Macro Factors and their impact on Monetary Policy,
the Economy, and Financial Markets
Investment letter – November 2010
THE ‘GREENSPAN PUT’
In September 2007 we used the metaphor of a tsunami to describe the convulsion that had swept through the credit markets in August 2007. In just seven days, 90-day Treasury bill yields plunged from 4.9% to 2.5%, and within a month, the $2.2 trillion commercial paper market contracted 15%. The sheer magnitude of these dislocations left little doubt that a significant seismic event had occurred, providing a clear foreshadowing of events to come. In August 2008, it was noted the perception of a tsunami is a single giant wave of water that sweeps away everything in its path once it reaches land. In fact, a tsunami is actually a series of giant waves, each one causing more destruction. Within weeks of writing those words, Lehman Brothers would fail, unleashing the largest wave of financial destruction that has reshaped the global financial landscape. It also exposed numerous fissures in the economic foundation of the U.S. and global economy that had been building for decades.
In late 2007, we discussed how the business model of the large banks had evolved over the prior 25 years. Rather than holding a car loan or mortgage loan on their books, banks had increasingly relied on the capacity of Wall Street to securitize their lending. This allowed banks to effectively leverage their capital base by moving loans off their balance sheet. By doing so, they could increase lending and increase origination fees on a larger volume of lending, without a corresponding increase in their capital base. By 2007, traditional bank lending was providing 35% of total credit creation, while securitized credit creation was 40%, according to BCA Research. This new business model, however, was dependent on market provided financing, which the banks incorrectly assumed would always be available. As liquidity dried up in the second half of 2007, banks found their balance sheets bloated with $400 billion of ‘temporary’ bridge loans to private equity, and a more challenging credit market environment.
The change in the bank business model has also had a profound impact on the effectiveness of monetary policy. When banks were providing 75% of credit creation, the Federal Reserve’s leverage on the economy was significant. By increasing or lowering interest rates, the Fed would immediately impact the cost of credit to a broad cross section of the U.S. economy, including housing, automobile purchases, and business inventory financing. However, as the amount of bank credit creation shriveled from 75% to 35% of total credit creation, so did the Federal Reserve’s leverage on the economy. As we have seen, the Federal Reserve has lowered the Federal funds rate to nearly 0%, and it doesn’t provide much of a lift for the economy.
As we wrote in December 2007, the Fed’s diminished leverage on the economy through the banking system is why this crisis was likely to be quite different than the other crisis’ faced by the Federal Reserve during the prior 20 years. Most mutual fund managers are ‘bottoms up’ stock pickers, who primarily focus on individual company balance sheets, or a specific sector, i.e. small cap, mid cap, etc. Given their approach, they spend very little time on the ‘macro’ side of the ledger. They also don’t understand the credit creation process. They didn’t see the last crisis coming, and they won’t see the next one either, since that’s not where their focus is oriented. As a result, they didn’t comprehend the scope of the crisis, and the Fed’s limited ability to deal with it. As we said in December 2007, “It really is different this time.”
A further indication of how few market strategists, economists, and policy makers grasp the big picture is how many of them reacted to the Fed’s announcement of QE2. In one corner, are those who have sharply criticized the decision through editorials, and statements by a number of Federal Reserve Board district presidents. A group of prominent Republican leaning economists and lawmakers are even running ads in the Wall Street Journal and New York Times. “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.” Reaction from overseas has been even more strident. The German Finance Minister astutely observed, “It doesn’t add up when the Americans accuse the Chinese of currency manipulation and then artificially lower the value of the dollar.” The Brazilian finance Minister said “It will lead to greater disequilibrium in the world markets”. And Brazil’s new president volunteered an interesting reference “The last time there was a competitive devaluation of currencies it ended up where it did, in the Second World War.”
Over the last two months, the financial markets have weighed in with their opinion by rallying almost non-stop in anticipation of the Fed’s November 3 official announcement. The expectation is that QE2 will be the Red Bull for a faltering recovery that needs something to become rejuvenated. Investors have also inferred that a secondary goal of QE2 is to boost asset values, and stock and raw material traders have been more than happy to oblige the Fed. Our take has been that QE2 will not provide much benefit to the economy, and those who think it will are naïve. The reports of inflation’s imminent arrival are greatly exaggerated. The 30-year average for Capacity Utilization is just under 81.0%. In October, the utilization rate was 74.7%. With an output gap that large, most companies have virtually no pricing power. So they will be forced to swallow most of the recent increase in raw material prices, which will cut into their profit margins. The unemployment rate is 9.7%, the underemployment rate is near 17%, and there are 5 workers for every 1 job opening. Wage gains have been stagnant, and given the dynamics of the labor market, wages are more likely to remain under pressure for years. Since wages comprise 65% of the cost of goods, the risk of persistent inflation is negligible. The recent run up in food and energy prices is a different kind of inflation, since it reduces disposable income. The more consumers spend on energy and food, the less they have to spend on everything else. Less disposable income in a weak economic environment adds an element of deflation, along with its measure of inflation.
With all the negative publicity and concern about bubbles, poor Lawrence Welk must be truly perplexed. As we have often noted since 2007, the one bubble the Federal Reserve cannot allow to deflate is the credit bubble, so let’s review it again. For each $1.00 of GDP, there is $3.70 of debt that economic growth must support. If economic growth doesn’t throw off enough cash flow to support that mountain of debt, debt defaults will accelerate. In total, GDP of $14 trillion is supporting $50 trillion of debt. Layered on top of this debt load is another $30 trillion to $50 trillion of debt based derivatives (rough guess). The Fed’s QE2 program of $600 billion looks inadequate to insure the credit bubble will not deflate, especially if GDP growth is too slow or housing and stock prices decline again.
For many years our writing has been focused on the Federal Reserve, since monetary policy easily has the largest influence on the economy and financial markets. Since World War II, every recession was preceded by a tightening of monetary policy and higher interest rates, and every recovery spurred by lower rates and an easing of monetary policy. Every cyclical bear market and bull market was also strongly influenced by changes in monetary policy. Since the stock market crash in 1987 and the 1998 collapse of Long Term Capital Management, investors have believed the Federal Reserve also possessed the capacity to manage every crisis. Since those two crisis’ occurred when Alan Greenspan was Chairman and Maestro of the Federal Reserve, it became known as the ‘Greenspan Put’. This reference to the value of a put option during a market decline, increased investors bravado that they needn’t worry about a negative Macro event, since the Fed would simply exercise ‘Greenspan’s Put’ and restore order. The current financial crisis has exposed numerous fissures in the U.S.’s economic foundation, which will be addressed later. More importantly, it has shown that the Federal Reserve no longer possesses the capacity to manipulate economic activity, as they did during the last 60 years. The balance of power has shifted from the Federal Reserve being proactive and exerting a strong controlling influence on the economy, to one of being reactive. The Fed can now only indirectly affect the numerous drags on economic growth, despite an unprecedented level of monetary accommodation. This change in the balance of power, from the Federal Reserve being proactive to reactive is significant, since it means ‘Greenspan’s Put’ has expired. The majority of mutual fund managers, market strategists, economists, and investors have not yet realized that this shift in control and power has occurred. Their continued faith in ‘Greenspan’s Put’ may cost them dearly in the next few years, as the Federal Reserve struggles to keep the credit bubble from deflating.
Everyone is familiar with the phrase ‘A rising tide lifts all ships.’ But the tides also come in and go out. For most of the last 65 years, the tide has been coming in and rising for the U.S. economy. During this period, the macro tides underpinning the U.S economy were supportive of economic growth, which raised the living standards of most Americans. As discussed in September, the U.S. was in recession just 64 months of the 300 months between 1957 and 1982. Despite this enviable record, those in control of Congress in 1978 passed the ‘Full Employment and Balanced Growth Act. The Act mandated that the Federal Reserve utilize an ongoing monetary policy that strived for full employment, growth in production, price stability, balance of trade, and balancing the Federal budget. The last item is a Congressional classic since the Constitution places the full responsibility for balancing the Federal budget on Congress. But members of Congress from both parties have rarely ducked an opportunity to shirk responsibility. Passing legislation that absolves Congress of fiscal responsibility is a lot better excuse than my dog ate my homework. In the 300 months between 1982 and 2007, the economy was in recession only 16 months, so the combination of liberal monetary policy and the lack of fiscal discipline appeared a great success. Unfortunately, a number of large imbalances developed during the 25 years of policy ‘success’, topped off with a financially engineered housing bubble.
The implosion of the housing bubble has exposed a significant number of fault lines that were hidden, as long as the credit bubble was expanding and debt driven GDP growth exceeded 3.0% on average. The Federal Reserve is no longer ahead of the economic curve. Instead, they are using every conventional and unconventional policy tool available just to keep the economy growing. Their primary goal is to buy time, and hopefully enough time for all the healing needed. However, they are pushing against a number of macro tides, both large and small, that will continue to weigh on economic growth in the U.S. and globally for at least the next 2 to 3 years. The financial crisis that kicked off in August 2007 has never really ended. Much like a Category 5 hurricane, the global economy was battered by the outer wall as it came ashore in 2008 and early 2009. The eye was created, as every central bank adopted an extraordinary level of monetary accommodation. Governments around the world launched massive fiscal stimulus programs that resulted in historic budget deficits in almost all of the developed countries. In the United States, the eye of the hurricane allowed GDP to grow, but at a sub-par pace. Compared to the recession of 1973-1974, the first five quarters of GDP growth since the summer of 2009 have averaged 2.8%, half as fast as the first five quarters after the 1973-1974 recession. The first five quarters after the deep 1981-1982 recession averaged GDP growth of 8.4%, three times the strength of this recovery.
There are a number of indications that suggest we will be moving out of the hurricane’s eye sometime in the next six months. Most of the Federal fiscal stimulus has been spent, without launching a self sustaining recovery. Job growth has been exceptionally weak when compared to other post World War II recoveries. Without a healthy increase in disposable income, consumer spending will not elevate GDP growth above 3% on a sustainable basis. The only way that will occur is if solid job growth of 300,000 jobs per month kicks in, and that’s not likely anytime soon. Spending may marginally pick up during the holidays. Keeping a rein on spending gets old after awhile and the holidays are a good reason to loosen up a bit. Unfortunately, millions of unemployed workers will see their unemployment benefits expire, unless Congress extends them, which we expect. However, that will only make cutting the Federal budget deficit more of a challenge. State legislators do have to balance their budgets and they will be raising taxes and fees, and laying off more state workers. Housing prices are set to fall further, as more than 70% of homes in foreclosure have yet to hit the market.
In Europe, the eye of the hurricane resulted in a very uneven pick-up in economic growth. Although Germany has done well, actually recovering all of the ground lost during 2008, many other countries have not fared well. Ireland and Greece are still contracting, while unemployment in Spain is almost 20%. European banks are in worse shape than their U.S. counterparts. Although we expect the European Union to bail out Ireland’s banks, the credit crisis is likely to eventually engulf Spain. This will prove significant since Ireland and Greece combined represents just 5% of total E.U. GDP, while Spain represents 10%.
In response to the global slowdown in 2008, China initiated a $570 billion stimulus package, and ordered state run banks to lend aggressively. In 2009, Chinese banks increased lending by $1 trillion, an enormous amount given the size of China’s economy, $4.5 trillion. The combination of fiscal and monetary stimulus had the desired effect of boosting China’s economy, but has also resulted in a burst of inflation in 2010. In October, official consumer prices were up 4.4% from year ago levels. The real inflation rate in China could be at least twice as high. China has not revised its CPI since 1993, and the weighting of many food components are not realistic. According to official government data, food prices have risen just 19% over the last three years, but over that period, rice was up 38%, wheat up 35%, and beef and milk prices rose 44%. In contrast, two major supermarkets reported that rice prices had soared by 132% and 190% over the last three years.
In response, China’s central bank has raised its lending rate and bank reserve requirements. Rising inflation isn’t just limited to China, but to most of the Asian countries, which have been enjoying solid growth. South Korea had increased rates once, but Australia has boosted its bank cash-rate seven times from its 2009 low of 3.0% to 4.75%. India has hiked its repo rate six times to 6.25% from 4.75% in early 2010. Inflationary pressures are likely to intensify, since the output gap between capacity and production have disappeared in India, South Korea, China and Indonesia, according to the Royal Bank of Scotland. This makes it easier for companies to raise their prices. These are the countries with the strongest growth, but the gradual tightening of monetary policy will likely result in a slow down during 2011.
As the back wall of the hurricane approaches the global economy with its Category 5 winds, investors will realize that most of the problems that emerged in 2008 were not solved or fully addressed. The macro tides which lifted the global economy for decades have shifted. Investors will have to focus on preservation of capital in 2011, and batten down the hatches.
COMPONENTS OF THE MACRO TIDES
The following is a list of individual headwinds. Each will weigh on growth in the U.S., keep GDP growth from reaching a self sustaining level, and cause GDP growth to average under +2.0% in coming quarters. This list will provide a worksheet that will allow us to monitor which headwinds are deteriorating or improving. At some point in the future, the majority of these headwinds will begin to improve and help indentify when another eye in this extended hurricane is approaching. Many are interconnected and there is some overlap. The most important common denominator is that solid economic growth will address most of these issues. Adopting policies that will strengthen economic growth is imperative. However, there are no easy choices since there are potential negative outcomes associated with every option. We’re in quite a fix. One, even Houdini would struggle with:
The ratio of total debt to total GDP in the U.S.
Monetary policy impotence
Finding a short and long term solution for the federal budget deficit
Recapitalizing the US banking system, so lending broadly resumes
Weak job and disposable income growth
The change in middle class spending psychology toward less is more
Stabilizing housing despite the large overhang of foreclosed homes
Commercial property rents and values
Dealing with state budget deficits
The demographic shift of baby boomers into retirement
Addressing the income inequality gap between the top 1% and average worker’s pay
The lack of true leadership from either political party
The cost of health care rising faster than personal income
The unintended fallout from financial regulatory reform
The European sovereign debt problems
Recapitalizing European banks
The global economic drag from closing fiscal budget deficits in developed countries
Keeping Israel and other middle eastern countries from starting another war
China and its currency and trade policies
China’s potential bank loan defaults from excess export capacity
The Basil increased requirements for international bank capital by 2020
The following is a brief overview of the primary financial markets. Specific recommendations are provided to subscribers of Macro Tides with Special Updates.
STOCKS As discussed in October, investors have become hopeful that QE2 and a new batch of Republicans in Congress will give the economy a lift. In recent weeks, investor sentiment has become even more bullish. Last week, the percent of bulls in Investors Intelligence’s weekly survey reached 56.2%, the highest since October 2007. Two weeks ago, the percent of bulls in Consensus’ weekly survey was the highest since last April, just before the April 2010 high was put in, and the 10-day call/put ratio also reached its highest level since April, just as the S&P pushed slightly above its April high at 1219.
The high level of bullishness is a warning that the market is near an important price high. A resolution to the Irish banking problem should provide the market a lift. With year-end approaching, trading will likely be choppy, but another push above the November high at 1227 is likely. It’s time for investors to become more defensive and sell into strength, especially if the S&P exceeds 1227.
BONDS In October, Treasury bonds were vulnerable to a sell-off, due to investor’s faith that QE2 will work in spurring the economy. The 10-year treasury yield has risen from 2.5% to almost 3.0%. The 10-year Treasury yield is likely to remain range bond between 2.5% and 3.2% for months.
DOLLAR If I’m right about a resumption of the credit crisis in 2011, the Dollar will experience a flight to a quality rally that should lift the Dollar index to 88.00 to 92.00
GOLD As long as gold holds above $1310, the major trend is up. A rebound to $1375 is likely.