Year in Review: Reflation to Gross Over-Liquefication:
prudentbear.com
Credit Bubble Bulletin, by Doug Noland
December 31, 2004
I haven’t read anything from the general or business media that does 2004 justice. Most articles mundanely note that equity returns lagged 2003, while bonds posted surprisingly good if not stellar returns. Yet focus on the major equity averages and the Treasury market misses the major story of the year: rampant liquidity excess and rising inflation. For the year, The Street.com Internet index was up 36%. The Dow Jones Transports jumped 26.3%, and the Dow Jones Utilities gained 25.5%. The Morgan Stanley Cyclical index rose 15.4%, and the NASDAQ Industrial index gained 15.8%. The small cap Russell 2000 surged 17%, and the S&P400 Mid Cap index jumped 15%. The Securities Broker/Dealers jumped 15%. The NASDAQ Insurance index jumped 19.8%, and the NASDAQ Other Financial index rose 19.6%. The NYSE Energy index gained 25.5%. The AMEX Composite rose 22.2%. The AMEX Biotechnology index gained 11%. The NASDAQ100 gained 10.5%. The S&P 500 Homebuilding index posted a 2004 gain of 33%. Clearly, sectors and groups that one would expect to be the most sensitive to over-liquidity and inflation have, in most cases, performed exceptionally well.
I realize some analysts continue to note the less than overwhelming 6.6% 12-month expansion in M3. I would like to again emphasize that “money” supply may not always be indicative of system liquidity. Today it is not; liquidity conditions remain overwhelming.
First of all, it is worth noting that M3 less money market fund assets expanded at a 10.3% rate over the past year. Many have had good reason to use bank and money market deposits to purchase some of the inflating quantity of higher-yielding Treasury bills and notes. Generally, there continues a major flight into riskier and higher yielding securities, which fueled record sales of junk bonds, huge record issuance of ABS, and strong issuance of CDOs and other structured products. Also, total Commercial Paper outstanding expanded by 11.5% this year. And with two weeks of data yet to report, we are about to conclude a record year for bank Credit growth (up $543bn, or 8.6% ann.). Bank loans have expanded at a 10.6% rate, with Real Estate loans increasing at a 14.4% rate. Even C&I (commercial & Industrial) loans will post a small rise (approx. 1.6%) this year, the first gain since 2000. Moreover, second-half C&I growth increased to a 6.2% rate. And, according to the Fed’s “flow of funds” data, Broker/Dealer assets expanded at a 12.6% rate during the first three quarters of the year. And, importantly, 2004 will most likely post another record year of $1 Trillion-plus total mortgage Credit growth.
Any discussion of systemic liquidity must also note the ballooning (largely with dollar securities) of Asian central bank balance sheets. The latest data from Bloomberg has Total Asian (Japan, China, Taiwan, Korea, Hong Kong, India, and Singapore) central bank foreign reserve assets up almost $460 billion over the past 12 months (28%) to $2.1 Trillion. (As noted above, foreign “custody” holdings of U.S. securities held at the NY Fed are up 25% this year to almost $1.34 Trillion.) I would argue that liquidity has never been as abundant and that U.S. monetary aggregate growth has been impinged by the nature of current dollar balance “recycling.” Instead of foreign exporters holding U.S. liabilities that would in many cases be included in M3, foreign central banks are acquiring these balances and recycling them into U.S. Treasuries, agencies, and other securities/instruments that are not components of “money” supply.
The bottom line – and crucial for assessing the financial backdrop and prospective risks - is that virtually every Credit and risk spread has narrowed to multi-year lows. This is a clear indication of over-liquefied market conditions. It is also worth noting that subprime - the marginal lender to the marginal borrower, and my favorite system liquidity “canary” indicator - had a gangbuster year. The stock of Metris Companies surged 189%, Americredit 55%, Providian Financial 43%, Advanta 74%, Credit Acceptance 67%, and Compucredit 30%. Lending aggressively was rewarded handsomely, as Capital One jumped 38% and Countrywide Financial 48%. The Bloomberg REIT index jumped 26%. Mortgage REITs generally provided investors strong returns, in the process ballooning their balance sheets. New Century’s stock rose 62%, and Impac Mortgage gained 25%.
I will aver that 2004’s rampant over-liquidity has had a much greater impact on the underlying structure of the economy than 2003’s “reflation.” It is worth mentioning that imports expanded at an almost 20% y-o-y pace during the second half (through October). “Luxury” goods have performed very well. In retail, Nordstrom’s stock rose 37%, Neiman Marcus 33%, and Coach 51%. Other notable gainers included Starbucks (89%), Whole Foods Market (43%), Guitar Center (64%), and Abercrombie & Fitch (91%). With its slick IPod, Apple Computer enjoyed a 2004 gain of better than 200%. Harley-Davidson rose 29%. Luxury homebuilder Toll Brothers saw its stock jump 72%, with a two-year gain of 240%. Internet stocks were hot, with EBAY up 81%, Yahoo 67%, Research in Motion 148%, Adobe 61%, and Monster Worldwide 54%. The ultra-loose financial environment this year imparted a major influence on the character of spending, investing, and speculating.
Unprecedented global liquidity ensured that the Chinese boom avoided a 2004 landing (soft or hard). It also stoked multiple booms in “emerging” economies from India to Eastern Europe to Brazil. And now that strong growth and rising expectations have taken hold, considerable effort will be extended to perpetuate these boom-time conditions. There has developed an increasingly powerful global inflationary bias.
Here at home, rampant liquidity excesses stoked extraordinary housing speculation and inflation, especially along the coasts and virtually everywhere “upper end.” The California housing Bubble evolved into a full-fledged mania. OFHEO’s index of national home values posted a year-over-gain of 13% during the third quarter. This compares to the 6.0% y-o-y gain reported during the third quarter of 2003, and was the strongest national housing inflation since 1979. During the third quarter, y-o-y price gains jumped to 22.72% in the Pacific region, up from 8.9% during comparable 2003. Mid-Atlantic price gains rose to 15.7%, up from 8.0%, while New England rose to 15% from 7.9%. Third quarter South Atlantic prices rose at a 14% rate, up from 6.4%, and Mountain prices inflated at an 11.4% rate, up from Q3 2003’s 3.7%. Through November, total combined new and existing home sales were running almost 9% above 2004’s record pace. And with real estate inflation driving consumption, it is no surprise that Personal Spending is increasing at a 5.9% rate, while Personal Income is lagging at a 4.9% pace.
From my analytical framework, liquidity excess is having profound and all-encompassing effects on the financial markets and real economy. Never has over-liquidity been so conspicuous, not even with the technology boom. Crude oil prices rose 34% and energy prices surged during the year; import prices are now up 9.5% from one year ago; CPI and PPI moved solidly higher; and home prices inflated at a pace last seen in the late-70s. Accordingly, a strong case can be made that 2004 deserves the designation "The Year of Inflation’s Serious Reemergence." Inflation expectations have certainly returned with a vengeance. Speculative interest in a wide range of hard assets – including real estate, commodities, art, myriad collectables, and precious metals - took firm hold during the past year. And, importantly, once such market psychology manifests, signficantly tighter monetary conditions are required to quell the resulting Monetary Disorder.
Throughout the financial markets, liquidity excess incited The Year of the Blow-off. Junk bond spreads collapsed. Emerging bond spreads collapsed. Credit spreads collapsed. Credit default swap premiums collapsed. Equity option volatilities collapsed. And especially after President Bush secured a second term, the unwind of “bearish” bets and hedges incited virtual melt-up conditions in some sectors of the equity market and speculation throughout. M&A activity went to frothy extremes, inciting only greater Credit and speculative excess.
And over-liquidity also can also take Credit for inspiriting The Year it Didn’t Matter. Crude prices ran to $55, but it didn’t matter to the bond market. Commodity markets on fire – didn’t matter. Sinking dollar – nope, didn’t matter. Heightened inflationary pressures – didn’t matter. Fed raising rates – didn’t matter. Fannie and Freddie with major accounting irregularities – didn’t matter. And that was the kind of year it was: major fundamental developments developed with respect to the dollar, inflation, and the integrity of our financial system but all were trumped by rampant system liquidity excess.
To wrap this up this brief and incomplete “review,” we are now 25 months into historic “reliquefication.” As students of inflation would expect, the nature of Inflationary Manifestations has evolved and intensified over time. I would strongly argue that the powerful strain of inflation that has taken hold during 2004 is of the most precarious variety. “Animal spirits” and speculative impulses have been unleashed everywhere. And the problem with extended periods of rampant over-liquidity is that it becomes only more difficult to wean the levitated financial markets, inflated asset markets, and distorted economy off the stimulant. I expect that The Year it Didn’t Matter will be followed by The Year it Does. |
