Category: Debt Levels

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Deflationistas and base effects

Deflationistas like respected economist David Rosenberg point to a sharp decline in bank credit over the past 12 months as evidence of deflation.

By the end of April, commercial bank loans and leases had declined by $510 billion, or 4.7% of total, over the past 12 months.

Commercial Banks: Loans & Leases

That would be cause for concern but it does not take into account the massive $742 billion surge in lending in the preceding two months, March-April 2020, when borrowers drew on lines of credit to ensure that they had sufficient liquidity during the pandemic. They were afraid that banks would withdraw credit facilities in anticipation of widespread corporate defaults.

Commercial Banks: Loans & Leases

Conclusion

There is no credit contraction.

Bank credit did shrink by $510 billion in the past 12 months but this followed an unusual $742 billion surge in credit as borrowers drew on credit facilities to ensure liquidity during the first two months of the pandemic. What we have witnessed is the normalization of bank credit, with borrowers repaying credit temporarily drawn at the height of the liquidity crunch.

We expect normal credit growth to resume.

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Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

CNBC VideoClick to play

Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.

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Jim Bianco forecasts higher inflation in 2021

Jim Bianco from Bianco Research:

“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”

The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.

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A stock market bubble of epic proportions

A great deal has been written in recent years about real estate bubbles, stock market bubbles and even bond market bubbles. But there is really only one kind of bubble — that is a debt bubble. Without low interest rates fueling rapid debt growth, any form of bubble would wither on the vine.

The Wilshire 5000 broad market index, compared to profits before tax, recently peaked above 15.0 for only the second time in history before retreating to 13.97 in Q3. The fall in Q3 is attributable to recovering profits rather than falling stock prices, so a return to above 15.0 seems likely if the index rises in response.

Wilshire 5000 Index/Profits

The reason for the surge in stock prices is clear on the chart below: interest rates at close to zero for an extended period act like rocket fuel.

Wilshire 5000 Index/Profits & 3-Month T-Bill Yield

Anna Schwartz, co-author of A Monetary History of the United States (with Milton Friedman, 1963) once said:

If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates.

That is particularly true of the current bubble.

When will it end?

The Fed seems unlikely to change course and is expected to keep interest rates near zero for an extended period, so when is the bubble likely to end?

If bank credit growth stalls, falling to zero (the red line) as it did before the last three recessions, stock prices are likely to tumble.

Wilshire 5000 Index/Profits & Bank Credit

There may be three possible causes of slowing credit growth:

  1. Inflation surges, forcing the Fed to raise interest rates;
  2. Low interest rates cause investment misallocation, as in the Dotcom and subprime bubbles, leading to rising defaults and tighter bank credit; or
  3. An external shock causes falling aggregate demand and high unemployment, with banks tightening credit policies in anticipation of rising defaults.

Chairman Jay Powell has assured us that the Fed will tolerate higher inflation, with its new policy of inflation averaging, so higher interest rates do not seem to be a major risk. While there has been some investment misallocation, falling aggregate demand and high unemployment seem to be the greatest threat.

Initial claims for unemployment insurance jumped to 853,000 for the week ended December 5th, while initial claims for pandemic unemployment assistance surged to 427,600.

Initial Claims

Latest Department of Labor figures (November 21) show total unemployment claims remain high at 19 million — or 1 in 8 people who had a job in February 2020.

Bank credit standards have tightened significantly.

Bank Credit Standards

Conclusion

Keep a close watch on bank credit growth. If this falls to zero, then stock prices are likely to tumble.

Bank Loans & Leases

Commercial paper often acts as the canary in the coal mine, giving advance warning of a credit contraction.

Commercial Paper Outstanding

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S&P 500: Leaders no longer leading

Daily new cases of COVID-19 continue to spike upwards, warning of further shutdowns as medical facilities are overrun.

USA: Daily COVID-19 cases

Payrolls

The latest labor report disappointed, especially as the November survey came before the latest round of layoffs after states imposed tighter restrictions.

Payroll growth flattened, leaving total payroll down 5.99% compared to November last year.

Payrolls Annual Change

Hours worked are slightly more encouraging, down 4.68% on an annual basis, compared to -2.9% change in real GDP.

Real GDP & Hours Worked

Vaccines

Encouraging news on the vaccine front but “when you hear the cavalry is coming to your rescue, you don’t stop shooting. You redouble your efforts.” (Dr Anthony Fauci)

Now This News

Stocks

Progress in manufacturing vaccines that will soon be widely available has buoyed stocks despite the dismal economic outlook. The S&P 500 made new highs, assisted by hopes of further stimulus and ultra-low interest rates. The large megaphone pattern is a poor indicator of future direction but does flag unusual volatility.

S&P 500 SPDR (SPY)

Growth in the big five technology stocks has slowed in recent months, with only Alphabet (GOOGL) breaking above its September high. Too early to tell, but failure of market leaders to make new highs is typical of the late stages of a bull market.

AAPL, AMZN, GOOGL, MSFT, FB

Conclusion

Vaccines should succeed in flattening the third wave and suppressing future outbreaks but are unlikely to succeed in restoring the economy to normalcy.

Federal debt is at a record 123% of GDP and growing. Further stimulus is required to support the still-fragile recovery.

The Fed will continue to expand its balance sheet to support Treasury issuance.

Ultra-low interest rates are likely to stay for a number of years.

If massive federal debt, QE and ultra-low interest rates does not cause a spike in inflation, that will encourage authorities to push the envelope even further (we fear this would have disastrous consequences).

Unemployment is expected to remain high and GDP growth likely to remain low.

Zombie corporations and commercial real estate with unsustainable debt levels will continue to be a drag on economic growth.

Growth stocks are expected to remain overpriced relative to current and future earnings.

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Nasdaq: Devil take the hindmost

I am fond off quoting Jesse Livermore’s maxim “You don’t argue with the tape” but Livermore was a keen student of market conditions and based his decisions on far more than just price action in the market.

We are witnessing a spectacular stock market rally, driven by retail investors and hedge funds piling into the market while institutional investors are sitting on the sidelines.

The Nasdaq 100 broke through resistance at 10,000, new highs signaling a fresh primary advance. Bearish divergence on Twiggs Money Flow index may warn of selling pressure but it is hard to argue with the tape. Only a fall below 9500 would signal another decline and that seems unlikely at present.

Nasdaq 100

Even retail sales (ex food) have recovered sharply, from -15.3% in April to -1.4% in May (annual % gain).

Retail Sales (ex Food)

Light vehicle sales are more sluggish but June sales of 13.05 million are still a sizable bounce.

Light Vehicle Sales

So why are many old investment hands acting with such caution?

We know that the efforts to contain the COVID19 outbreak are struggling, with over 60,000 new cases per day, but the economy still seems in good shape.

COVID19 Daily Cases

Source JHU CSSE

Let’s look at where the money is coming from.

Federal Debt

Treasury debt has expanded by more than $3 trillion in the last four months (March 9 – July 9) as the government does everything in its power to cushion the economy from an unprecedented shutdown. Rescuing airlines, bailing out Boeing, emergency business loans, job preservation schemes, and supporting Fed purchases of a wide variety of financial assets to keep the plumbing of financial markets open. Every way they can, government has been flooding the market with money and some of that has found its way to the stock market. Whether through boosting stock purchases, enabling companies to raise debt or boosting consumer spending to buoy up sales, the market is flying on borrowed money.

Steep up-trends like this typically end in a blow-off. A trend is self-reinforcing if rising prices attract more investors who in turn bid up prices even further. A steady influx of new investors is required to sustain the trend, else it dies.

Similar self-reinforcing cycles are evident in nature, where they expand violently outward at an exponential rate until they run out of fuel. The fuel driving the event may differ, from dry tinder in a forest fire, warm ocean temperatures in a hurricane, consumable vegetation in a locust plague, …..or exposed population in a virus outbreak. The cycle expands, feeding on itself, until the fuel is exhausted.

A stock market blow-off is no different. The up-trend will continue for as long as rising prices are able to attract new investors. It will stop when the source of new money dries up. In this case, when Treasury tries to slow the unsustainable growth in federal debt. Then it becomes a case of devil-take-the-hindmost as a preponderance of sellers attempt to offload their stocks on a rapidly shrinking pool of buyers.

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