Guest Post: It's A Long, Hard Road

From Contrary Investor

It's A Long, Hard Road





If there has been one consistent theme since day one at CI, it has been our perhaps near myopic focus and focal point highlight of importance that is the macro credit cycle.  Does this play into long wave and perhaps Kondratieff cycle or Austrian economics type of thinking?  Call it what you will, but elements of all of these schools of thought very much overlap.  Right to the point, we believe THE key thematic construct to keep in mind as a macro cycle decision making overlay and character point dead ahead is the now more than apparent collision of the generational long wave credit cycle with the current short term business cycle of the moment.  Without trying to reach for melodrama, this is the first time a multi-decade long wave credit cycle has collided with the short-term business cycle since the late 1920’s/early 1930’s.  Most decision makers and Street seers of the moment have absolutely no experience with this type of a generational collision.  Moreover, our illustrious academician Fed Chairman has never even considered long wave or credit cycle based Austrian economics thinking in his and the broader Fed’s policy making – absolutely key and crucial mistake.  Although it’s just our perception, this will be Bernanke’s legacy Waterloo.  It also tells us directly that his only policy tool ahead will be more money printing.

We suggest to you that macro credit cycle issues did not end in 2009.  Certainly Europe is a poster child example of this thinking, but it absolutely also applies to what lies ahead for the domestic US economy.  We’ve only had a reprieve from long cycle reconciliation over the last few years due to historically unprecedented Government and Federal Reserve balance sheet levering, which itself is unsustainable longer term.  Has the election cycle played havoc with needed deleveraging reconciliation and simple identification of the underlying causes of current circumstances?  Without question.  Although it’s clearly a personal comment, we’ve been disgusted with the short-term focus and actions of politicians at the expense of longer cycle strategic domestic economic thinking and needed financial reconciliation.  These actions simply guarantee the deleveraging process will play out over a longer period than may otherwise have been the case.  A very important construct with direct implications for the tone and rhythm of the domestic economy over time.

Let’s start with a quick look at the following chart.  Just what issues do we need to keep in mind as a long wave credit cycle peak and ultimate reconciliation process collides with ongoing current domestic business cycle rhythm?  The first issue of importance to investment decision-making is that aggregate demand will remain subdued as the deleveraging process plays out.  Important to a Wal-Mart or a Family Dollar story?  Definitively important.  Of course the top clip of the following chart is probably the one graphic we’ve published the most times over our short existence.  Total US credit market debt relative to GDP.  As is more than clear, the process of total credit cycle reconciliation has barely begun. 

The bottom clip of the chart is one you’ve seen a number of times from us and we believe quite important to what lies ahead.  To the point, real final sales to domestic purchasers is GDP stripped of the influence of inventories and exports.  What we’re left with is as good look at domestic only GDP and as you can see, the year over year change in terms of growth in the current cycle is the weakest of any initial economic recovery cycle over the time in which official numbers have been kept.  Message being?  We are seeing very weak aggregate demand, exactly as one would expect in a generational credit cycle reconciliation process. 

We also need to remember that THE primary goal of the Fed and politicians has been to thwart the generational credit cycle deleveraging process to the best of their abilities while it is occurring, all in the interests of being reelected.  So as you look at the bottom clip of the chart above, remember that this is the growth in domestic economic activity in the current cycle that has occurred while the Government has borrowed $5 trillion and used the proceeds for increased transfer payments, cash for clunkers, help for those with mortgage problems, deals for appliances, etc.  And yet still we’ve experienced incredibly subdued domestic economic activity.  Just what would this have looked like in the absence of historic Government balance sheet leveraging?

The second issue clearly characterizing a generational systemic deleveraging event is that domestic capacity utilization (production) will remain very subdued.  As you can see below, at least as of now, capacity utilization remains at the lowest level ever seen in an initial economic recovery cycle over the entirety of the history of the numbers.  And "initial" is charitable as we’re now a full two years into the official recovery period.  Validating weak aggregate demand?  If not, then just what is it saying?

          


               

Please remember that in the current cycle, US exports as a percentage of GDP rest at an historic high.  Domestic production has benefited meaningfully from foreign stimulus.  And yet utilization rates of the moment look more like historic near recession lows than otherwise.  A classic fingerprint of a generational deleveraging cycle.

We’ll move through this next point in lightening speed as we’ve covered it recently.  In the current cycle, large corporations are in very good shape financially.  We do need to remember that non-financial corporate debt to GDP levels rest near historic highs, but the gift of a once in a lifetime low in cost of debt capital courtesy of the Fed offsets the nominal dollar debt heaviness.  But not so for households.  As is more than clear in the chart below, household debt relative to GDP rests just not that far off of all time highs even as of now.  And without question a good part of this balance sheet reconciliation so far into the current cycle has been achieved via default.  There’s a long way to go on the household balance sheet reconciliation front.  And it’s this unfinished reconciliation cycle that will continue to hold back aggregate demand regardless of Fed and Government intervention that only delays the inevitable.

Quickly, as we've recently discussed at length, the household financial obligations ratios appear as though household debt payments relative to income have already dropped meaningfully so far in the cycle, implying significant household leverage reconciliation.  But as we've explained the denominator used in the calculation is disposable personal income.  As we've shown you in chart format many a time, government transfer payments as a percentage of disposable income rest at historic highs at present.  These transfer payments are set to start dissipating very soon.  As of year end, 3.7 million will lose unemployment benefits after an unprecedented 99 weeks.  Their debt interest obligations are going nowhere.  The financial obligation ratio numbers just do not pass the smell test relative to the household debt to leverage ratio seen in the top clip of the chart.  The household balance sheet as well as Government balance sheets are the key deleveraging cycle issues that remain far from finished.  They've just been "papered over" during the last few years.

                    

Although it appears obvious conceptually, we're not so sure the markets yet fully appreciate the fact that in true generational deleveraging cycles, monetary policy is powerless to influence credit expansion.  Again, our near myopic focus on credit is driven by the fact that credit is the cornerstone of modern economic development and balance, and certainly not just in the US.  The character, availability and price of credit regulate the ongoing tone of aggregate demand, so monitoring credit is simply crucial.  If credit cannot expand, then neither can aggregate demand.  A simple yet key truism, especially in our current circumstances.  As you can see below, we've seen literally unprecedented monetary expansion so far in the current cycle, yet private sector credit creation (as is exemplified by the bank loans and leases outstanding) remains wildly subdued at best.  The whole pushing on a string thesis?  Exactly.
                         


                 

The bottom clip of the chart above has been adjusted for the $450 billion of off balance sheet bank loans that were mandated to arrive back on bank balance sheets as per FASB dictates in April of last year.  As is clear, bank loans and leases out since early 2009 have declined significantly.  The bulls have trumpeted the growth over the last three months.  You can decide for yourself whether this minor uptick is deserving of trumpeting, if you will.  To ourselves the message appears absolutely crystal clear.  In generational deleveraging cycles, Fed monetary policy is simply a non-event.  Rather monetary extravagence finds its way into inflation hedge assets and can be used simply to speculate.  Remember, as per Fed monetary largesse, the banks are sitting on $1.5 trillion of excess reserves as we speak.  Excess reserves can be used as collateral for derivative and futures trading.  You already know trading profits have been a crucial piece of bank earnings since 2009.  As of now, monetary policy has been completely ineffective in the current cycle in creating credit - the lifeblood of economic activity and growth - except in one instance.  And that instance lies below.  Of course we are referring to Government debt.                         

                    

In typical recessionary periods past, the Fed has been able to lower interest rates and stimulate demand for credit.  Demand for credit ultimately stimulates broad economic activity via an increase in aggregate demand.  But in deleveraging cycles as opposed to typical business cycles, interest rates can fall to zero and still not positively influence demand for credit.  This is exactly what has occurred in the current cycle.  You may remember from our discussions over the years we asked one question again and again, "is this a business cycle or a credit cycle?"  The only borrower of substance in the current cycle has been the Federal Government, yet we are currently reaching the limits of Government balance sheet expansion tolerance, as clearly witnessed by the debt ceiling melodrama.  This has only served to weaken the US as a credit.  Again, the inability to generate demand for credit by almost any means (and in our present circumstance historic means) is simply a classic fingerprint of a generational deleveraging cycle.

Finally, as a result of the inability of the system to generate credit creation, which clearly affects the real economy and manifests in very slow to no growth in aggregate demand, in generational deleveraging events unemployment remains stubbornly high.  And again this exactly characterizes the current cycle so far.

            



Never in modern history have we faced the type of domestic labor market circumstances we face today.  As we've tried to describe, monetary policy is powerless to change this.  If Mr. Bernanke was the true student of history he would fully realize exactly the circumstances we've described.  It's not that we don't have precedent.  The US in the 1930's and Japan over the last two decades are the model.  Looking at the Depression years and claiming the issue was that the Fed was not loose enough misses the key fingerprint character points of a generational deleveraging cycle completely.  Again, the refusal of Bernanke and friends to even acknowledge Austrian or Kondratieff economic constructs has been and will continue to be their policy making downfall.  Who knows, maybe all of this will find its way into the economics textbooks of tomorrow.  Let's hope so anyway for future generations.  But as the old market saying goes, people don't repeat the mistakes of their parents, they repeat the mistakes of their grandparents.

"We're Here To Help"...Again, we simply cannot overemphasize the importance of getting the big picture macro model right as we make investment decisions ahead.  Our primary goal is simply to stay in harmony with directional changes in financial asset and hard asset prices ahead, not necessarily making continual value judgments about policy.  But that does not mean that policy analysis is not important.  As we step back and look at the bigger cycle picture, it's clear that so far into the current cycle policy makers have been reenacting the playbook of recent history.  They have attempted to apply the "solutions" of what have been normal business cycle downturns to the current, which again is a generational credit cycle reconciliation overlaid on top of current business cycle dynamics.  Specifically Government and Fed policy has been aimed at fostering credit creation up to this point.  Fed money printing and Government borrowing has been undertaken in an attempt to stimulate credit creation and likewise spark broad reacceleration in consumption.  Certainly Government and Fed actions have also been an offset to the contraction in private sector (think financial sector) credit so far in the current cycle.  As of now, unprecedented Fed actions have acted to both devalue the dollar and suppress interest rates.  But in a generational deleveraging cycle, the Fed is ultimately impotent in terms of being able to successfully spark private sector credit creation that would lead to expansion in aggregate demand and macro GDP growth. 

But what has occurred as a result of Fed and Government "solutions" again is a classic macro deleveraging cycle response - a devalued currency and negative real interest rates has driven investors into inflation hedge assets such as gold, oil, ag assets, etc. at the margin.  As opposed to having achieved the stated goal of fostering employment growth, credit creation and raising aggregate demand, etc., Fed QE has essentially succeeded in raising the cost of living in a cycle characterized by generational labor market and direct wage pressure among the middle and lower class wealth demographic.  From a broad perspective, has Fed and Government policy actually done more harm than good?  It simply depends where one sits amidst the wealth demographic pyramid of life.  Policy has been fabulous for Wall Street and the banks, but not so fabulous for the average household.  The average household has faced vanishing interest income and negative real wage growth amidst an environment of a meaningfully rising cost of every day living (food and energy prices).  Again, we're not discussing all of this to make value judgments about policy.  What is is.  The important issue is what lies ahead and how do we navigate properly.

Classic business cycle recessions past have usually been caused by excess inventory accumulation and/or Fed policy tightening that goes just a bit too far.  The prior cycle downturn saw neither of these two character points.  The prior cycle (and really current as this issue is far from being resolved) downturn was driven by a generational credit cycle that simply hit the inevitable macro balance sheet tipping point.  Excess credit creation of the last few decades "drew forward" years of aggregate demand, and this is exactly why both - credit creation and aggregate demand expansion - will be so hard to come by as the current cycle plays out.  It's now payback time.  It's now balance sheet reconciliation time.  And nothing will stop this process from playing out over the intermediate to longer term.  Isn't this exactly why the direct influence of monetary and fiscal policy has seemed so fleeting in the current cycle?  Of course.

So what does all of this mean for investment decision making ahead?  What it tells us personally is that the road ahead will be bumpy for really all asset classes, including inflation hedge assets.  Active management will be a mandate.  The marriage of fundamental and technical analysis will be critical, as is really always the case anyway.  The world is not about to come to an end, but the thinking that aggregate demand will somehow accelerate meaningfully in the absence of credit creation is false over any type of intermediate to longer term time frame.  Credit creation, and hence aggregate demand, is not about to move significantly higher until balance sheet repair is further along than is the case today.  And unfortunately this needed repair has actually been hampered by policy to the extent that income needed to be devoted to a higher cost of living has crowded out the ability to pay down debt and delever balance sheets.  Policy has been counterproductive because policy makers continue to focus on short term outcomes as opposed to longer term structural remedies.  Remember, people repeat the mistakes of their grandparents, not their parents.  Mr. Bernanke is apparently an "expert" on the actions of "grandparents", yet he is very much repeating their same mistakes by his implicit refusal to even consider Austrian/Kondratieff like economic ideas.  You already know, THE key character point of successful investors over time is flexibility in outlook and behavior.  It's just a shame we can't clone that character point inside the Fed and Administration at present.  But of course that would be counterproductive to the interests of Wall Street and the big banks.  Therein lies the tension.

:Lastly, one pattern we've seen repeated in the current economic cycle so far has been the continued overestimation of forward macro economic growth.  We saw it in 2010 domestically and we're seeing it again this year, but on a much broader global scale.  We suggest that this absolutely fits with what we've described above in terms of a mini-roadmap.  Policy has created the hope of growth.  Asset prices have moved on this anticipation.  Yet the inability of the system to spark organic private sector credit creation is a boat anchor around the neck of aggregate demand acceleration.  Although it's just our perception of life, false dawns are a hallmark fingerprint of generational deleveraging cycles.  Just look at equity market action in the 1930's and post 1990 Japan.  Over the intermediate horizon ahead as the deleveraging cycle necessarily continues to run its course, we need to expect this type of perceptual rhythm and position investments in active fashion accordingly.  Time heals all.  And that's the issue - time.