By Contraryinvestor.com | 2 February 2009
We’ve Only Just Begun?…Yeah, that’s pretty much how we see it at this point. We’re referring to the process that is macro or systemic deleveraging. It was way back in April of 2007 that we penned a discussion entitled, "It’s Delightful, It’s Delovely, It’s Deleverage". At that time very few folks were talking about deleveraging as a concept and economic force to come.
Fast forward to the present and it’s now consensus thinking. Although the theme has been very much popularized in the mainstream press, we see very little attention to specific detail. So, in that spirit, this discussion is all about checking in on the concept and establishing where we now stand. Nothing like the facts to illuminate the true picture, no?
To the point, deleveraging is not an event, but a process. As we've explained in the past, the multi-decade credit cycle phenomenon was key to economic and financial market outcomes in the US, as well as globally for close to three decades. The whole concept of deleveraging dramatically interrupts, or really derails that cycle.
Coincidentally, the Fed/Treasury/Administration are in do or die reflation mode at present. Reflation really meaning an attempt to restart what is a critically wounded credit cycle. Mortally wounded? We’re going to find out.
In this light, monitoring the process that is deleveraging becomes very meaningful in terms of trying to interpret just what the financial markets are pricing in at any point in time. We believe it's also helpful in terms of trying to monitor the economic slowdown magnitude and duration issues so key to near term investment outcomes. Looking at the hard data, it's our interpretation that deleveraging has barely begun when looking at the economy and financial market broadly.
Below are a number of highlight data points. Through the third quarter of last year, US consumers have not yet gone into a net debt contraction mode, but have merely slowed their borrowing dramatically YTD. It's a darn good bet net debt contraction is here now and will show up in quarterly numbers very shortly as official 4Q numbers are published.
Directly below is the near half-century history of the quarter over quarter nominal dollar change in household debt obligations. In this and all like charts that follow we are not using 'seasonally adjusted', so we're pretty much looking at the real thing. For perspective we've included the 12-month rate of change which smoothes an incredible amount of monthly volatility. To suggest what has transpired at the household level is dramatic both on the upside and downside is an understatement.
From taking on close to $350 billion quarterly in new leverage some years back, household debt grew by only $14 billion in the last quarter (3Q 2008) for which info is available. That’s absolutely a rounding error set against a $14 trillion+ economy. As we stated in the chart, the last time households actually paid down debt on a quarterly basis was 1975. Yet, we’re convinced net debt reduction at the household level lies ahead.
Although we will not drag you through that chart, both revolving and non-revolving consumer credit balances have contracted with 4Q data available as of now. Bottom line being, for households the deleveraging process has only just begun despite all the sound and fury over deleveraging as a concept last year. As with the macro economy, magnitude and duration of the deleveraging to come at the household level will be a key data point for 2009.
The Fed/Treasury/Administration (the F/T/A) may be begging the banks who’ve received TARP money to lend it out, but households are telling us by the trend in these numbers that they are not necessarily willing borrowers, regardless of cost and availability of credit. As we see it, the financial markets have priced in the F/T/A response to the credit market freeze/economic slowing, but as of now the household response to borrowing inducement remains a question mark. Maybe the key question mark of the moment. If households begin a process of net debt contraction (which we believe they will), then financial markets trying to anticipate a turn in the US economy by the second half of this year will be jumping the gun in a big way.
Moreover, existing 2H 2009 bottom up analyst earnings estimates are a good bet to be far too high at the moment. For now, we believe the markets have not priced in household indifference to monetary stimulus. The chart below tangentially documents the rhythm of household balance sheet cycle reconciliation over the prior half century. As is clear, never in the half-century plus period that is covered has the year over year change in household debt growth been at the record low level we see today. Does this trend dip into negative territory before the current cycle is over?
We think so, which will be unprecedented, but we’ll just have to wait to see what happens. From our perspective, equities have not yet fully priced in the ramifications of actual household debt contraction. Remember, the reality of the prior half year auto sales, retail sales, and residential property activity all occurred during a period characterized merely by a slowing in household debt assumption, not net debt contraction. And, in this [[relatively benign: normxxx]] environment, we already saw the year over year change in headline retail sales at the lowest level in the history of the data (dating back to the late 1940’s).
As we have stated in the past, actual deleveraging has been occurring in the financial sector during 2008. The poster child example for this phenomenon is the asset backed securities markets. The following chart is self-explanatory. Since the dawn of the asset backed markets in the mid-1980’s, there had never been a quarter over quarter decline in asset backed securities market leverage until 4Q of 2007.
We already know that it’s the non-bank credit creation arena (the shadow banking system necessarily inclusive of Wall Street) that has been ground zero for broader credit cycle reconciliation in the current period. Have the markets already priced in contraction/deleveraging in the non-bank financial sector? To a large extent, you bet.
Yet confidence in the sector will never be restored until investors can truly assess balance sheet risk. Given the revelations of companies like Citi, State Street and BofA lately, it’s clearly what we don’t know that’s the issue. And we’re miles away from confidence restoration. Miles.
In terms of specifics, and we will not drag you through a myriad of long term charts, within the financial sector actual deleveraging (net debt contraction) is evident as we look at the REITs, funding corporations and the asset backed markets. But outside of that, continued leverage acceleration is still evident looking at the banks, insurance companies, GSEs, the broker/dealer community and credit unions. As such, this data and the trends underpinning recent experience suggests there is still a good deal of deleveraging potential within the broad US financial sector itself.
Although the financial sector stocks have been resoundingly hit over the past year and one half, true recovery seems a long way off given that actual deleveraging in the sector has been meaningful, but isolated, as opposed to broad based. Further potential deleveraging in the US financial sector remains a high probability outcome well into 2009. The importance of this will be its ramifications for the broader economy as a whole.
The non-financial corporate sector, much like its household sector counterpart, has only experienced a slowing in leverage assumption, as opposed to outright contraction, through 3Q of last year. As you can see in the chart, in the prior two recessions, the non-financial corporate sector actually engaged in net debt reduction/deleveraging. We think it’s a very safe bet that that occurs again in the current cycle.
The dramatic drop in debt assumption is occurring now. The markets know this and we believe have priced this in. What remains to be discounted is once again the magnitude and duration of the net debt contraction that we believe lies dead ahead.
Collectively the data points we have briefly reviewed above are strongly suggesting that a broad based deleveraging process has not yet gained maximum wind speed. In fact, in strict definitional terms, the real deleveraging process has not even yet begun— outside of the asset backed securities markets as a component of the financial sector. As of 3Q 2008, quarter over quarter total US credit market debt grew by almost $730 billion. YTD that number is just shy of $2 trillion in growth.
Of these numbers, federal debt grew $525 billion in 3Q of last year (accounting for 72% of total US credit market growth) and $675 billion YTD (accounting for a third of total credit market growth) at that time. We will not belabor the point as we discussed it many a time last year, but we all know Federal debt is set to mushroom ahead. A little preview of what may be to come in comparison to past experience lies below. Talk about the antithesis of deleveraging.
In summation, debt growth throughout the broad US economy, exclusive of the asset backed securities markets (that is in clear deleveraging mode) and the Federal government (that is in clear leverage acceleration mode), has merely slowed, but not yet gone into net contraction. As per the nearer term directional trends seen in the charts above, it appears households and the non-financial corporate sector are either in or will enter the process of net leverage contraction (deleveraging) very soon. Consumption, production and price deflation trends in a number of asset classes (primarily residential real estate and equities) has occurred up to this point against a backdrop of household and corporate debt growth that is only slowing.
Just what will happen if/when household and non-financial corporate leverage begin actually to contract in nominal terms? That’s the key question for us as investors over the quarters directly ahead. The markets have priced in sector implosion (financial sector) and the potential for a recession of a mid-1970’s/early 1980’s magnitude. But, the broad deleveraging process has really just begun.
We have a very hard time seeing this process truncated in the quarters ahead [[or even merely accelerated to its conclusion, as the Fed is trying desperately to do: normxxx]]. The potential clearly exists for a multi-year reconciliation process. Have the markets already priced in a multi-year deleveraging process, with specific emphasis and implications as per consumers?
That we do not believe has happened, except maybe in the Treasury market. You already know we will be monitoring and discussing these very issues as we move forward. Deleveraging is scarcely done with. As you can see, it has barely begun.
Moving Toward A New Normal? …We all know by now that Microsoft missed its 4Q 2008 earnings a few weeks back. Moreover, for the first time in their history they are beginning to reconcile labor costs, as are so many firms domestically. But probably the most important aspect of the Microsoft announcement we believe simply did not receive enough headline attention, as it had absolutely nothing to do with earnings or layoffs.
Getting to the point, we want to quickly cover a very brief comment made by Microsoft big cheese Steve Ballmer with the earnings report. Without sounding melodramatic, we have to hand it to Ballmer in a big way. As we see it, his comments were absolutely spot on regarding what we believe is one of the key macro themes of the moment. We’re convinced by these simple comments that he gets it in a very big way. Sorry if you have already seen these comments, they are just so dead on we had to reprint them.
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We never thought we’d say it, but BRAVO Mr. Ballmer. You hit it right on the head thematically, baby. We're moving to a "new normal" for the economy and corporate profits. That’s exactly what is occurring, as far as we are concerned, and this is the exact set of circumstances the equity markets are in the process of adjusting to and discounting right now. Late last year we ran a series of charts comparing the longer cycle of total credit market debt growth in the US relative to the like period directional movement in after-tax US corporate profits. A snippet is seen below.
Like Ballmer, we are convinced that the recent credit cycle clearly enhanced corporate profits and lifted asset values, both physical and financial. Our question at the time that still stands today is, "what happens to profits, and by extension US GDP, in a credit reconciliation process of perhaps generational magnitude?" Wouldn’t ya know it, Ballmer seems to be asking the same question. We have the distinct feeling this theme will be one of the most important to investment decision making and economic outcomes in the year ahead, and will gain in popularity as it works its way into consensus thinking. [[Well, we are already talking about a $10 trillion economy— down from a $14 trillion economy: normxxx]]
Click Here, or on the image, to see a larger, undistorted image.
We believe that the gigantic credit cycle of the prior period was a massive anomaly. That anomaly raised US nominal GDP, corporate profits and asset values to levels they never would have experienced in the absence of maniacal credit creation [[thanks largely to Alan Greenspan and, latterly, GWB: normxxx]]. Now that the meaningful deleveraging process we have been ranting and raving about is being evidenced all around us and is really still in its infancy, we believe the US economy, corporate profits and asset values are in the process of shifting downward to a "new normal". [[So, we can really anticipate a "new" economy— but of much smaller size than the old!: normxxx]]
This is what the current equity bear market is all about. Corporations are adjusting to this new normal by cutting costs as their revenues shift downward. Households are adjusting [[to this huge reduction in credit: normxxx]] by massively lowering their intake of leverage and consumption, and, we believe soon, even by paying it down. Even Ballmer recognizes the anomaly is over and is acting appropriately as far as Microsoft is concerned.
When will this most important of messages and conceptual thinking make it to Washington? Answer: Don’t hold your breath, okay? After all, everything we've seen from the powers that be so far suggests to us they have absolutely no intention of 'adjusting to a new normal', but rather are doing everything in their power to recreate the old anomaly.
[[And who wants to break the news to the American public that they must now settle for a much reduced standard of living going forward!?! Shades of the late '30s and '40s! : normxxx]]
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Homes For The Holidays
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By ContraryInvestor.com | 28 January 2009
Homes For The Holidays… Unfortunately, yeah, and plenty of ‘em. It’s an understatement to suggest residential real estate was either directly or tangentially very important to both economic and financial market outcomes in 2008. It has been the cornerstone of solvency, or lack thereof, in so many quarters of the financial sector. And as such, has had profound influence on the character of the US and really global credit cycle.
It’s been a while since we’ve checked in and all of us know that residential RE will continue to be a key macro economic health watch point as we move into the New Year. The current reconciliatory cycle drag that is residential real estate affecting financial sector balance sheets, household balance sheets (and P&L's for that matter), etc. is not about to dissipate in importance to macro economic outcomes in 2009. You’ve seen what has happened recently as the Fed has gone into a good bit of hyper drive in terms of trying to financially engineer at least some type of stabilization in what continues to be a downhill journey for the asset class.
They’ve allocated $600 billion to essentially buy agency debt (Fannie and Freddie paper) in the hopes of getting and keeping US conventional mortgage rates down. And so far that has indeed happened as post the establishment of this new Fed investment endeavor, conventional 30 year fixed mortgage rates dropped a good 100 basis points, plus or minus, in a matter of weeks. We’ll spare you the graph, but in recent weeks we’ve seen new mortgage applications and refi apps spike meaningfully higher.
Mission accomplished by the Fed? We’ll see, as we need to remember that a lot of folks with rate-locked in-process loans could only have taken advantage of these new lower mortgage rates by canceling the prior loan and writing a new one, probably with another mortgage vendor, which naturally would count as a "new" mortgage or refi app in recent data. Hence, there may be a bit of anomalistic higher counts in recent weeks due specifically to getting around the prior rate lock issue, so we’ll need to continue watching the data in the months ahead. Lastly, and you may know this already, China and a few foreign friends have been big sellers of government agency paper since the summer of this year. The $600 billion the Fed has already so generously provided is in part simply offsetting current foreign selling of US agency paper.
Additionally, the Fed followed up the $600 billion down payment, if you will, in trying to spark housing price stabilization/reacceleration with an announcement that they would like to put a program together (through wonderful taxpayer sponsored Fannie and Freddie) to provide 4.5% 30 year conventional loans to new home buyers. After all, it is the season of giving, no?
Bottom line being, the Fed is starting to pull out all the stops to arrest home price contraction. Upping the ante in a big way relative to prior efforts. We expect the Obama regime to likewise address this issue, and perhaps forcefully. They’ve suggested rewriting existing mortgages, but that enters into the very dangerous and cornerstone area of contract law.
Key question for both our economic monitoring and investment decision-making ahead then becomes, can the US government decree/legislate/manipulate home prices higher, defying the natural laws of asset class supply and demand, as well as character and path of a generational credit cycle now in reconciliation? Defy? We doubt it. Temporarily arrest? The correct answer is, we’re going to find out. Important in that, as we all know, the locus of initial US credit cycle trauma was the mortgage securities markets.
Residential real estate was also the locus of consumer credit creation this decade [[to 2007: normxxx]] and a current key driver of household net worth decline, certainly along with equities, influencing household financial well-being. Lastly, we need to remember the importance of investor psychology and bear markets as this applies to housing. Any even temporary stabilization in residential real estate would echo in positive psychological influence to the financial markets. All part of the ebb and flow of cycles in both financial markets and investor psychology.
A few macro overview observations about just where we are in the cycle itself. Cutting to the bottom line, at least in our minds, inventory and price remain the two largest cyclically unresolved outstanding fundamental issues for residential real estate at the moment. Once inventories at least get in line with historical precedent and prices stabilize, then we can begin to anticipate a better tone to mortgage credit markets, the housing industry itself, consumer well being and hopefully the macro economy.
It’s when housing stabilizes that the unprecedented stimulus being force fed into the system by the Fed/Treasury/Administration may begin to bite and gain traction. Let’s get right to a few simple and self-explanatory views of life. The following is a four and one half decade view of median family home prices relative to median family income.
To get back to the average level for this ratio since 1963 (the red line in the chart), median home prices would need to drop roughly another 12% from current levels. And of course this assumes the cyclical correction stops at the historical average. Let’s face it; we’ve already lived through a lot of price correction. The problem clearly is that other factors are weighing on residential real estate prices at the current time. Weak labor and wage growth, a coordinated global economic downturn of historical significance, and a credit market contraction of very meaningful magnitude is colliding with a housing reconciliation cycle, arguing the relationship above being arrested at the average of the last four and one half decades may be wishful thinking.
Is the Fed essentially trying to speed up the reconciliatory process implied by the above relationship in manipulating the important plug factor in the real estate equation that is financing costs? Of course this is exactly what they are doing. Whether they will be successful is the unanswered question. And in good part that depends on the ability of inventory to clear as a result of the character of both price and financing costs.
Let’s move right on to the also important issue of inventories. In the past we’ve shown you a lot of raw numbers when looking at this data. Time to stop that. Below is a look at the number of homes listed strictly as "for sale" properties (in other words this does not include second homes, rentals homes, etc.) at the current time. This go around we compare these per unit of inventory for sale numbers to the total US population to get a sense of historical perspective.
We’ve heard "everybody’s gotta live somewhere" a million times by those trying to bull up the residential real estate markets over prior years. And since the population is ever growing, comparing current nominal inventories to past cycles is misleading because of the dynamic of population growth. Oh yeah? Well now we’re looking at the number of homes for sale relative to "everybody". Any questions?
As the chart tells us, when looking at per unit for sale residential homes on what is essentially a per capita basis, we’re looking at a current level that is just shy of twice the historical average of the last four-plus decades. Yes indeed, everybody needs a place to live. It’s just a good thing there are so many places to choose from at the moment relative to historical precedent, no?
The last chart characterizing current residential real estate inventories very much mirrors the directional pattern of what you see above. It’s very simply the number of vacant single-family homes relative to all single-family homes. Bottom line? We’ve never seen anything like current levels. Residential real estate as an asset class cannot begin to fundamentally recover until the inventory 'clears', and this is far from an "all clear" view of life. Seems a matter of relatively basic common sense, no?
House That Again? …Before concluding, a few last housing related anecdotes we hope are of some interest. As per the comments above, we know that fundamentally housing prices and current residential real estate inventories remain open question mark issues. And the home building industry is more than aware. This is a very good thing in terms of cycle reconciliation.
As of the latest data, housing starts rest near half century lows in nominal terms. Residential real estate construction has essentially collapsed. Existing inventories and price have been very strong drivers of this collapse in new activity. Years of demand were more than satiated in the prior mortgage credit cycle. The view of per unit starts is seen in the top clip of the following chart.
In the bottom half we look at starts again as a percentage of the total US population. A new record historical low at recent levels. Clearly existing inventory remains the issue for real estate, not new inventory. As existing inventory clears, the asset class will heal. That process is well underway. The Fed just wants to speed things up a little with a big bit of financial engineering. Of course financial engineering has worked so well for them in the past, right?
Finally a very simple update of macro US homeowner equity as a percentage of the market value of real estate. You already know this ratio has been plunging for many decades now, plumbing new depths at an accelerating rate with each passing quarter over the last two to three years. The Fed has been quite kind to recently manipulate credit market mortgage costs downward, but only the real economy and real world residential real estate cycle can change the trajectory of what you see below. And this is the key to credit market collateral values, a sense of household financial well being, access to real estate based consumer credit, etc. Important? Yeah, we'd say so.
As we look at the chart above and contemplate what may be to come ahead, we again come back to the macro issue of deleveraging, running through the domestic and global economy. How do homeowners act to turn the trajectory of the relationship you see above upward in an otherwise very tough pricing environment? Deleveraging. Paying down mortgage debt.
We're pretty convinced US financial sector deleveraging is well underway and more than discounted by the markets. Alternatively, we'd suggest household deleveraging is more just getting started in comparison and we believe has a long way to run. We expect this will be a major macro theme for 2009.
Have the markets completely discounted this thought? We're simply not sure at this point. Residential real estate was incredibly important to economic and financial market outcomes in 2008. We expect exactly the same in 2009.
The message of the data above is clear, price and inventory cycle reconciliation is not yet finished. What is also clear is that the Fed/Treasury/Administration are stepping up their efforts as we walk into 2009 to truncate the unfinished cycle reconciliation at almost all costs. Although we'll save this for a future discussion, we're not only focused on the importance of residential real estate in our current economic and financial market circumstances and how it will influence the financial sector, credit cycle dynamics and the real economy, but place enormous weight on the assured unintended consequences of the Fed/Treasury/Administration's efforts to truncate the natural cycle. The markets know what the Fed/Treasury/Administration are doing and are discounting these known actions in financial market prices. But it's the "at almost all costs" unintended consequences of this truncation attempt that may indeed be most important to 2009 investment decision making.
M O R E. . .
Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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