October 2004

The Outer Limits?

The Outer Limits?...Here's a humble question for you.  Are we approaching the outer limits of one of the greatest monetary, stimulus, reflation and credit expansion "experiments" of all time?  We guess we could have asked the same question five years ago, let alone last year or the year before.

What prompts us to bring up the question now is the recent spotlight focused on those creative folks at Fannie Mae.  We believe the current circumstances at Fannie may ultimately have much broader meaning to the financial markets and economy than perhaps is generally perceived at the moment.  First, even folks like ourselves have been point out and screaming about the Fannie equity capital ratio for years now, let alone highlighting the potential dangers in the mushrooming of their balance sheet over the last decade.  Even though we’ve screamed at the top of our lungs, these types of thoughts and dialogue have largely been confined to the bearish underground for some time.  That these facts are now hitting the headlines represents change.  In our minds, significant change.  It represents the evolution and perhaps acceleration of the end of the innocence that must make its way into the mainstream before the equity bear market can truly be deemed dead and buried.

But getting back to the matter at hand, a hastily crafted settlement between Fannie and the OFHEO details that Fannie must increase their regulatory capital ahead.  And that means one of two things, or perhaps both.  It may very well be that Fannie needs to reduce the size of their current balance sheet over a period of time.  This has direct implications for credit creation in the mortgage markets.  Secondly, it almost goes without saying at this point that future growth possibilities for Fannie will be nothing like what has been experienced over the last decade.  To be honest, many of these same comments apply to Freddie by default.  In our minds, this is quite meaningful not only for mortgage markets, but for the US economy as a whole.  You don’t need us to tell you that Fannie and its GSE cohorts have been one of the, if not the most significant macro US financial system credit expansion provocateurs of the last decade, and especially so over the last three to four years.  In the recent past, what has been good for Fannie and the GSE’s has been good for keeping the US credit acceleration game going.  To cut right to the bottom line, at the margin the game changes ahead.  For an economy extremely dependent on credit acceleration, the implications are meaningful.  In all sincerity, we can’t overstate the significance of this forward potential change.  As we've said for years now, the US is currently running on a credit cycle, not a business cycle.

And whether anyone chooses to believe it or not, there has been more total systemic credit created in the US financial system during this most recent economic recovery than any similar period of the last half century at least.  In the following table we’re looking at nominal GDP and total credit market debt expansion in the first eleven quarters of each economic recovery of the last 50 years.  To keep it simple, in the final column we calculate how many new dollars of credit market debt has been created for each new dollar of GDP growth for each cycle.  Simple enough, right?

The problems at Fannie strike directly at the heart of US household credit expansion possibilities moving forward.  Of the near $6.7 trillion of new debt put on the books in this country since the fourth quarter of 2001, 34% is directly attributable to increased household leverage, primarily mortgage, and 36% is attributable to financial sector debt – the very folks who lend to households.  The current circumstances at Fannie and Freddie suggest these merry pranksters are just about to shut down the no-host credit expansion cocktail hour.  With a potentially diminished ability of consumers to treat their homes like ATM machines going forward, household consumption will more heavily rely on personal income.  But, wait a minute, the growth rate in personal consumption has been outstripping the growth rate in personal income for some time now.  Personal income in July was up all of 0.2%, one of the lowest monthly numbers seen in two years.  Spending growth was up 1.1%.  So far in 2004 alone, growth in personal spending has outstripped growth in personal income by a good 50+ basis points.  Can this continue if Fannie and Freddie are wearing  choke chains around their balance sheet necks ahead?  Highly unlikely.  Admittedly, just released August numbers showed no growth in month over month consumption at all, but this was almost entirely attributable to weak auto sales.  A volatile number to say the least.

Although we certainly do not have the definitive answer as to where households hit the outer limits in terms of their ability to continue consuming at a rate faster than their income is growing, we do have a few observations on extremes that relate to household spending.  Extremes that have been in place for some time now.  To us, these extremes characterize the historical outer limits of credit and financing opportunities that have been made available to households, to say nothing about the ease of credit terms and conditions.  Of course, the important question to us as we move ahead is just when do we hit the outer limits and then commence the return journey?  We suggest that it’s this conceptual inflection point that may be the key to timing a real consumer slowdown at some point.  As you know, we’ve gotten the hint of consumer slowdown’s from time to time over the past three to four years, yet into each breach stepped yet further extraordinary credit availability and financing opportunities, along with government sponsored tax cuts that were directly aimed at supporting the heart of the US economy – consumption.  Dare we say, "it's different this time?"  This go around, Fannie won't be there to catch us.  Freddie won't be there to catch us.  Greenspan and the Fed are presently working without a net in terms of monetary policy.  And there's no question that further tax cuts of meaning are not in the offing.

You're Traveling Through Another Dimension - A Dimension Not Only Of Sight And Sound, But Of Mind.  A Journey Into A Wondrous Land Whose Boundaries Are That Of Imagination…Although it’s still a bit too early to call with any precision, it very well may be that our journey back from the outer limits or extremities of consumer finance has already begun.  It’s a subtle turn not necessarily recognized broadly.  A turn almost imperceptible, except to those with a sense of long term historical context.  It may very well be the beginning of a return from the land of anomalies.  Specifically, the following charts are our graphical depiction of the past journey to the outer limits.

RESIDENTIAL REAL ESTATE

We won’t bore you with a drawn out soliloquy on the residential housing market.  We’ve been through it all before.  Quite simply, the current cycle looks nothing like the prior housing cycles of the last forty years.  The picture below tells the entire story.  Let’s put it this way, we think it’s pretty safe to say that pent up demand is the antithesis of a correct characterization of housing at the moment.
        

And the important question remains as to whether we have now begun the journey back from the outer limits.  The circumstances at Fannie suggest the train is leaving the station.  As you can see below, we still see fixed mortgage rates sitting near 3+ decade lows as we speak.  Although we won't go into significant detail as it's a discussion in an of itself, due to portfolio "convexity" in the mortgage backed securities markets, it's hard to see how mortgage rates can drop really significantly from here.  We fully expect the lows or thereabouts of the last year-plus to hold at this point.  In that sense, it's a good bet that we've already reached the outer limit lows in terms of the financing cost of a conventional mortgage.  And now that Fannie and Freddie are under the heat of the spotlight, talk of 40 year mortgage products should be subsiding in a matter of minutes, so to speak.
       

What is whispering to us that the return journey from the outer limits of mortgage finance has commenced in terms of the total mortgage finance bubble is that despite a meaningful drop in mortgage interest rates over the past two months or so, refi activity has barely been able to lift its head off the mat.  As you know, 30 year fixed mortgage rates are now down over 50+ basis points in the last two months and what you see below is all the refi activity that rate drop has been able to spark.  Oh well, looks like the hundreds of billions of  dollars “unlocked” from real estate equity over the last few years is now but a memory.
        

AUTO SALES

If anywhere we’ve traveled to the outer limits, it’s in the area of auto sales financing.  Again, you know what’s happened over the last three years in terms of financing opportunities and sales incentives.  We won’t rehash the details.  Just as in the residential housing market, auto sales activity over the recent past looks absolutely nothing like prior periods of economic reconciliation.

Could it be that the following pictures of life hold the answers as to why?  As with mortgage rates, interest costs on car loans hit generation lows in the last few years.  We're currently off the lows as many car companies have substituted higher cash incentives in lieu of 0% financing.  It's simply hard to imagine that two decades back car loans were being priced in the mid-teens and higher.
       

The loan-to-value relationship in auto financing likewise hit an unprecedented high a year or so back.  It's as close to 100% as we've ever come.  The recent drop in this ratio is in part being driven by cash incentives.
        

Finally, its really only been in the last five years that the average length of car loans measured in months has widened out noticeably, after being relatively stable for a good long time.  It's come down a bit since the peak, but it's still a very high number relative to history.  No wonder so many folks are upside down on their existing loans when ready to purchase new cars these days.
       

As per the three auto financing characteristics seen above, unprecedented extremes were all experienced in the last few years.  And each chart is suggesting that the return from the outer limits has begun to some extent.

PERSONAL SAVINGS

One dynamic of the July mismatch between personal income growth and personal spending acceleration is the fact that the personal savings rate stateside literally plummeted.  As of July, the personal savings rate fell to 0.5%.  It’s the second lowest number on record.  As you would imagine, the period of lower experience occurred in the last three years.  For now, the savings rate in August recovered to a phenomenal 0.9%.  Although we readily admit an absolute outer limit is zero, it’s hard to argue that we’re not already there in the greater conceptual scheme of things.  As you can see, we're currently so far away from the 45 year average that it's hard to see us making a return visit anytime soon.
      

Let’s put it this way, it’s very hard to see how personal savings could even come close to helping support household consumption ahead.  In fact, this data tells us that wage and personal income growth will necessarily be the key drivers of spending ahead, if at all.  What this outer limits reading also tells us is that there is mile of room for improvement in personal savings.  And we ultimately expect this ratio to improve significantly, but that's over a long term perspective.  For the sake of consumption in general and the US economy broadly, let’s just hope households never figure out they have little put little to nothing away for a rainy day, let alone a potential rainy decade.  Without sounding melodramatic, the lack of savings stateside is an extremely serious longer term issue we believe most have become simply complacent about, among other things.  In classical economics, the savings of a country is the bedrock of its capital formation, ultimately translating into supporting and increasing its means of production.  As per the savings rate, our current economic house is built on sand.  Let's just hope it's not of the quick variety, OK?

Just where are the limits of new home sales?  Auto sales?  Credit expansion and financing opportunities?  Can we for all intents and purposes run a 0% personal savings rate for an extended period?  Can spending continue to outstrip personal income growth relatively indefinitely?  During the current cycle we have pushed through what were prior in place historical limits for many of these parameters.  The graphical depictions of history above tell us that the journey back, if it’s ever to be made, is a long one.  Likewise, these pictures of human behavior also tell us that the journey back may have already begun, despite the fact that most passengers have not yet felt or become aware of the ocean liner having left the dock.  If indeed we’ve commenced the return journey from the outer limits, we say bon voyage.  After all, the consumption driven economy’s going to need all the good luck it can muster for this leg of the journey.  Let’s just hope our return passage is not aboard one of the White Star Line’s finest of vessels, OK?  One thing we are sure of is that US households are nowhere near prepared for the icy waters surrounding potential financial icebergs.

Charting The Return Voyage?...So, just how will we know if we're set to or have already embarked on the return voyage from the outer limits?  We hope it will be helpful to keep an eye on those who had the most to gain in the first place from the initial trip into the extremities of credit extension and financing opportunities.  They should be the first to hand in their return trip tickets.

Unless there's a pretty sharp break to the upside in the not too distant future, the Retail Holdrs Index (RTH) appears to be putting in a rather classic rounding top formation at the moment.  Albeit, it's broader and more extended than was the case with the picture perfect rounding top of late 2001 and early 2002.  Moreover, the RTH 50 day moving average is now below the 200 day MA for the first time since the broad equity market rally began back in the first and second quarters of 2003.  At least for now, this Index appears on track to complete the technical rounding top by moving lower.  It's flirting with its 200 day MA as we speak.  We just have to see how long the courtship lasts.
       

Although the current character of auto financing dynamics appears to be turning back from the outer limits of historical experience established over the last few years, with the exception of nominal dealer cash incentives of the moment, the large US auto stocks have been a technical mess for years already.  For both GM and Ford below, the longer term declining tops trend lines are firmly intact at this point.  You already know they have been making negligible money making cars and most of their money financing cars and residential real estate over the past few years.  Just recently, both announced production cutbacks to clear bloated inventories.  Not exactly the type of news long term declining tops trend lines are broken to the upside over.  Moreover, longer term pension and medical benefit obligation issues loom large for these two.  Very large.
       

Despite gapping down a bit in May, reacting to the bond market sell off, the Philly Housing Index has found its sea legs for now and has retraced its steps to the old highs.  A break to either higher highs, or the forward occurrence of a failed double top, should set the tone for what's to come with the housing stocks ahead.  Although mortgage interest rates have come down over the past few months, we remain convinced that increasingly by the day, wage growth is taking center stage as the forward driver of household consumption potential.  Looking at the chart of new home sales above, it's hard to imagine how the character of new home sales could accelerate in more vertical a fashion.
       

Maybe with the exception of the Philly Housing Index for now, the retail index and the two big auto stocks sure seem to have already embarked on little return trips of their own at this point.  Perhaps it helps corroborate the thought that we've already reached the outer limits.

Post Script…As you know, in this discussion, we’ve really dealt only with the outer limits possibilities of credit expansion driving household consumption.  For now, the fiscal deficit, trade deficit, current account deficit, etc. can also all be considered well into outer limits territory relative to historical experience.  And it doesn’t stop there.  It’s a virtual certainty that we’ll be following a return path well marked with financial breadcrumbs now turned stale sometime in the future in terms of macro imbalance reconciliation.  It’s simply a matter of when.  And as the example of Fannie shows us, the disturbing facts can be in plain view for years on end without sparking caution or fear.  As has exactly been the case with these various and interrelated deficits.  We’ll leave you with one last thought.  As of the end of 2Q, the US current account deficit was 5.7% of US GDP.  A record across the history of this country.  Never in the existence of modern man has an economy run a current account deficit even approaching 6% of its GDP without having had justice swiftly and severely meted out in the currency markets (a trashing of the offending country's currency).  Never.  Are we about to set yet another new global tolerance record for the outer limits of the borrowing of the world’s savings by a single country?  Anything can happen, until at some point the already known facts start to matter, of course.