From The Contrary Investor [18]
The Cliff Notes
Certainly we’ve started 2012 with a better tone to a number of economic indicators. Employment numbers have strengthened, leading economic indicator series have trended higher, and there’s even a little bit of life in housing as many former savers have now become mom and pop landlords in the effort to achieve some type of rate of return in what essentially is a Fed sponsored yield starved environment. If you’ll remember, this is very similar to the landscape seen at the outset of 2010 and 2011. What’s decidedly different at the outset of 2012 is the very much anomalistic warm winter we’ve experienced. Important as warm weather has allowed macro economic activity to be a bit more vibrant than would otherwise have been the case in the first quarter of the year. Think construction, housing activity, more money in consumer pockets saved via lower home heating energy costs in a less cold winter, etc. Moreover, most headline economic numbers have been perceptually pleasing as so many statistics are massaged by what are termed “seasonal adjustments”. Since the government and other providers of the body economic factor in seasonal weakness based on winter weather at this time of year, the very absence of cold weather can easily act to overstate the perceptual reality of overall economic tone in what continue to be seasonally adjusted numbers presentations. We’ll know soon enough as we move into Spring whether weather has been a perceptual distortion agent over the last quarter, or otherwise.
One way to attempt to see through these seasonal adjustments is to look at very simple year over year trends. Here are just a few:
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We’ve tried not to “cherry pick” these data points and quite necessarily have included a few directly related to US households for a very important reason. Important issue being, there are no “seasonal adjustments” being made in these numbers. The year over year directional trajectories are clear. For now, they do not paint quite the same overall message as shorter term seasonally adjusted stats.
As we’ve written about many a time, credit is the lubricant that makes really any economy move forward. In a generational credit cycle deleveraging environment, which we believe is still the correct macro, if credit contracts in one sector of the economy, that contraction must be offset by another sector continuing to take on leverage at a rate at least equal to the sector contraction in question simply to keep macro economic growth stable. To the point, Government sector credit (debt) expansion has offset household credit contraction in the current economic cycle so far. But that may be about to change in a very meaningful way directly ahead.
So far into the current year, the markets and investors specifically have been primarily focused upon all of the “unexpected” good cyclical economic news, news that in at least some part owes its character to much warmer than usual winter weather and the perhaps overly enthusiastic message exuded by seasonally adjusted economic stats because of this anomaly. This, along with continued (and quiet) Federal Reserve balance sheet expansion, in conjunction with collectively unprecendented and simultaneous central bank money printing in China, Europe, England and Japan has raised financial market animal spirits and dulled the sense of risk. The following chart is a look at the S&P 500 set against the 13 day moving average of the VIX indicator. In popular parlance, the VIX is the “fear” indicator. In actuality it measures the implied volatility of S&P 500 index options. The lower the reading, the less concerned are investors about forward potential price volatility, and vice versa. Historically, low readings have often been associated with interim market tops just as high readings have been associated with important near term price lows. The current message is that investors are not too concerned at all about forward price volatility as this moving average of the VIX rests near five year lows. Investors are relatively complacent.
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But being somewhat of a contrary indicator, we’re back to the lows in this indicator recorded since 2008. At least so far in the current cycle, each of these lows occurred very near important interim equity market highs? Will it be so again? Regardless of what lies ahead, this indicator is suggesting investors are now as little concerned about forward volatility as was the case at both the 2010 and 2011 interim equity market highs.
The reason we're bringing this up is that beyond the better than expected seasonally adjusted economic stats of the moment lies what has been termed the “fiscal cliff” for the US. To the point, you’ll remember that at year-end 2011 what have come to be known as the “Bush tax cuts” (think dividend and capital gains tax rates) were extended for one more year, as were payroll tax cuts and extended unemployment benefits. Secondly, you’ll also remember the 2011 melodrama over the US Government debt ceiling, which by the way has been violated five times to the upside since. At the time Government spending cuts under a fiscal consolidation agreement were passed, but not set to go into effect until the beginning of next year. Given that the Super Committee convened to address this spending cut issue came up empty handed last December, unless legislation is changed prior to year-end the agreed upon Government spending cuts will take effect on the first day of 2013, hence the characterization “cliff”.
As it now stands, the US economy faces a “fiscal cliff” in early 2013 – meaningful Government spending cuts AND tax increases at the household level. Nothing like a double whammy, now is there? Unquestionably this is one of the reasons why the Fed has pledged to leave short-term interest rates low for some time. So what happens if nothing is changed and both tax increases and spending cuts are allowed to materialize? Although it’s an approximation, the deadly combo could shave 1.5% plus from US GDP next year. Estimates from the Congressional Budget Office are for a more meaningful contractionary impact. And that’s before the ultimate global economic fallout influence of Europe and China slowing.
But there is a larger and very important issue beyond this, although the “cliff” is something investors will not ignore and could be very meaningful to forward economic and financial market outcomes, especially given the relative complacent market mood of the moment. Think back to comments at the outset of this discussion. For an economy to expand, overall credit acceleration in the economy is a necessary ingredient. The “cliff” ahead suggests that the Government will not be the key credit acceleration provocateur it has been since the start of the current cycle back in 2009. With household taxation set to increase and automatic Government spending cuts to take effect in January of next year, total Government borrowing needs will drop by these revenue raising initiatives. So if the Government is set to slow its borrowing, remembering the truism that total credit must expand for the overall economy to expand, just what economic sector will step up to the plate and increase its borrowing (and spending)?
Will corporations increase borrowing? Not likely. They have already partaken of the nectar of generational lows in interest rates. Although many a corporation is flush with cash, total corporate debt relative to GDP stands near an all time high. Only to be expected as corporations have already had the chance to borrow at once in a lifetime interest rate lows. So that leaves households as the only other sector that could offset the academically negative impact of the impeding Government sector driven fiscal cliff/credit contraction. Are households up to the task of taking on more debt?
This demands a bit of analytical digging given that recent superficial Wall Street as well as mainstream analysis has been suggesting household deleveraging is now over and consumers are once again borrowing. Is this really true? We’ve seen too many analysts/strategists point to the year over year growth in total consumer credit that now stands at 4.9% as proof positive households are now once again borrowing. Unfortunately, Government student loans are included in the consumer credit totals that have completely skewed the message of the headline numbers in this cycle due to the unprecedented magnitude of Government student loan grants.
The following chart looks at headline consumer credit numbers as they are reported (top clip) and the numbers adjusted for the anomaly that has been student loan growth. Two very different pictures collectively proving to us that stripped of the influence of student loans, there has been no increase in consumer credit at all. Even to this day the year over year rate of change remains in negative territory as it has over the entirety of the cycle so far. Unfortunately, you’ll never see this chart on CNBC.
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If we look at the other largest component of household debt that is mortgage debt, the numbers and trend are clear in that mortgage debt has contracted each and every year since 2008. Unfortunately in the household mortgage balance numbers from the Fed there is no delineation between pay down of debt or default. Certainly the bulk of mortgage balance contraction in the current cycle has been default. To hopefully get much clearer insight into the current household psyche regarding household debt, we think the mortgage refi numbers help a lot as points of character. Specifically the levels of cash out and “cash in” refi activity. The following chart is self explanatory. As of 4Q 2011, the level of cash out refi’s resulting in 5% or higher new loan amounts fell to the lowest level in the history of the data. Moreover, the level of refi activity resulting in a lower loan balance (essentially a “cash-in” refi) rose to the highest level ever recorded very near 50% of all refi activity. It sure appears that this indeed continues to be deleveraging 101, and not the picture of a household sector all set to lever up anew. Exactly the opposite as this is direct debt pay down.
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In the first table presented in this discussion, have a look at the year over year rate of change in real (household) consumption and personal disposable income. Again, these are not the numbers we’d associate with a household sector on the brink of balance sheet expansion, quite the opposite.
This is exactly why the “fiscal cliff” issue is not to be brushed off. Is this the next point of worry for investors that will send the VIX to higher ground? We’ll see. Personally, we do not expect the fiscal cliff to actually occur as per current legislative mandate. Not a chance when self preservationist concerned politicians are involved. If we had to guess, these tax increases and Government spending cuts will be phased in over a series of years in the final outcome. But we’ll suggest to you that THE key to forward financial market and economic outcomes is what happens between now and reconciliatory legislation is passed.
We need to remember that over the past two to three years, it is very fair to say that political decision making on key issues can be correctly characterized as 11th hour at best. Just in time political decision making? Something like that, but this type of behavior necessarily breeds uncertainty and anxiety. The reality is that in this election year, it’s a very good bet politicians will dither and do nothing about the fiscal cliff issue until after the elections. So will investors calmly sit by and serenely await the 11th hour political mud slinging as we approach the proverbial cliff, never raising a concern about the ongoing rhythm of economic healing, corporate earnings growth, etc.? Will business decision makers look past a key issue such as this with never a passing concern about what may be in store for their own business prospects? Or will a certain sense of anxiety begin to express itself in financial asset prices as well as real world economic decision making?
Although we’ve experienced a bit of headline improvement over the last six months, the US private sector is not growing at a current magnitude sufficient to offset a potential contraction in early 2013 Government spending. Additionally, will the US employment base achieve a lift in wages enough to offset forward personal tax increase mandates? At current rates of wage growth, not likely. The important issue we want to leave you with is to be aware of the facts and anticipate potential investor and broader economic reaction to the fiscal cliff issue as the current year unfolds set against what will certainly be the volatile ongoing rhythm of political rhetoric and decision making.
For now, in historically low territory, measures such as the VIX are telling us investors do not expect many volatile ripples ahead. Alternatively, if there has been one truism in the financial market and economic cycle up to this point, it’s that we continue to be in a bull market for price volatility both on the upside and the down side. The time to contemplate investor and economic reaction to the fiscal cliff issue is while no one else seems to be currently addressing or concerned with the same. Before it hits the front page, you’ve been put on notice via the “cliff notes”.