July 2001

The Service Economy 

Buy The Dip Or Sell The Blip?...After 275 basis points in Fed Funds rate cuts over an incredible compressed six month period, it only seems a natural that we should be seeing some semblance of stabilization in the economy, right?  The fact is that monetary policy works in strange ways.  Historically, easing shifts in monetary policy have begun to bear economic fruit in a range of approximately three to eighteen months after the beginning of the exercise.  From our vantage point, that's one wide range in which to speculate on an exact bottom.  Just this week we saw some nice upticks in consumer confidence, the Chicago PMI (as a precursor to the National Association of Purchasing Managers Index), and the LEI, as well as another drop in weekly jobless claims.  Could this be it?  The bottom investors far and wide have been anticipating and discounting in financial asset prices?  The answer is a solid maybe, but nothing more than that for the moment.

As you know, our favorite intellectual construct as it applies to the financial markets as well as the real economy is non-linearity.  Embrace non-linearity and you are half way home to becoming a much better investor.  Historical economic headfakes, or more tactfully non-linear movement, is really more the norm than the exception.  A mid-summer stroll down domestic economic memory lane teaches us to avoid jumping to any immediate conclusions.  As you will see in the following charts, virtually every recession of the last thirty years was preceded by a series of economic data point "headfakes":

As you can see, there have been many an occasion where the economy has looked left, but dribbled right directly before an academic recession.  We're not saying that recent macro economic statistics do not offer hope of economic stabilization.  Rather that historical perspective is incredibly important as the current economy struggles to rationalize excesses created in one of the greatest financially engineered economic expansions in US history.

Although it is far from certain that the Fed is done lowering interest rates, the 25 basis point move this week is ultimately a precursor to the end of the monetary easing cycle.  Given that monetary accommodation in other major G7 realms has been much less significant of late relative to our domestic experience, a slowing in Fed driven rate easing has broader implications for the global economy.  Implications directly measurable in the US trade deficit.  Let's face it, at this point, foreign economies are as dependent on Fed accommodation as is the domestic US economy.  What happens when the Fed ultimately cuts back on the liquidity flowing through the economic IV tube (rate cuts, open market operations, etc.)?  Moreover, what happens when what seems the ever expanding credit markets ultimately meet up with the credit default risk gang of hooligans in a dark alley some evening?  Our humble answer?  Non-linearity.

The Service Economy...You better believe it's different this time.  The new economy is all about service.  Debt service, that is.  A level of service relative to signposts such as GDP, etc. that has really never before been experienced in modern US financial history.  We attribute much of the relative increase in government, household, corporate and financial system leverage over the last few decades directly to the linear nature of human decision making.  The thought that what has happened in the immediate past has a high statistical probability of continuing to occur in the immediate future.

We're not trying to suggest that the current leverage seen in the macro balance sheet of the US financial system is about to plunge our society into the black abyss of economic "no return".  Rather that this generic balance sheet mix will act as a constraint on our ability to reinvigorate economic growth ahead.  The financial markets may be looking for economic stabilization in the current period, but possibly the more important question to be addressed is the potential trajectory of real growth that can reasonably be expected to occur once this significant period of adjustment winds down.  And, of course, what market participants should currently "pay" for this expected rate of growth.

As you know, over the past twelve+ months, our financial markets and economy have experienced a reduction in speed.  After cruising along on the economic superhighway of our tomorrow at a 65 mph speed limit, all of a sudden the engine won't allow us to move much faster than 25 mph.  We have a Fed pouring a high octane liquid fuel mixture into the gas tank, but so far it doesn't seem that mixture has made its way to the combustion chambers of the engine quite yet.  Financial asset prices have stalled.  GDP is "below potential", as we have heard it described.  And, we've caused foreign vehicles on the road to slow down behind us.  The one thing still outpacing economic growth, financial asset prices, real wages and consumption in this country is growth in credit market debt outstanding:
  

Despite a slowing in rate of change during 1Q of this year, quarterly annualized growth in credit market debt outstanding outstrips real economic expansion by a mile. 

GOVERNMENT SECTOR

Rate of change in government debt outstanding has been contracting over the last year+.  As you know, capital gains tax receipts and a booming economy swelled government coffers in cyclical fashion, affording the government the chance to repurchase a portion of outstanding debt.  What lies ahead is an increase in transfer payments, tax rate reductions, and a potentially significant slowdown in the capital gains component of tax receipts.  As you can see in the table, the 1Q 2001 experience is a bit different than what was seen over the last year.

HOUSEHOLD SECTOR

Leverage at the household level is driven by mortgage and consumer debt.  So far in 2001, the consumer has been the champion of the economy as the icy winds of cyclical corporate capital spending blow across the land.  Continuing to lever and spend despite increasing labor market softness.  

Consumer credit outstanding in 1Q rose just shy of an annualized 10% growth rate.  Clearly not outrageous by historical standards.  But, what must be remembered is that the law of large numbers becomes meaningful on top of absolute dollar consumer credit outstanding that is easily ten times what was seen three decades ago.

Now is as good a time as any for a quick tangent.  The rebuttals to the potential problem of debt growth we often hear among mainstream Street commentators is that the asset portion of the balance sheet has grown to meet the demands of higher leverage.  Net net, everything is just fine.  Additionally, since we are in a period of low rates, the consumer can take on a higher level of debt as the current cost of that debt mitigates the burden on the total household P&L and balance sheet.

First, as you know, the asset portion of any balance sheet, personal or corporate, is anything but linear.  As they say on Wall Street, "past performance is no guarantee of future return."  In fact, over the last twelve months, consumer balance sheets have directly experienced hardcore year/year deterioration.  Unlike anything seen in decades.

Year/year consumer net worth dropped 8% in the last twelve months due specifically to the contraction in stock market values.  Consumer credit expanded 10% year/year, as if the contraction in net worth was some type of fluke, or maybe just temporary.

Although the Fed has done a fine job of reducing the Fed Funds rate this year, it would be our contention that the only benefit to the consumer has been psychological.  It sure appears to us that there has been about zero change in the economics of consumer leverage:

Although the economics of consumer finance have changed very little since the Fed embarked on its economic rescue mission earlier this year, it is true that the costs of consumer finance have fallen from what was seen in the early 1990's or early 1980's.  Does that mean that the consumer easily has the ability to carry higher leverage at reduced costs?  Since a definitive answer would be speculation, we would suggest taking one more step back in time for a possibly different perspective.  The difference between consumer financing costs today and what was seen in the early and mid-1970's is very little:

In noteworthy juxtaposition, what is different between the 1970's consumer experience and today, despite very similar financing economics, is the following:

The second important component of household debt is mortgage debt.  In rather wondrous fashion, real estate prices in many parts of the country have continued skyward over the past year.  Many achieving double digit pricing gains.  As one of the charts above displays, conventional mortgage rates are bumping along near 30 year lows at the moment.  Very attractive financing from a historical standpoint.  If it weren't for the fact that pricing has advanced, the year/year change in consumer net worth would have been a decline closer to 12%.  Yes, mortgage rates are at a low.  But something else is also very near all time lows.  Have a look:

Can you imagine what the above chart would look like if prices weren't increasing?  On second thought, maybe you really don't want to imagine that.

CORPORATE SECTOR

It doesn't exactly take a rocket scientist to notice that annualized growth in quarterly corporate leverage slowed noticeably in 1Q.  Not too hard to fathom as corporate earnings and cash flow is slowing substantially at the moment.  Likewise, risk is all of a sudden becoming topic numero uno among corporate lenders and the corporate credit markets of the moment.  Plenty of Fortune 500 names have been shut out or priced out of the debt markets.  Corporate America has turned off the capital spending spigot and what are now sparing stock buyback announcements are declared in the hollow canyons of Wall Street followed by an echo, not the roar of the crowd.  After a decade of financing stock buybacks and stock options programs with increasing leverage, it's payback time.  (Pun definitely intended.  Unfortunately.)

Corporate debt as a percentage of GDP rests at all time highs.  Yes, cost of debt is lower today, but again, some historical perspective:

Yes, corporate borrowing has really become the province of the capital markets over the last three decades as opposed to the banking system.  But, plenty of businesses that make up the backbone of America (such as the local dry cleaners down the street or the local construction firm) borrow from the bank.  No matter how you cut it, corporate leverage is significant going into an economic period of slowing growth.  

FINANCIAL SECTOR

The importance of "financial services" as a component of the economy has taken on ever increasing meaning over the last three decades in this country.  Without the growth in this service sector business, much of the growth in total system financial leverage we have witnessed may not have been possible.  Clearly, this sector has provided a stimulus to GDP growth vis-à-vis the mechanism of debt financed consumption.  Financial sector expansion has been a key hallmark of the new era economy.

There is simply no question that the business of financing is big business in the world of today.  We basically draw the conclusion that the growth of the financial sector as a component of the economy has facilitated credit expansion system wide that has resulted in many historical balance sheet leverage relationships hovering at or near record levels.  The financial sector has been one of the great facilitators of money supply growth in the new era, changing the nature of Federal Reserve control over the velocity of systemwide credit expansion.

On a bottom line basis, one of the elements that will surely affect our ability to reinvigorate economic growth in this country ahead will be balance sheet flexibility and P&L driven debt service capability in all sectors of the economy.  At the moment, we find ourselves in a position unique to historical experience.  A period that suggests flexibility is limited relative to similar slowing economic periods of the past.  A period that suggests to us that the price of money may be a much lesser issue than the demand for that money.  Given that financial asset values can be considered anything but cheap at the current time, this is clearly a period where a proper discounting of current price against future growth will be nothing short of crucial to investment success ahead.

Highway To The Danger Zone?...After a series of very sobering earnings preannouncements in March of this year, investors chose to discount brighter days ahead even as the reality of those warnings became reported earnings during April and into early May.  As we have experienced over the last month, second quarter earnings warnings were another eye opener, accompanied by very few, if any, top executives willing to comment on the third quarter outlook and beyond.  Lack of visibility is the mantra of the day.  "Hoping for a bottom" is about as far out on the SEC FD requirement plank conference call conductor's are willing to venture at the moment.  Are the equity markets ready to rocket skyward again in the hopes of better corporate earnings in the second half or 2001 and into 2002?  After all, for all intents and purposes, the bad news on 2Q is already out.  It's history.  It's so yesterday.  Are we destined for a replay of the April/May running of the bulls?

Clearly no indicator is the Holy Grail, but we always like to check in on the VIX (OEX Volatility Index) to get a feel for how "excitable" investors are feeling at the moment.  How investors are or are not pricing volatility into financial assets.  There are no magic VIX numbers, only broad ranges from which history suggests complacency or fear.  Current suggestion?  Complacency.  In the following historical charts courtesy of the super work from the folks at StockCharts.com, the red lines indicate periods of fear being priced into volatility premiums.  A VIX range of the mid-30's to 40.  The blue lines are periods of complacency or expectations of low volatility being priced into volatility premiums.  A VIX in the low 20's.  

As you can see in these charts, the March/April period of this year witnessed a pretty high level of VIX readings.  A level seen rather infrequently.  A level suggestive of fear driving investment action.  At the moment, the VIX looks nothing like the March/April bottom.  Far from it.  Almost at the opposite end of the spectrum.  Despite the choppiness of the indices over the last month or so, the only volatility investors seem to be worried about currently is stirring their mixed drinks too hard while they sun themselves at the beach.  Is a rip tide approaching?