By Contrary Investor | April/May 2010
The average credit contraction experienced by quarter was close to $300 billion over the entire last year. If the Fed stops the 'printing' accommodation, will banks pick up the slack and lend $300 billion+ each quarter just to keep the money supply stable? Our prediction is that as the Fed stops the balance sheet expansion, at the first sign of M2 contraction the Fed will have a very tough time simply standing back and 'watching'.
Remember, it's not really even which assets they buy that's important, it's just that they create (deposit) balances for the non-banking sector so their actions are additive to M2 that is the key issue. You already know that, academically, money contraction is deflationary. Something we have not really lived with since the 1930's Depression. And our friend Mr. Bernanke has assured us that that will never happen again. So we can only assume that money printing will, instead. So, THE important issue is what will that event mean for investor behavior, asset class movement, etc.
Even if we strip away the financial sector and look at households singularly, the question of 'credit cycle reconciliation' looms very large. The following is simply an update of a combo chart we have shown you in the past, but absolutely speaks to the fact that it appears we are only in the early innings of household balance sheet reconciliation. In the recession of the early 1980's, household debt relative to GDP was less than 50%. In the 2001 recession it was roughly 65% and at the peak during the most recent recession, it was above 95%.
We've drawn in what we believe to be an appropriate trend line for the entire period and would not be surprised at all if this ratio at least fell to that line in the current cycle. That's still a long way down. If debt is to be repaid, then that's a lot of dollars that could have gone into consumption or investment. But if some or a good portion is defaulted upon, then the downward pressure on M2 will be even more significant.
The top clip shows us that from 1946 (at least) through 1999, households held more cash than they had liabilities. It was only from 2000 to the present that this number has been negative. It's simply representative of the dramatic leverage households took on over the last decade. And now that the asset side of their balance sheet has been hit hard, we expect meaningful reconciliation still to come as we have really only so far come up off the extreme lows.
Lows probably thought totally improbable even ten years ago. Please remember that our definition of cash includes everything from household bank accounts to CD's to all household bond holdings (record purchases in 2009), etc. We load the proverbial boat in terms of defining cash and really only exclude equity, pension balances, insurance policies and real estate in the definition. And still the numbers are eye opening.
Point being, we believe households will continue to exert very meaningful downward pressure on M2. Again, we don't know how on earth the Fed can stop printing money when financial sector and household balance sheet reconciliation is only modestly down from record levels and nowhere even near their longer term averages since 1980 (forget going all the way back to the 40's or 50's). The next (updated) chart has little to do with leverage specifically, but a lot to do with what got households to lever up so maniacally over the past decade.
We're looking at household net worth as a percentage of disposable personal income. The numbers go all the way back to 1946 and we've calculated two averages— one over the entire period and one during the conservative period from 1946 through 1994. Of course we've drawn in these two averages as a range (the dotted lines). Magically we find ourselves right in that historical average range right now. Exactly as one would expect over longer-term cycle movement.
So what does all this mean? What this means to us is that it took asset bubbles to induce households to embark on a generational leverage binge. It took household net worth going off the historical charts relative to income to produce an increase in household leverage that also went off of the historical charts. First equities, then residential real estate.
And of course the housing part of the equation was "net worth" that households could lever and monetize for 'here and now'— immediate— consumption, making leverage acceleration all the more enticing [[especially as incomes remained flat to declining: normxxx]]. As we look ahead, the obvious question stands out like a sore thumb— in the absence of another household asset bubble forming, just what will induce households to leverage up well beyond historical averages, and essentially support M2 growth in the process of leverage expansion?
We do not know the answer. Probably, no one knows that answer. This is exactly why the Fed/Treasury/Administration are hell bent on reflation. No matter what, that's not going to stop unless the global capital markets call the tune.
We're sure you get the picture. The process of leverage reconciliation necessarily involving credit defaults is not over in the private sector, especially at the household and financial sector levels. Moreover, it's very hard to argue that either households or the financial sector are ready to embark on any type of renewed leverage/credit cycle expansion. Neither of these two sets of circumstances will be supportive of M2 growth.
Over the last eighteen months of historic money printing and asset purchases by the Fed, Fed actions have only been just able to offset this absolutely well defined private sector debt destruction reflected as the lack of equivalent M2 growth. So if the Fed walks away now on money printing, it seems M2 will rapidly decline as private sector credit contraction continues— that latter basically a certainty as per the current period trends and numbers. Again, as we see it, the Fed will be back to manning the printing presses well before the current cycle is over.
Stay tuned, as you know we'll be watching the blow-by-blow action. We believe that watching the dollar and Treasury yields near term will be the key to equity outcomes. Likewise, watch gold, as rationally we would expect it to anticipate a Fed money print restart long before the presses are warmed up.
We are absolutely convinced that there is little to no chance the Fed can stop printing money and/or the government stop borrowing and spending until private sector credit turns positive and accelerates. Either the private sector borrows or the government does. Either the private sector borrows and effects money supply expansion, or the Fed carries the load. We believe it really is as simple as that.
We know that up to this point monetary and fiscal policy has been unequivocally aimed at trying to 'restart' the credit cycle and inflate household assets. Cash for clunkers and the home buying tax credit were framed to 'incentivize' folks to borrow for homes and cars. Great while it lasted, right? But what about an encore?
We believe this restarting of the credit cycle is key to real economic recovery, or otherwise, near term— unless monetary and fiscal stimulus is limitless— which we all know it's not. And, moreover, increasingly such stimulus comes with very meaningful negative longer term consequences with each passing day. So far, the Fed has failed at restarting private sector credit expansion and getting the money supply to grow, but has been very successful at inflating financial asset prices.
The first chart below shows us what we believe is the very important linkage between household asset values, household income, and the greater household credit cycle. We believe that this relationship shows us that when household assets are inflating faster than household income, households are much more likely to leverage up than otherwise. This is exactly why the Fed is hell bent on reflation— it's the only way to restart the credit cycle!
And if that means goosing the stock averages— since real estate is turning out to be the 'immovable object'— then so be it. The blue bars we marked in the chart depict those periods where household net worth (asset values) was not growing in excess of income, and low and behold, these were also the exact periods where household debt relative to GDP stayed flat.
Moreover, as we see the numbers and interpret the chart, it's the asset inflation relative to income that leads the leverage expansion. This is the key point. And this is exactly why the Fed is trying to reflate stocks because they already know real estate is a non-starter and will be a further drag.
Of course the early part of the last decade watched the household net worth to income ratio decline, but leverage was just starting to skyrocket as cheap mortgage credit laid the seeds for the next asset and leverage bubble. So fast forward to the present where net worth to income has descended to average levels of the last three to four decades (as shown above) and personal income is under pressure exclusive of government transfer payments. Unless the Fed can massively inflate household assets from here, the chances of starting another household credit cycle of significance appear slim at best. Attempts to reflate housing have been a failure and will continue to be until the leverage is cleared, which is a long way off. That leaves equities as the inflation object of choice, as if you didn't know.
Finally, a look at the relationship between household asset inflation and personal savings. Important, but why? As a choice with available personal income, saving is clearly one alternative in addition to consumption and debt repayment. Healthy competition, no? We believe the chart below reveals the historical 'truism' that the savings rate has increased during periods where household net worth relative to income has declined, and vice versa. This is exactly the directional relationship shown.
The net worth to income ratio is now back to the area that has seen average activity over the last half century. Gone are the twin net worth to income bubbles of the 1994-2008 period. And with this the saving rate has turned up with relative vigor. We're back in an area of net worth to income where— at least pre-1994— we have seen the US savings rate in the 8%+ range.
Is this where we are headed in the current cycle? Stay tuned. The bottom line is that this relationship tells us that savings will be in serious competition with consumption and deleveraging for the household income dollar. A competitor that has really not been in the running for close to several decades now. Maybe the 27% of the folks in the EBRI survey will double their retirement savings to $2,000. It would be funny if it was not so sad.
What the reality of personal income and household asset values tells us is that the current cycle is very different than anything we have seen in quite some time. Really in our lifetimes. Organic income growth has not yet been seen. We have a $700 billion personal income (excluding government transfer payments) chasm between current levels and 2007 prior cycle highs— not that it is preordained in the heavens that this gap must close.
We also have a Fed and Administration fighting to the death to restart a household credit and asset inflation cycle using unprecedented means. We do not think they will stop voluntarily anytime soon. As a result asset distortions are a reality and again, it's ultimately the unintended consequences of these circumstances and actions that will be most important to longer term investment decision making. Watch out for 'incoming', okay?
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