Superb missive from Noland tonight:
prudentbear.com
The Other Side to the Story:
Yesterday’s headline read “U.S. Economic Growth Weakest in Over 4 Years.” At 0.6%, revised first quarter annualized Real GDP was certainly nothing to write home about. Gross Private Investment contracted at a 9.3% annualized rate, led by a 15.4% annualized drop in Residential Investment. And the ongoing weakness in housing was confirmed by this morning’s Pending Homes Sales data (weakest in four years). Certainly, there is some support for the bearish view that ongoing housing weakness is in the process of dragging down the U.S. consumer and our consumption-based economy. But why then is the Morgan Stanley Cyclical index sporting a 22% y-t-d gain, the Dow Transports a 17% rise, and U.S. and global stock markets all posting robust advances on top of last year’s gains? Why are 10-year Treasury yields almost back to 5%?
There is an Other Side to the Story. First quarter Nominal GDP actually expanded at a 4.7% rate, an increase from Q4’s 4.1% and Q3’s 3.9%. At 4.0%, the strongest GDP Price Index gain in years weighed heavily on Real GDP. Interestingly, Personal Consumption was actually revised up to a respectable 4.4% rate (from 3.8%), accelerating from Q4’s 4.2%, Q3’s 2.8%, and Q2’s 2.6%. In annualized nominal dollars, Personal Consumption jumped 5.8% ($522bn) from Q1 2006 to Q1 2007’s $9.601 TN.
How is it possible that consumer spending holds up so well in the face of faltering housing markets and reduced mortgage borrowings? Well, there’s no mystery. First quarter Personal Income expanded at a blistering 9.4% pace, up sharply from Q4’s 5.9%, Q3’s 5.0% and Q2’s 3.2%. In nominal annualized dollars, first quarter Personal Income increased 5.8% ($626bn) from Q1 2006 to Q1 2007’s $11.348 TN. Disposable Income grew an annualized 8.2%, up from Q4’s 5.4% and Q3’s 5.7%.
The huge Income gains were not a quarterly anomaly. We already knew that, through the first seven months of fiscal year 2007, federal Personal Income Tax receipts were running 17.3% ahead of the year ago level. Clearly, enormous capital gains and investment income growth coupled with strong compensation trends are having a significant impact.
I read interesting research the other day taking exception to the bullish view that the economy will soon emerge from a “mid-cycle slowdown.” I appreciated the analytical focus on the relationship between GDP and debt growth. The basic premise was that only accelerated debt growth would empower an economic bounce-back. It was their view that with household mortgage debt growth slowing sharply and government deficits shrinking, even a meaningful jump in corporate borrowings would likely prove insufficient to support the necessary expansion in total system Credit. I’m mentioning this Credit analysis because it touches upon key pertinent analytical and economic issues.
To begin with, this analysis follows the conventional method of examining Household, Corporate and Government debt growth – analyzing only “Non-Financial” Credit. It is traditional thinking that Financial Sector debt must be disregarded, as including it with “Non-financial” debt would be counting the same loan twice (for example, a home mortgage loan held on a bank’s balance sheet). And while there is definitely a “double counting” issue at play, financial sector borrowing dynamics should be anything but ignored – especially these days. They are the key to liquidity abundance and hold the key to sound analysis.
As I’ve noted in previous analyses, the aggressive financial sector expansion in the face of slowing Non-Financial Debt was the notable 2006 development. From the Fed’s Z.1 report, nominal Non-Financial Debt growth slowed to $2.100 TN from 2005’s $2.279 TN. Yet at the same time Financial Sector Credit Market Borrowings (that exclude some categories of financial sector borrowings, i.e. deposit growth) increased a record $1.200 TN, up significantly from 2005’s $1.040 TN. Remarkably, Broker/Dealer assets surged 29% last year to $2.742 TN.
The slowdown in Non-financial debt growth has been consistent with moderating nominal GDP (as one should expect). What has caught many analysts by surprise, however, is the acceleration of Income Growth and overly abundant marketplace liquidity (and booming global stock markets). In both cases, the rapid expansion of Financial Sector debt has played the prevailing role.
Examining the “Big 5” Wall Street broker/dealers (Goldman, Morgan Stanley, Merrill, Lehman, and Bear Stearns), one can see that combined 2006 Net Revenues were up 33% y-o-y to $133bn. These firms paid out 44% of Net Revenues – or $58.3bn – in Compensation last year. Compensation actually increased 31% from 2005. Furthermore, the spectacular growth trend has only accelerated so far in 2007, with combined “Big 5” Assets expanding at a 41% rate during the first quarter. Combined first quarter compensation increased to $19.7bn.
Obviously, “Big 5” paychecks are only part of today’s Financial Sphere Compensation Bonanza. Employee pay was up 18% y-o-y during 2006 to $30.3bn at Citigroup, 17% y-o-y to $21.2bn at JPMorgan, and 21% y-o-y to $18.2bn at Bank of America, to mention a few of the largest “banks.” And let’s not forget the hedge fund industry. To get some perspective on possible income gains, let’s assume a $2.0 TN (or so) industry enjoys returns of 10%. With the industry standard 20% incentive payouts, hedge fund managers would enjoy a $40bn windfall ($2.0TN*.10%*.20%). Whether it is a Wall Street firm, “money center bank,” hedge fund, or local bank branch, the expansion of financial Credit provides growing revenues and rising income that Bubbles outside the traditional confines of Non-financial debt statistics.
But direct compensation is only one aspect of today’s Credit Bubble-induced surge in financial sector debt growth. On might have assumed that slowing mortgage debt growth would have impacted liquidity. Instead, the rapidly expanding financial sector – aggressively using leverage to balloon securities holdings – set in motion unprecedented marketplace liquidity creation. This liquidity has fueled myriad self-reinforcing asset price and Credit booms.
June 1 – Bloomberg (Bryan Keogh): “U.S. corporations…sold a record $141.6 billion of bonds in May… Sales shattered the previous high of $131.8 billion in November, according to…Bloomberg… U.S. corporate bond issuance this year totals $531.6 billion, up from $464.3 billion the same period a year ago… ‘What’s driving corporate bond issuance has been the funding of acquisitions, stock buybacks and special dividends,’
said John Lonski, chief economist at Moody’s…”
Importantly, overly abundant liquidity has spurred a historic global M&A and debt issuance boom. At $530.9bn, year-to-date corporate issuance is running 16% ahead of last year’s record pace. And it is worth noting that, according to Bloomberg, “banks, brokerages, insurers and other financial companies” accounted for $92.4bn, or 65%, of May’s record bond sales. It has become rather obvious that financial sector Credit expansion is financing much of the acquisitions boom.
Deals are driving debt issuance, and each acquisition completed with debt adds additional “liquidity” into the system. Some of this new liquidity flows to the sellers, where it will be used to purchase other assets or financial instruments. Some of this newly created liquidity is enjoyed by the acquirer through the currently popular private-equity “special dividend.” Some of the new financial Credit becomes Revenues and Income for the various financial intermediaries.
Meanwhile, the M&A boom is definitely a major factor stoking stock prices generally, in the process providing additional collateral for leveraging (i.e. margin debt, derivatives, borrowing against capital gains). The backdrop certainly provides ample incentive to start a new business or aggressively grow an existing one in hope of a deal. And, importantly, strong earnings growth coupled with abundant liquidity spur the ongoing stock repurchase boom, reinforcing asset inflation and a recursive cycle of Credit and liquidity excess – not to mention huge liquidity windfalls for corporate insiders and others sellers. It was double-digit financial sector debt growth that permitted last year’s record $432bn S&P500 companies’ stock repurchases, buybacks that enriched many and supported general stock market inflation. Today’s powerful interplay between financial sector and corporate Credit growth should not be downplayed.
Importantly, the massive expansion of financial sector Credit has become the key marginal source of liquidity for the real economy. Undoubtedly, it is the prevailing underlying source – The Other Side of the Story – for booming government tax receipts and shrinking deficits. I would also argue that the ballooning financial sector goes far in explaining how the (negative savings rate) household sector retains sufficient liquidity to send $100s of billions to speculate on foreign financial markets. And keep in mind that the “recycling” back of some of this liquidity (in conjunction with Current Account Deficits) is spurring double-digit U.S. export growth and huge foreign purchases of U.S. assets. This process today provides another important source of revenue and income growth outside of domestic Non-Financial Debt growth.
While it is impossible to quantify, I am convinced that the rampant financial sector expansion is distorting the true scope of the current Credit expansion. Clearly, the massive expansion of Financial Credit is boosting Income, gains on assets sales, foreign flows recycled back into the U.S. economy and confidence generally. As such, it today requires less – and perhaps significantly less – household, corporate and government debt growth to sustain the U.S. Bubble than would traditionally be the case.
It is my belief that the U.S. bond market is coming to recognize this dynamic. For some time, players have been monitoring housing market dynamics with the expectation that an abrupt slowdown in mortgage Credit growth would have dire implications for the vulnerable U.S. economy and Credit system generally. Not only has unparalleled financial sector expansion created more than ample liquidity to sustain the boom, resulting income and securities markets gains have supported home prices and held a full-scale housing bust at bay.
Some analysts see rising global bond yields as evidence of waning liquidity. I believe that bond markets are instead finally wising up to the implications of chronic global liquidity excess and the likelihood that central banks still have an abundance of work ahead of them – perhaps even at the Federal Reserve. Considering the amount of leveraging in the system – especially in the U.S. where markets have been too well-positioned for the next easing cycle – it is now conceivable that a spike in rates could lead to some problematic de-leveraging and liquidity issues.
I don’t buy into the bulls’ fanciful imminent recovery from a “mid-cycle slowdown” thesis for a moment. I’m also not much of a fan of the prevailing bearish view that housing is well into the process of dragging the economy into recession. I, instead, see the economy in the process of bouncing back at the hands of precarious Credit Bubble excess – especially throughout the financial sector. Housing has been a meaningful setback, but the enterprising U.S. Credit system has found a way to sustain more than ample Credit and liquidity creation – not to mention speculation.
I’ve argued for too long that the U.S. Credit Bubble is acutely vulnerable to a spike in interest rates. With the booming U.S. financial sector and global financial and economic Bubbles as a backdrop, we might now be only a growth spurt and a negative inflation surprise from testing this thesis. Deleveraging and the unwinding of speculative positions – and the associated reversal of today’s key sources and flows of liquidity - would be especially debilitating for our unstable financial sector and economy. And that’s, as they say, The Other Side of the Story. |
