November 2009

Dear Prudence, Won't You Come Out To Play?

Dear Prudence, Won't You Come Out To Play?...For years now, we have been focused on the macro theme of the credit cycle in all its wonderful glory quite intently.  For those reading our work over the years, you’d probably characterize it as focused “to a fault”.  Again and again during the current decade we asked, is it a business cycle or a credit cycle?  Of course after the events of the last few years, it sure seems that question has been answered in spades.  At the moment, we believe our little credit cycle obsession is still the key focal point for what may lie ahead in terms of real economy and financial market outcomes.  In this discussion we want to have a brief look at components of credit cycle character that as of today simply have no precedent over the last six decades of recorded Fed data.  After looking at these data points, we want you to ask yourself, should we really be expecting a “typical” economic recovery?  Secondly, we want to briefly have a look at historical patterns of consumption in prior recessionary cycles and what experience of the moment may be telling us relative to behavioral patterns of the past.  Let’s get right to it.

When it comes to the macro credit and conjoined economic cycle, we suggest an important item to keep in mind is that historically; US economic recoveries of the last half-century have had similar “fingerprints”.  Those being pent up demand for auto’s, housing and accelerating credit usage by the private sector.  Every single one.  They all look the same.  But what we are seeing at the current time that is completely different than anything seen over the last six decades is net private sector credit contraction.  The following chart could not be more clear on the issue.  Remember, the private sector is made up of households and corporations (including the financial sector).
                

As you can see in the chart, even at the depths of any recession of the last half-century plus, year over year credit demand by the private sector has always been in positive territory.  We’re currently breaking new ground.  And this new ground begs the question, is Fed monetary policy impotent?  Here we have the lowest Fed funds rate of a generation, and credit is contracting.  Completely the opposite of what we have experienced in prior cycles.  It could not be clearer.  We are convinced this key fact is simply not getting the attention it deserves.  Moreover, we need to remember that government stimulus efforts have been focused on reviving credit demand as of late.  C4C (cash for clunker) and the tax credit for home buying was the sheep’s clothing used in an attempt to spark credit reacceleration.  Crazily enough, despite the success of C4C in August, non-revolving (largely car loans) consumer credit balances actually shrank in the month!  Not even C4C could offset the power of household balance sheet reconciliation.  That’s a very loud message.

We know we are going to sound like pessimists and doom and gloomers with a few of these comments.  We also know that we risk looking like idiots down the road by suggesting we buck the longstanding Street truism of “do not bet against the US consumer”.  But every dog has its day, and we believe the consumer/household dog is barking, and loudly.  Is it the end of the world?  Of course not, but we believe changing patterns of behavior at the household level will have very meaningful consequence for investment outcomes ahead.  As it applies to US households, two themes emerge from the numbers.  First, we are currently in the beginning stages of a household balance sheet reconciliation cycle that we feel will be of a magnitude greater than anything we have seen in the post War era.  Secondly, and we’re still early in this, household behavior regarding consumption is likewise in the midst of necessarily important change directly linked to the balance sheet reconciliation phenomenon.  Lastly, we believe these two forces will be greater in magnitude than Wall Street may be discounting and will play out over a longer time period than the consensus now expects.  Let’s get to the numbers and trends relative to historical precedent. 

It should be no surprise to anyone that household debt outstanding fell again in 2Q (the latest Fed Flow of Funds data), making this now three quarters in a row of household net debt contraction.  The important character fingerprint in the 2Q period being that debt contraction at the household level accelerated.  Over the last three quarters through 2Q, US household debt balances have fallen 1.4%.  In nominal dollars that’s a contraction of $199 billion.  Admittedly pocket change set against the totality of household balance sheets, but from a thematic perspective, this contraction was a diversion from consumption.  As we’ll see in a minute, consumption patterns in the current cycle are very different from prior cycles.  Balance sheet reconciliation does not happen in isolation, and that should be key to our investment thinking ahead.  The combo chart below chronicles close to six decades of the quarter over quarter change in household credit balances.  The anomaly that is the past three quarters is clearly noticeable and nothing short of a dramatic contrast to experience of the current decade through middle 2008.  Very quickly, although official Fed numbers are not yet available, anecdotal monthly data such as consumer credit suggests strongly the contraction in household credit balances continued in 3Q.
              

Certainly contributing to the net US private sector credit contraction highlighted above.  If this is not the very picture of changing US consumer behavior, we just don’t know what is.  Household sector credit contraction is a first in post War history.

And given yet still current levels of household debt relative to GDP, it seems a very easy bet that there is plenty more to come in this reconciliation cycle.  Although it may sound a bit confusing to hear this, the household debt to GDP ratio depicted in the following chart has actually been quite healthy over the last few quarters.  The ratio fell just a bit in the current quarter, but the positive is this ratio fell in a period where GDP also fell.  That’s the picture of a household sector determined to restructure its balance sheet.  Very healthy from a longer-term standpoint.  And you probably thought you'd never see the day, right?  In the spirit of non-linearity, that day has arrived.
                 

As you can see above, the average for this ratio over close to the last six decades was 53%.  There is no way we are going back to that level any time soon and we do not expect current cycle reconciliation to come even close to that number.  But is it reasonable to expect that over a period of years with the combination of very modestly increasing GDP and continued net debt reduction by households that we approach a household debt to GDP ratio near where we began the current decade?  Let’s say somewhere between 70-75%?  We believe that’s more than reasonable.  And that will change the face of the domestic economy and have important ramifications for consumption, and the investments represented by household consumption.  This does not mean the world has to come to an end.  It just means the world (the character of the US domestic economy) we have come to know over the past few decades, and especially this, is going to look different ahead.  And that means we once again highlight the need for correct identification of active sector participation and avoidance.  Retailers and the consumer discretionary sector have been riding a wave of macro liquidity, momentum and coveted out of the starting blocks high beta participation since March of this year.  The character behavior of households as exemplified by the Flow Of Funds numbers suggests that may be one dangerous wave. 

We’re going to step out of the Fed numbers for just a second and have a little walk down memory lane.  Memory lane of personal consumption expenditures.  As we see it, this is the natural counterpart to what we see playing out in the FOF numbers.  If households are paying debt down, then something has to be given up for that balance sheet reconciliation decision.  And the give up is consumption.  Although you may not realize this, and this is clearly one of the key reasons why the long tenured Street truism suggests no one bet against the US consumer, personal consumption in nominal dollars has actually increased during each and every recession of the last six decades (at least).  Each and every recession until the present, that is.  The following table documents the increase in nominal personal consumption expenditures during each recession since 1960.  Of course in the table we are assuming the current recession ended 6/09, given the perceptually positive 3Q GDP number.

It’s no wonder the Street does not want to bet against the US consumer, right?  But it is also clear that the current cycle is very different.  From December of 2007 until August of this year, point to point there has been no increase in US personal consumption levels.  Completely the opposite of what history would suggest.  Important enough to suggest secular change?  We’re still early in the game so we’ll just have to see how it goes.

Okay, we know the numbers above are nominal.  We also know that during the 1970’s and early 1980’s inflation was a major theme and certainly could have worked its wonderful way into these numbers.  So the next table below looks at the personal spending numbers adjusted for inflation (using the CPI to reflect consumer prices).  The numbers change a bit, but the current cycle still stands as the anomaly of weakness relative to the last half century.

Of course we also need to remember that ours has been the longest official recessionary period on record since the Depression.  So everything you see in the tables above for prior cycles happened over a much more compressed space of time.  In other words, we have had much more time in the current cycle for personal consumption to pick up, but it has not.  Lastly, we believe it’s also important perspective to remember that in our current circumstances, households have been treated to some of the lowest interest rates of a lifetime and consumer product price weakness has been pronounced.  Yet still zip in terms of consumption gains 19 months into official recession territory.

Because of the extraordinary length of the current recession, we also felt it important to quickly review the acceleration in personal consumption in post recessionary cycles since 1960.  And that’s exactly what the following table reveals.  Remember, some of these cycles saw official recession periods of less than one year.  Important point being post every single recession on record since 1960, up went consumption.  In fact, as is absolutely clear in the table, percentage growth in personal consumption proceeded in linear fashion each and every quarter, each and every period, over the 3,6,9, and 12 month periods following all recessions of the last half century.  Like literal clockwork.  

We concluded the table above with a few averages.  The first is the average growth in personal consumption one year after all recession conclusions since 1960.  The other covers only the post 1991 and post 2001 periods as these were considered “jobless recoveries”.  Okay, what does this entire picture mean in dollars and cents and just how likely are US consumers to follow these historical patterns in the post recessionary period ahead?  Well, at least as of September quarter end, the recession is now finally DOA as per the numbers from the Bureau of Economic Analysis (government reporting).  In terms of headline or consensus thinking, this is where we are.  So let’s mark June as the government’s version of the recession end period.  As of the end of June, personal consumption expenditures stood at a SAAR (seasonally adjusted annual rate) of $10.05 trillion.  So, using the historical averages and applying these numbers to current PCE levels, an 8.3% increase in nominal PCE over the next 12 months post recession implies a pick up in spending of $836 billion.  Wow, that’s one big number. 

Unfortunately, US wage and salary trends have been deteriorating since mid-2008.  From the peak last year, annualized wages and salaries have fallen close to $300 billion since the third quarter of 2008.  And remember, this is the exact period over which households have actually paid down debt.  Very difficult to do in a deteriorating wage environment and very much a statement on a changed household outlook given their determination to reconcile balance sheets in a wage hostile environment.  
                                 

So our question becomes, just how will consumers follow historical patterns and increase consumption in a post recession environment anywhere even near the magnitude of growth we have experienced historically?  There is only one answer to that question and that is to increase debt.  But this is exactly what consumers are not doing right now.  Quite the opposite.  To finance $800 billion of consumption in the twelve months ahead, total household debt would need to increase by 6.1%.  Not a chance.  We ask you, given these pretty darn clear facts of the moment, how could anyone be expecting a sustained “V” economic recovery in a consumption based US economy?  We’re scratching our collective heads.

Very quickly, we did mention the jobless recovery periods of post 1991 and post 2001 recession environments.  PCE grew much less in those initial post recession periods because job recovery ultimately took place years after official recession end.  Not too hard to figure out why out of the starting gate consumption growth was sluggish.  But you already know current consensus thinking is that the present will also be a “jobless recovery” period.  So, for drill, if we were to experience “jobless recovery” average consumption growth over the next twelve months, we’d be looking at $455 billion in household consumption growth.  If debt financed, household debt would have to accelerate 3.4%.  Again, one tall order we believe has little to no chance of occurring.

We know that at this point you get the picture.  Let us try to quickly summarize the key thematic issues here.

         For now, asset disposition is not an option for many US households.  Remember, a huge chunk of current homeowners have little to no equity in their homes.  So it follows that household balance sheet reconciliation will be driven primarily by income used to pay down debt, income that will not find its way into consumption.

        For boomers and their retirement expectations, reality has hit home.  The need to save in the absence of asset inflation is here.  The ability to do that, as well as pay down debt and consume means something in the equation has to give.  Again, the logical give point is consumption.  Below is a quick table we believe provides point blank perspective regarding demographics.  The massive pre or post retirement boomer wave is moving beyond their consumption years and the numbers below tell us the demographic wave behind them is much smaller in size.  Again, this says something about aggregate consumption levels ahead.  A secular inflection point for the boomers in terms of their consumption habits?  We suggest this should not be dismissed lightly.

        Although we only have one quarter of household net worth growth under our belts as of official Fed Flow of Funds 2Q period end numbers, the personal consumption numbers tell us the “wealth effect”, per se, from higher equity prices is simply not kicking in.  Not this time.  Just the opposite as households accelerated their balance sheet rationalization in 2Q.  We suggest that the whole idea of the wealth effect ahead will be tested as a concept or perception.  Again,  in recent FOMC commentaries looking specifically at the Fed’s own recorded meeting minutes, they cited growth in equity values had offset a number of negatives at the household level.  For now, it appears that the Fed is banking on the wealth effect with the liquidity driven equity levitation act to change consumer behavior.  Is this a good assumption on the part of the Fed?  Perhaps a key test of this theory lies literally dead ahead during the Holiday shopping season.

Hopefully in a bit of quick summation, consumers appear to have for now taken a vow of frugality.  Whether by necessity or choice, prudence seems the order of the day.  Does that mean consumers are not going to come out to play in the land of increased personal consumption any time soon?  We think that’s the theme, along with continued household balance sheet reconciliation that must come.  Is monetary policy now impotent in an environment where consumers choose not to borrow and spend?  If so, that leaves increased fiscal policy as the lever ahead for the government, with all the consequences that come along with that.  Finally, as we have said for years now, we believe investment success in the current period will necessarily be accomplished by active sector participation as well as active sector avoidance.  Moreover, we believe it is critical to at least be open to the thinking that economic and financial market relationships we have grown to know and love over the past three to four decades are in the midst of meaningful change, perhaps secular change.  As we see it, from a longer term standpoint linear thinking is death on Wall Street.  If there was ever a time to think out of the proverbial box, so to speak, and leave the linear pathway, this is it.  And for better or worse, so we will.  The current unprecedented character of the credit cycle is simply forcing us to take this unbeaten path.