctly, lack thereof.  The last time year over year growth in corporate debt was this low was during the last recession.  No real surprise:
     

What we believe makes this experience so meaningful at the current time is that not only was the corporate sector largely responsible for the bulk of the recent economic downturn via a collapse in capital spending, but we feel that it is primarily the corporate sector that will govern the character of economic growth ahead.  Certainly the health of the corporate sector will be reflected in labor market conditions.  Although weakness may be moderating at the moment, we are nowhere near significant or sustainable employment growth as of yet.  As first half corporate budgets are reviewed with an eye toward 2H planning, we just may be in for further labor market weakness as cost cutting to meet current business circumstances intensifies.  

More importantly, maybe the larger issue centers around the potential for forward capital spending.  In our book, the need for balance sheet repair and the potential for increasing absolute dollar capital spending are two dichotomous objectives over any shorter term time frame.  The chart above is a picture of financial repair in action.  Will adequate balance sheet mending be completed overnight?  The following chart suggests that is simply not in the cards from a cyclical standpoint:
              

Peaks and troughs in corporate debt accumulation and reconciliation relative to the benchmark of GDP have been multi-year processes by nature.  Cyclical in duration.  The length of stay in the repair shop is measured in years, not quarters.  It just so happens that the historical peak in the relationship between absolute dollar corporate debt and GDP was seen in the fourth quarter of last year.  We're just getting started in terms of corporations tending to their balance sheets.  The corporate sector faces many of the same dynamics as households in terms of leverage reconciliation.  We suggest that just like their household brethren, corporations face a world ahead where the ability to refinance debt at the largesse of lower interest rates is largely over.  This has been a two decade refinancing boom that has most likely breathed its last as far as the contribution of interest rates to that process.  And quite unfortunately, current corporate interest payments as a percentage of pretax corporate profits are at levels seen when historically interest rates were much higher in a prior cycle.  Periods where the gift of refinancing remained in front of corporate America, not behind it:
     

Implicitly, the striking message of the slowdown in debt acceleration on the part of the corporate sector is that capital spending ahead is a huge question mark while balance sheets are under repair.  A huge question mark for the macro economy.  Certainly there will be fits and starts in capital spending as we move forward.  By definition, it is not going to zero, but we'd guess that the potential to enter a period such as we lived through in the latter half of the 1990's is half a decade to a decade away at least.  In this week's second revision to 1Q GDP, it was trumpeted far and wide that capital spending was one of the reasons for the upward nature of the numbers reworking.  The fact is that capital spending in 1Q was revised from a decline of over 2% to an increase of all of 0.1%.  As you know, that's a hair above a strike out in terms of growth rate:
          

So just how does the foreign community fit into the domestic corporate picture?  We thought you'd never ask.  In our wonderful world of global financial connectivity, it turns out that the foreign investment community was one major support to the corporate capital spending boom of the late 1990's.  See what we mean?
         

On an absolute dollar basis, over the last seven plus years foreign investors have almost quadrupled their commitment to US domestic corporate debt.  From close to 14% in 1995, the foreign community now owns approximately 24% of total US corporate debt.  Do you think they have a vested interest in the integrity and quality of US corporate accounting?  Just what do you think would happen if foreigners decided to sell just 25% of their holdings of US corporate debt?  Do you really need us or want us to answer these questions?

Through the recycling of trade driven dollars into US financial assets such as you see above, the foreign community played a major role in financing the US "new era" of the latter 1990's, to say nothing of corporate debt driven stock buybacks.  Given the recent accounting disclosures in the marketplace you can bet they are rethinking that investment decision.  In addition to investment trust being chipped away, the recent real world movement in the dollar relative to foreign currencies is entering the global financial capital allocation decision in a significant way.  Even if US corporations were to decide to lever anew in supporting renewed capital spending, the foreign community simply may not be the capital support it has been over the last half decade plus.  In fact it may be many moons before we see this type of capital transfer again.  Unfortunately, given the way events are unfolding in our financial markets, it may not be that long before we do witness a certain type of capital reallocation on the part of foreigners - one characterized by the term "180 degrees".

THE HOUSEHOLD SECTOR

As we seem to be witnessing at least the beginnings of change in the corporate leverage cycle, we can't help but wonder just how long it will be before this type of corporate behavior catches up with the consumer economy.  The consumer simply cannot continue to outspend and out borrow GDP growth rates indefinitely.  A GDP which owes a good chunk of its prior decade growth not only to consumer spending, but importantly to corporate capital spending.  As you may remember, just a few short years ago virtually no one in the mainstream consensus anticipated an implosion in corporate capital spending that was literally right around the corner, despite the fact that anecdotal evidence was in abundance.  Does that same experience now hold true for consumer spending?  We are beginning to see the anecdotes right now.  We ask you, is the following a picture of a healthy economic recovery?
              

Certainly during the first quarter, household mortgage debt was the star performer in terms of household leverage acceleration.  In part, a warmer than normal 1Q was the beneficiary of well above seasonally normal new and existing home purchase activity as well as picking up meaningful remnants of 4Q 2001 refi madness.  As you can see in the following chart, recessions have usually been periods of declining annual mortgage debt rate of change.  Not so this go around:
        

As a very generic and possibly haphazard comment, ease of credit availability in the mortgage markets today probably has no parallel in any recessionary period of recent memory.  In recessions past, credit restrictions in terms of mortgage lending have tightened.  But, as you know, those were times when many a bank actually held mortgage paper as an asset.  They were simply protecting their own capital.  That was yesterday's ball game.  The GSE's (Government Sponsored Enterprises - Fannie, Freddie and Home Loan) sponsoring the bulk of current system wide mortgage funding have not tightened the credit restriction screws even one notch.  In fact quite the opposite.  Moreover, the "setback" in the equity markets has tilted more and more investment and discretionary dollars in the direction of real estate as an asset class, helping to sustain and advance prices.  The recent confluence of mortgage credit ease and real estate price acceleration has been a source of consumption funds to the US household as refi activity ballooned over the last twelve months.     

Had it not been for the ease of mortgage credit that both allowed significant monetization of real estate equity and supported absolute dollar real estate price acceleration, household behavior in terms of total consumption may have been much different over the last few years.  We believe the real estate markets just may hold the key to consumer confidence ahead, just as they have over the last 24 months.  Each quarter we monitor household net worth in trying to gauge the fragility or strength of consumer confidence at any point in time.  Due to the destruction of financial asset values, household net worth plummeted at one of the greatest rates in 25 years during 2001:
          

Yet during this period of total net worth decline, the real estate subcomponent of household net worth kept climbing in value.  We can only imagine what would have happened had real estate values declined even slightly, or for that matter just remained stable.  As of the close of 1Q 2002, year over year household net worth was as follows:
        

As you can see in the table, the rate of change in total household asset appreciation was outstripped by the year over year rate of change in household liability expansion.  Tangible assets, by far the bulk of which is real estate, continued its upward march.  Certainly tangible assets helped sustain and drive household net worth expansion as of March 2002.  As you know, since first quarter end, equity markets in the US have behaved very poorly.  It's virtually a sure bet that once again in 2Q, the value of household financial asset holdings has contracted.  Perhaps significantly.  It is our humble observation that consumer behavior over the last half decade at least has been very dependent on having at least one meaningful household asset inflate.  Common equity did the trick in the late 1990's, but it now seems that household confidence rests largely on real estate inflation.  Especially as households are now learning that the popular financial media, Wall Street analysts, corporations and the corporate auditing community cannot be completely trusted to be looking out for the best interests of common stock shareholders.

Much as appears to be the case with corporations at the moment, will the US household sector enter into a period of balance sheet reconciliation at some point?  Either willingly or as a result of credit market imposition?  Endangering the fragility of the now largely consumer dependent economic recovery?  For the moment, the jury is out.  All we can do is look to points of continuing extreme and surmise that the risks are high.  The risks are very high.  Again, we humbly ask for how much longer can these two charts continue to trend in the directions they have over the past decade plus?
              

If the above charts do not characterize a complete change in intergenerational attitudes toward the acceptance of household leverage, we simply do not know what does.  And the big ticket in this picture is mortgage debt.  As the bear market in financial assets continues to unfold, households and the economy as a whole are becoming ever more dependent on real estate price inflation.  Or more correctly, ever more dependent on mortgage credit creation.  It's just a good thing that most of the folks who lived through the post financial bubble severe real estate price busts of the 1930's and the late 1800's are dead.  And, of course, everyone knows that what happened in the post bubble environment in Japan during the 1990's simply can't happen here, even in part.  Right?  We're not worried about an immediate real estate price bust.  We're just questioning whether mortgage credit creation can continue at the pace of the last 2-5 years.  Because if it can't, for the sake of US household confidence, the bear market in equities better end soon.

Although few may realize this, just as in the case of the corporate sector, the foreign community has been a key support to the US mortgage market.  In essence, a key support to US household confidence.  How so?  Just have a look:
           

Over the past seven and one half years, foreign ownership of US government agency debt has quintupled.  The foreign community now commands ownership of over 14% of the total government agency market.  To suggest that foreigners have supported mortgage credit expansion in the US is simply an understatement.  Once again, should the foreign community even begin to question the soundness of the US mortgage markets, the impact on mortgage credit creation in the US vis-à-vis a potentially higher interest rate structure would change the game in a big way.  If nothing else, it would be lights out for the bulk of refi activity.

If the domestic auditing community in this country had a tiny bit of difficulty catching those off balance sheet entities at Enron, minor overstatements of revenue at Xerox, capitalization of expenses at Worldcom that were just a touch more than a rounding error, and a potential host of other "oversights" yet to be revealed, do you really think they've got their hands around the interest rate and derivatives exposure of these two entities?  Notional derivatives exposure at Freddie that has just about doubled over the past year?
         

Our very meek answer to the above question is, "You better sure as hell hope so".

Seeing Double...We see double trouble ahead.  The Flow of Funds report is telegraphing the message that corporations cannot be counted on in aggregate to increase capital spending significantly while simultaneously reconciling balance sheet excess built up in the prior cycle.  It's a good bet that balance sheet excess is the very reason the Worldcom's, Xerox's, etc. of the world have had to resort to creative accounting in the first place.  Coincidentally, the US household sector is clearly dependent on mortgage credit and real estate price expansion to shore up household net worth near term.  Given that mortgage rates sit near multi-decade lows, possibilities for further refi activity depend largely on price inflation ahead.  The corporate sector and the household sector represent double trouble for sustainable strength of a domestic economic recovery.  Overlay the extreme importance of foreign capital infusions to the US financial system and the characterization of double trouble simply takes on a whole new meaning, now doesn't it?

Let The Fear Take The Wheel And Steer...To suggest that the US equity markets have had a rough go of it during the first half of this year is an almost laughable comment.  We believe the NASDAQ just experienced its worst six month performance in history.  It appears that at least for now, the Greenspan "put" has turned to pot.  Although monetary accommodation is surely working its way into the real economy, the equity market has barely taken notice.  We hear the calls all around for a summer rally.  For a technical bottom coincident with the Sept. 2001 lows.  There is certainly a chance of that happening, but any definitive statements to that effect on our part would be sheer guesswork.  We instead prefer to look for points of confirmation, of which there are or will be many.  Given the accounting shenanigans chipping away at the rock of domestic and foreign investor confidence recently, one point of serious interest for us are equity mutual fund inflows.  So far on a YTD basis through last week, US domestic equity mutual funds recorded their lowest absolute YTD dollar inflows in at least five years.  

It just so happens that since the equity bear market began, there have been very few periods where we have experienced four straight weeks of equity fund outflows.  We've now just experienced five.  In the past, each and every occurrence has marked an intermediate term bottom in aggregate equity indices.  In the following chart we use the S&P 500 as an equity benchmark:
                 

It may be that the bit of fear shown in recent equity fund redemptions represents another of these bottoms of some form.  Alternatively, if the equity markets cannot recover ahead and equity fund outflows continue, we just may be looking at the beginnings of something very different.  Something that has not been seen in this country for more than a decade.  Keep an open mind, an open chart book and an eye on domestic equity fund flows directly ahead.  With all due respect to the Conference Board, in our mind you are looking at one of the most important modern day measures of consumer confidence directly above.