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Ken Wilson
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Market Observations - ContraryInvestor.com
August 8, 2002
The Other Bubble?
The Other Bubble?...Certainly bubble reconciliation plays out over time. A historical truism borne out by financial and economic bubble experiences past. Both stateside and abroad. As we mentioned on Tuesday, we've been meaning to do a little bubble update for some time now. Just where are we in terms of the multiplicity of deflating bubbles around us? The equity markets, the economy, etc. Although we expect that continued equity market rallies and sell offs of relatively decent magnitude lie ahead as the secular bear in equities progresses, we need to keep tabs on the macro characteristics of valuation as certainly this bear will not last forever. Just when is it appropriate to begin traveling down the path of becoming less bearish in earnest?
Today we thought we'd address an area where there has been virtually no deflation in bubble like characteristics since the equity bear market commenced. That area is system wide debt accumulation. The other bubble, if you will. The bubble given far too little attention by the mainstream. Despite literal fixed income train wrecks in the capital markets thanks to the likes of Worldcom, Global Crossing, Enron, Kmart, etc., corporate debt in the aggregate remains high. Cyclical reconciliation has only just begun in the corporate sector. Household debt continues to rocket ever skyward despite household net worth buckling under the weight of equity price compression. You've heard the comment that real estate is displaying bubble-like qualities. The clearer truth may be that the bubble lies in mortgage credit creation, as a major issue separate and distinct from housing prices. Quite simplistically, despite the obvious and apparent price reconciliation taking place in the equity markets, can we really expect some type of sustainable turn in the economy and financial markets while the bubble in credit creation has not yet been reconciled in the least from a macro perspective? We have a lot of graphs that follow. Quite simply, they tell the story of an ever enlarging bubble that appears hidden from mainstream concern at the moment. But an issue ultimately inextricably linked to the economy and the equity markets of tomorrow.
Taking All The Credit...Consumer credit for the month of June was reported yesterday.
Compared to experience during the in process equity bubble reconciliation period, a 6.1% month over month annualized growth rate in total consumer credit appears simply run of the mill type of experience. And relative to personal income growth, year-to-date monthly credit expansion appears very even handed.
What does give us a bit of pause for reflection in the above chart is that despite relatively even growth in both personal income and consumer credit year-to-date, corresponding quarterly GDP growth this year was miles apart. As you know, 5% macro economic growth in 1Q and 1% in 2Q. Clearly the 4Q auto sales resulting from zero percent financing created the need to rebuild inventories in 1Q that helped boost 1Q GDP as a result of 4Q sales. As you know, the auto folks have just recently reinstated a number of zero percent financing programs and have at least so far benefited from the move as witnessed by July auto sales coming in near an 18.1 million unit annualized run rate.
At the moment, it's a pretty darn good bet that July consumer credit numbers may spike as a result of non-revolving credit growth driven by auto sales. Resultantly, if non-revolving credit does spike in the months ahead in support of further strength in auto sales, it just may induce GDP contributory production growth. We'll see what happens ahead. But the issue of non-revolving credit growth allows us to segue into a broader historical look at the components of consumer credit growth and how our present experience differs from recessions past. More importantly, what has been the experience of consumer credit during the equity bubble deflation period is suggestive as to what may lie ahead for the economy.
It's Different This Time...Despite one the the worst equity bear episodes in many a decade, an implosion in corporate profitability with little precedent in the last half century, and a labor market certainly displaying signs of stress unlike anything seen in a decade at least, expansion in consumer credit over the last few years has been quite unlike most recessionary episodes of the last four decades.
As always, we try to smooth the data a bit by using a quarterly moving average. As you can see, in every recession in the latter four decades of the last century with the exception of the brief 1970 downturn, consumer credit actually contracted for a period. That has not happened at all during the last few years. It is instructive to look at the components of overall consumer credit in trying to decipher just what may lie ahead for both the consumer and the economy. Although macro consumer credit expansion trends during the latest downturn are quite unlike what was seen in prior interludes of GDP contraction, it just so happens that revolving credit expansion did display one of the weakest growth rates in over two decades recently. Admittedly we do believe that some of this may be related to tax advantaged mortgage credit expansion supplanting revolving borrowing needs.
Again, using the smoothed quarterly moving average data, one has to venture back to 1980 to find growth rate weakness in revolving consumer credit has we have seen recently. Whether it is now turning back up in cyclical fashion remains to be seen ahead. In converse fashion, it is non-revolving credit expansion that has been the true anomaly for this cycle.
As you know, non-revolving credit expansion is closely linked to both the housing (furniture and appliance purchases) and auto markets. These are the areas where credit expansion has been the most liberal for this cycle, continuing to the present day. These are the areas that have held the economy up over the last few quarters. These are the areas where we seriously have to question forward sustainability of demand subsequent to the current environment where the costs of financing auto and housing purchases is near a generation low. Just what would GDP have looked like without the ease of credit availability into these sectors? As we view the credit system around us, corporations right and left are being shut out of segments of the capital markets or being held hostage to higher risk premiums (costs of obtaining financing). Consumers characterized as being of sub prime quality are experiencing an evaporating pool of credit availability that was so generously available only a few years back. But in the broader housing and auto sectors, credit continues to be available in mass quantities and on incredibly favorable terms. Potentially enabling the significant borrowing of tomorrow's physical unit demand into today's sales realizations. Unlike economic recoveries past, can we really expect forward auto and housing experience to provide a significant boost to economic growth in any type of meaningful fashion when these areas have already been the glue holding the system together throughout the recent downturn? Especially given that auto sales recently set a monthly record and home ownership in this country sits at a record high. This economic "glue" of the recent past has been brought to us courtesy of continued credit expansion, plain and simple. Credit expansion quite uncharacteristic of a period of soft economic experience as suggested by the context of history.
Tiny Bubbles...Unfortunately, it doesn't appear as such at the moment. At least not from the message implicit in a number of the following charts. In addition to looking at changes in the components of credit expansion over time, we find looking at growth against relative benchmarks such as GDP quite helpful from a broader perspective. Consumer credit outstanding today stands at roughly 16.5% of GDP. Up from maybe 12.5% three decades ago.
But what is certainly more apparent is the fact that consumer credit as a percentage of GDP contracted during and after each and every recession of the last three decades with the exception of the current. Again, despite labor market woes and a significant contraction in common stock equity "wealth", households have moved steadily forward in terms of revolving and non-revolving credit accumulation. But what is certainly more striking is what has happened in mortgage credit expansion.
As you can see, mortgage credit outstanding currently accounts for approximately 53+% of present GDP. Up from the 30% area three decades ago. Again, during recessions past, this relationship has contracted. But not during the current episode. In all honesty, a portion of this expansion most likely had its roots in the mid-1980's changes in the tax laws. As interest on consumer credit was phased out as a personal tax deduction, the substitution of tax advantaged mortgage related credit for what was formerly consumer credit was just a natural phenomenon. But certainly the influence of substitution does not account for the whole story here as simultaneous expansion in consumer credit as a percentage of GDP so aptly implies. The mortgage credit graph is significant in our minds. The monetization of real estate equity appreciation has been a major driver sustaining this economy over the recent past. Both of these graphs in conjunction speak to the fact that total consumer debt growth has been in secular rise for the past few decades. Both speak to the fact that as the equity bubble has deflated in part, the debt bubble has continued to inflate. We will soon have the household net worth figures for 2Q with the Fed Flow of Funds report in another month or so. We expect some pretty serious deterioration. Up until recently, the deflation in the common stock bubble has not seriously dampened consumer spending habits. The paramount question ahead is when will the still inflating debt bubble become a decision point for American consumers? Maybe it will never become an issue at all. Or maybe the 35% stock price flogging of behemoth electronics retailer Best Buy today serves as a harbinger of tomorrow's macro consumer spending predilections.
A few last shots on debt. If you have not figured it out by now, we'd venture to say that the single greatest risk to economic expansion ahead is systemic leverage. The other bubble. Household leverage. Corporate debt. Financial system leverage. In a very low nominal rate of return world, existing and ongoing costs of leverage are magnified, at least perceptually if not translated directly into the reality of decision making. Inclusive of the revised GDP numbers, household debt relative to GDP stands a hair away from 80%. Certainly a record in any description of recent financial history.
We know all of the panacea arguments regarding the above chart. Interest costs today as a percentage of income are no higher than what was the record setting experience seen in the mid to late 1980's. All well and good, but given that the general level of interest rates was much higher at that time (and there certainly was no zero percent auto financing schemes back then), principal balances are much higher today given a relative $1 of comparable interest costs. Unfortunately for most debtors, both interest and principal ultimately have to be repaid. Moreover, given the significance of mortgage debt within the household equation, approximately 35% of current mortgages are adjustable. Let's just hope that a potential dearth of foreign capital inflows into this country ahead does not kick off the "adjustment process", shall we? Although it may sound like a purely academic comment, household financial flexibility as measured by leverage against the backdrop of total economic sufficiency as measured by GDP has never been lower in the last half century at least. The bubble that is being reconciled in the retirement accounts of many American households may ultimately seem at lot less onerous than the existing bubble in household balance sheets that has yet to be addressed.
Lastly, total credit market debt (total household, total corporate and total financial sector) as a percentage of GDP is nothing short of a sight to behold.
If this isn't the very picture of a debt bubble, then what is?
No Dough, No Go?...Don't be too sure, at least very near term. Domestic equity funds experienced a ($2.8) billion dollar outflow for the week ended last night. In the past twelve weeks, only the week prior to this was a respite inflow of merely $700 million (pocket change in the equity fund world). As you know, the current week encompasses the weakness of late last week and the equity index pole vaulting event of early this week. The natives are clearly restless.
Does this mean that the market is simply running on fumes given that equity mutual fund cash levels are so near record lows? Well, just keep in mind that those fumes you smell just may be the smoking rear ends of the recent converts to short selling. Smoking as they bail out, that is. Going into July, short interest and short volume was spiking. After all, after 28 months of a secular bear market, it was time to pile in on the short side, right? At least that's what Maria Bartiromo was suggesting just a few weeks back. It sure appears that many an equity mutual fund holder are just beginning to give up on their long term approach to investing. But it has been our experience that burned shorts simply set the definition of throwing in the towel in terms of speed. Given the low volume on the recent rally, we smell fumes all right. Fumes of tanned hides. Of course a short selling give up can inspire longs chasing performance. Oh the nuances of short term market movements. No problem, it's only America's retirement assets being played with here, that's all.
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