June 2005

Cycle Paths

Cycle Paths…As we’ve mentioned a few times in the past, we believe there is one question that is the key to understanding and successfully navigating the current economic and financial market environment.  Point blank, and although this may sound wildly melodramatic and over the top, we believe that the correct answer to this question will absolutely determine success or failure for investors looking ahead.  We’re just trying to keep it simple and distill all of the noise and daily sound bites blaring at us from the financial media down to one overriding issue.  Here goes.  Is the current post recessionary economy more properly characterized as a business cycle or a credit cycle?  Which one is it?  Answer the question correctly you win the prize.  And we’re not kidding.

What stands out to us like a sore thumb in the current recovery cycle is the dichotomy of character relative to past economic recovery periods.  In so many key economic indicators of the moment, we see activity almost completely opposite of historical experience during recovery cycles.  Is it the new "service economy" that appears to be reshaping the rules?  Is it the rapid globalization of economic activity that is being displayed in such a dramatic change of domestic economic character?  Or is it simply the fact that what we are living through is not a business cycle at all, but rather a credit cycle?

Let's look at some of the specific and tangible economic characteristics we are referring to that we believe define the current environment in trying to access what we believe to be the ultimate question of the moment - business cycle or credit cycle?.  First of all, we sincerely have to tip out hats to US consumers.  As you already know by now, they have been the driving force of the consumption oriented US economy during this recovery cycle.  Moreover, it's also no mystery that US consumers have been largely responsible for helping to support many an export driven global economy of substance.  Asia in particular has been a very significant beneficiary of US consumption patterns over the last three to four years as is being transmitted directly through the ever burgeoning US trade deficit.  Let's get right to the historical dichotomies of the moment in the spirit of trying to seek guidance as to where we are headed as an economy and financial market looking forward.

In recessionary experiences past, it has been absolutely axiomatic that US consumers have pulled back on spending well in advance of the official recessionary period itself.  As you can see below in the history of auto sales data, prior to the recessions of 1980-82 and 1991, auto sales in physical units declined meaningfully.  From the late 1970's through to 1982, we witnessed in excess of a 40% drop in auto sales point to point.  From 1987 until mid-1990, auto sales declined over 25% end to end.  But during the current cycle, auto sales are virtually flat point to point since 1998.  There was no decline at all either leading up to or during the most recent recession.
          

Of all prior economic recovery cycles relative to the present, perhaps there is no greater dichotomy in statistical character than we are now witnessing with residential real estate.  If this isn't an "it's different this time" experience, then we just don't know what is.  Although we did not mark the prior recessionary periods in the following chart, you already know the dates.  1970, 1974, 1980-82 and 1991 - all years encompassing official NBER (National Bureau of Economic Research) defined recessions.  And as is absolutely plainly visible in this historical retrospective, prior to every recession of the last 45 years at least, new home sales declined on a significant absolute unit and percentage decline basis.  Every single one, except the current, of course.  In fact, in the current cycle the trajectory of acceleration is without precedent over the time period displayed in the chart.  To us, what you see below cuts right to the heart of the central question of business versus credit cycle.
       

As has been our analytical custom with so many economic indicators during the current cycle, we like to put current activity in perspective relative to actual prior cycle experience.  To do that, we've constructed many a graphical relationship that tracks percentage change in activity in post recessionary periods.  To put this in simple English, we assume the month of recession end is 100% and show economic growth in percentage terms as equivalent periods of time pass.  The following just happens to be personal consumption expenditures.  To cut right to the bottom line, here's what the chart is telling us.  Since November of 2001 (the end of the last recession) personal consumption expenditures in the US are up over 20% point to point.  As you can make out in the chart, we're very much on par with the experience of the post 1991 recession.  In like manner, we're lagging a bit behind meaningful increases in consumption post the very difficult and deep recessions of the mid-1970's and early 1980's.  In other words, consumption hasn't been stupendous, but likewise it has not been anything worse than has been past experience.
       

Again, given that the US economy is so heavily dependent on consumption to generate GDP growth at the current time, we believe these little peeks at historical consumption relationships are important in trying to grasp the differences between this and prior post recessionary economic recovery cycle experience.  Importantly, and as you know, what do all of the above characterizations of consumer activity have in common?  They all represent consumption that can be financed.  Is the current economy more properly characterized as a business cycle or a credit cycle?

The Roll Call...As you might imagine, differences and dichotomies in current versus past economic character don't stop with what you've seen above.  Much like the stark and striking differences in the current residential housing cycle, payroll employment recovery experience since the last recession has also been one of the largest anomalies completely in plain view.  Our recent cycle experience has literally been one of the worst job recovery environments on record.  Again, in the following chart, we've indexed payroll employment growth in each of the recessions of the last three decades.  Since November of 2001, total payroll employment growth point to point as of the latest report is up all of 1.5% for the current recovery cycle.  At the similar point during the "jobless recovery" of the post-1991 recession, payrolls had grown by approximately 7%.  And as you can see, post the mid-1970's and early 1980's recessions, payrolls had grown by double digits this far into each recovery.  
             

As we’ve argued for some time now, it’s not just body count in terms of payroll recovery that’s meaningful, but also wage acceleration.  And it’s meaningful in more ways than one.  First, as you’ll see below, the year over year change in service sector wage growth (that’s where virtually all job creation has occurred this cycle) as of the latest payroll report is 2.8%.  It’s been at least a year and one half now that the annual change in service sector wages has lagged behind what we believe to be an already low-balled CPI rate of change.  In other words, we’ve been treated to negative real wage gains during the current payroll recovery cycle.  Clearly this is important in that in the absence of credit ease and availability, it’s wage gains that ultimately support consumer spending, be that residential real estate or otherwise.
       

The second issue we believe is important when looking at wage growth is the thought that the Fed and Administration will simply “inflate away” current leverage in the system.  We wish it were that simple.  We are absolutely convinced that in the absence of broad wage acceleration, it’s a virtual impossibility for the Fed and Administration to “inflate away” the onerous household leverage of the moment.  Wage inflation is the key to sustainable longer-term inflation.  And wage pressure is absent from the current recovery cycle for a good number of reasons, primarily the unprecedented access of corporations to the global labor pool.  We doubt very much that domestic wages are about top rocket higher anytime soon given the current dynamics of the increasingly globalized economy.

So just where does that leave us?  It’s clear that US consumers have an anchor around their necks in terms of both job and wage acceleration stateside.  In like manner, they are displaying a pattern of consumption strength almost unprecedented in both pre and post recessionary economic recovery experience.  Just how can these two anomalies co-exist in any type of normal or logical economic recovery scenario?  For now, in our minds, the following table explains how this seeming fundamental economic illogic appears normal in the current environment.  Have a quick look.

As you’d imagine, we chose year-end 1999 as a starting point for looking at the character of household net worth given the proximity to the peak in financial market values.  You don’t need us to tell you that residential real estate values and the acceleration in household leverage are the two huge dynamics driving current cycle household thinking, feeling of well being, and ultimately consumption patterns.  The growth in household financial assets over the last five years has been a rounding error.  Point to point growth in household net worth of 10.2% annualizes somewhere near 2%.  But, as you can see, since the beginning of US economic history, so to speak, up through year end 1999, it probably took US consumers a century or so to accumulate $6.8 trillion in total household liabilities.  It only took five years to increase that number by 50+%.  Question.  Business cycle or credit cycle?  Which is it that explains the character of the current total economic recovery cycle? 

Mirror Mirror On The Wall?…Switching gears for just one second, we want to have a very quick look at the current character of corporate spending.  You remember, the “business” part of the economic recovery cycle, so to speak.  What you see below is the history of net corporate cash flow as a percentage of GDP on top of the coincident time period chart detailing non-residential fixed investment as a percentage of GDP (a proxy for corporate capital spending).  It’s pretty darn clear that as corporate cash flow grew in the 1970’s, corporate capital spending mushroomed.  At the time, much of this went into energy infrastructure.  Same deal in the post recessionary period of the 1990’s.  Corporate cash flow grew big and so did capital spending centered primarily in tech equipment.  In other words, as corporate cash flow has accelerated over time, so has corporate capital spending.  The patterns are pretty darn clear.

So here we have current net corporate cash flow as a percentage of GDP near all time highs.  The current cycle has no precedent in terms of strength.  Yet coincident time period capital spending relative to GDP has modestly increased relative to this burst of cash flow.  Just what’s going on here?  Why aren’t corporations spending their cash more aggressively?  After all, they are literally spitting out cash at the moment.  This too is an anomaly right alongside the consumption and employment pattern dichotomies described above.
      

So let’s see if we can pull this all together.  In typical post recessionary economic recoveries, corporate capital spending expands to meet the expansion in corporate cash flow.  That’s absent this cycle.   In typical post recessionary economic recoveries, job and wage gains have been well above what is clearly absent in the current cycle.  In pre-recessionary and post recessionary cycles past, consumers have shown patterns of delaying purchases of housing and auto’s primarily, and have slowed total personal consumption expenditures in the macro sense.  That’s not absent this cycle, rather it’s been completely turned on its head as consumption has bordered on feverish in front of, during and after the recent recession up to this point.  Parabolic when it comes to residential real estate.  Again, without sounding melodramatic, “it’s different this time” seems to be right on the money more than anything else.  Simple question.  Does what you see above represent a business cycle or a credit cycle?  We’re just trying to identify the correct cycle path, so to speak.

One last chart before we call it a day.  The following is our little concoction trying to get our hands around aggregate credit that is being created outside of the US banking system.  In one sense, we’re asking ourselves whether the credit cycle dynamics this go around are different than prior cycles.  All to answer question numero uno, as you know.  Alright, what lies below is the difference between the quarter over quarter growth in total credit market debt outstanding (from the Fed Flow of Funds statement) and the quarter over quarter change in M3 (as being representative of the credit being created in the US banking system).  In other words, total systemic credit expansion less credit generated by the banking system.  (As an example, remember that a while back we told you that the asset backed securities market provided the bulk of mortgage credit in the US during 2004.  That’s credit creation “outside” the official banking system.)  As you can see, the chart simply speaks for itself.  Credit system dynamics in the current economic recovery cycle are quite striking.  Massive dollar amounts of credit are being generated well away from the banks.  Let’s put it this way, the tinder is lying all around us for the current cycle to be more properly characterized as a credit cycle as opposed to a more traditional business cycle.  Perhaps, the strongest credit cycle of a generation.
       

Again, everything we have written about above importantly concerns current character as opposed to predicting ultimate outcome of this very special cycle.  We certainly have our own thoughts as to outcome, but we believe that understanding the dynamics is the key to successful decision making ahead.  If this is truly an economy dominated by a credit cycle, we know to look for the cracks in the providers of credit (FNM, FRE, GM, etc.).  And we also know to watch the potential cracks where that credit creation is finding an outlet (housing, auto’s and discretionary consumption).  We’re convinced that investment success ahead lies in being exposed to the correct sector bets and avoiding the at risk sectors like the plague.  So just what does all of this material say about the financial and consumer discretionary sectors?  Well, that all depends on how you personally answer the key question, right?  Believe us, we’re not covering this material to be negative by any means.  Realism is what we’re after.  We can assure you, the inmates are not running the asylum, it’s the cycle paths we’re watching out for. 

One last anecdote of interest.  As you know by now, 1Q 2005 GDP was revised up to 3.5% from the original 3.1% reported.  The much lower than expected March trade deficit clearly foretold the direction of this revision.  But here's what caught our attention.  In the revision, GDP components of consumption and residential investment were both revised up.  Interestingly, business fixed investment was revised down from the original assumption.  Hmmm.  Business cycle or credit cycle?  Tough call, right?