Rosenberg Takes On The Student Loan Bubble, And The 1937-38 Collape; Summarizes The Big Picture
Few have been as steadfast in their correct call that the US economy sugar high of the first quarter was nothing but a liquidity-driven, hot weather-facilitated uptick in the economy, which has now ended with a thud, as seen by the recent epic collapse in all high-frequency economic indicators, which have not translated into a market crash simply because the market is absolutely convinced that the worse things get, the more likely the Fed is to come in with another round of nominal value dilution. Perhaps: it is unclear if the Fed will risk a spike in inflation in Q2 especially since as one of the respondents in today's Chicago PMI warned very prudently that Chinese inflation is about to hit America in the next 60 days. That said, here are some of today's must read observations on where we stand currently, on why 1937-38 may be the next imminent calendar period deja vu, and most importantly, the fact that Rosie now too has realized that the next credit bubble is student debt as we have been warning since last summer.
First, Rosie on the big picture:
An Accounting Of The Macro Risks
We have been on the receiving end of endless analysis suggesting that double- dip recession risks in the U.S. are either zero or completely trivial. The primary reasons given for this view are: the positively sloped yield curve, negative real short-term rates, no sign of inventory excess and no sign of a flattening in the trend in the leading indicators (aside from the Economic Cycle Research Institute's weekly leading index).
Not too long ago, we were sent one particular Street report that began with a comment on how the analysis incorporated data from the last eight recessions in the United States. But why are these eight recessions in the post-WWII era relevant? This past recession was not just a blip or correction in GDP due to a manufacturing inventory-led recession, it was a traumatic asset price deflation and credit contraction of historic proportions.
Take us at our word, if Ben Bernanke is worried, it is not about what drives a post-WWII cycle. He has the 1937-38 brutal downturn in mind and this is actually a much more appropriate template, notwithstanding the changed structure of the economy.
Heading into both the 1937-38 and the recent downturn, there was no sign of inventory excess (prior to the '37-'38 recession, inventories contributed 20% to the economic expansion; in 2009, it was over 60%). And, going into the 1937-38 meltdown in the economy and the stock market, the U.S. yield curve was positively sloped to the tune of 240bps. But why do so many cling to the "yield curve" in a credit cycle in any event?
Just as the flattening yield curve and tightening Fed (the funds rate did rise 425bps) were no match for the parabolic credit expansion from 2003 to 2007, it would seem foolhardy to revert to the yield curve's steepness today as some bellwether leading indicator when we are on the other (darker) side of the credit cycle. At best it gives the banks another way to generate low-multiple trading profits, and that's about it.
Moreover, where were "real" short-term interest rates heading into the unexpected 1937-38 collapse? How about minus 200bps? What was at play in that recession was not inventories, the curve or real rates — it was the sudden withdrawal of fiscal support after years of massive New Deal stimulus.
Let's look at the situation from a top-down view. During this statistical recovery from the 2009 bottom, real U.S. GDP growth averaged 2.4% at an annual rate, and of that, 0.7 percentage points came from inventories. Excluding inventories, otherwise known as "real final sales" average annual real GDP growth was 1.7%, on average — is the weakest post-recession recovery on record. This despite a 10% deficit-to-GDP ratio, a government debt-to-GDP ratio rapidly heading to 100%, a near zero Fed funds rate, record low mortgage rates, an unprecedented tripling in the size of the Fed balance sheet, shifting accounting rules to help rejuvenate profit growth in the financial sector, cheap and easy FHA financing to virtually anyone who wants to buy a home, relentless government pressure on banks to modify defaulted loans and bailout stimulus galore.
Well, what's past is past. Where are we going? It's pretty clear from the manufacturing components of the last payroll report and the latest ISM index that the inventory cycle is either reaching its peak or it already has.
We can see from the latest auto sales report and auto buying plans in the confidence surveys that the bolstering economic impact from the revival in the motor vehicle sector has run its course.
As for housing, sales and mortgage purchase applications are still languishing despite mortgage rates at record low levels and this also attests to the degree of excessive demand from the prior bubble that is still being worked off. Moreover, commercial construction is beset by high and still-rising vacancy rates in the office and shopping centre space.
It would be nice to see an export boom but the overseas economies, to varying extents, are feeling the effects of last year's tightening in monetary policy (emerging Asia) or the current tightening in fiscal policy (submerging Europe). And, although the U.S. consumer is not exactly rolling over, spending fatigue seems to be setting in, along with a natural rise in the personal savings rate.
Perhaps U.S. capital spending will be a lynchpin, but at only 7% of GDP, it will contribute a handful of basis points to headline growth.
Then we come to the near-20% chunk of the U.S. economy, the government sector. Two-thirds of that comes from the beleaguered state and local government sectors, which are in a full-fledged retrenchment mode as it cuts services, raises taxes, and lays off civil servants to the tune of 10,000 month in and month out, to reverse the flow of red budgetary ink.
After contributing about one percentage point annually to OECD growth over the past three years, fiscal policy in the industrialized world is set to subtract the same amount in the coming year. In a world of small numbers, that's pretty big.
In the U.S., the fiscal withdrawal will be closer to four percentage points of GDP next year, unless more cans are kicked down the road after the November election. So, if the peak of inventory contribution is behind us, and all we have left is a baseline growth trend in real final sales of less than 2%, then economic contraction next year becomes a very distinct possibility. Besides, for any president, new or incumbent, it makes perfect sense to get the bad news out of the way in year-one of the election cycle than year four.
How the Gluskin Sheff strategist makes sense of it all:
What we have on our hands right now is a recovery built of straw instead of bricks. An economic expansion and bull market built on rampant expansion of the Fed and Federal governments' balance sheet is neither sustainable nor desirable. I am convinced that we will, before long, be replaying something along the lines of the reversal of the tech mania and the reversal of the housing mania, which were equally unsustainable.
Most importantly, Rosie's take on the student debt bubble.
The Next Credit Bubble
Could well be in student debt, where outstanding loans surged $117 billion last year to over $1 trillion. More than 80% of 18-24 year olds that have taken out college loans still have a balance and 30% have more than 20% owing. This overhang has far-reaching implications beyond Sallie Mae's balance sheet — it is also a reason why the young first-time homebuyer is notably absent from the real estate market and why this may well remain the case for some time to come as this key demand group works off the mountain of student debt before applying for a mortgage loan. For a sense of how this student loan saga is unfolding, also have a look at Trying to Shed Student Debt on page A3 of the weekend WSJ — as the deleveraging cycle is about to take on an entirely new deflationary dimension.
The lack of demand from the traditional first-time homebuyer group (the U.S. real estate market is really getting most of its underpinnings from investors buying up distressed units to then rent out) is compounding the inventory overhang that is, in turn, maintaining downward pressure on home prices in the vast majority of markets.
Take a look at page A2 of today's WSJ (Housing Ends Slide but Faces a Long Bottom): banks still own 450,000 foreclosed properties, there are another 2 million units right now in the foreclosure process and there are an additional 1.7 million homes in some form of delinquency. This means total supply (actual and potential) of over 4 million units and that does not include the near-record 3.6 million vacant units being held off the market for "unspecified reasons". This means a total vacancy rate in the owner-occupied sector of between 5% and 10% which is huge excess supply and likely a dead-weight drag on housing values for some to come, even if demand does manage to soon outstrip depleted rates of new construction.
Source: Gluskin Sheff