February 2004

The Mistakes Of Our Grandparents?

The Mistakes Of Our Grandparents?...We hold the folks at the Bank Credit Analyst in relative high esteem for their quantitative skills.  They are widely read among the institutional investment crowd, at least among those still taking the time to do some reading these days.  A month or so back they put out their 2004 outlook.  In very short fashion, they don't believe that any of the imbalances facing the economy or the financial markets will come home to roost in 2004.  From our vantage point, that's pretty much consensus thinking right about now.  They are believers that the great reflation in process as we speak will continue to reign the day and push both GDP and the equity markets ever forward.  For the sake of the real economy and financial markets in 2004, we hope they are exactly correct.  But what caught our eye in their outlook report were their comments regarding leverage.  They began their basic dismissal of near term potential pitfalls of leverage with the following quote:
      

Sounds like something directly out of the modern day bear's manifesto, right?  Those clever folks at the BCA go on to point out that what you see above was published in Fortune Magazine in early 1956.  They additionally recollect further instances of bearish cries of wolf concerning system wide leverage in periods subsequent to that initial Fortune article sighting.  The gist of their comments is that sounds of alarm over leverage have been going on for decades and at least so far, all calls for concern have been false dawns.  We bring this up, because with the latest release of the Fed's Flow of Funds statement covering 3Q of last year, we again have the chance to update what we believe to be one of the most important pictures of the modern era.  If we had to single out just one chart that we believe defines a generation and characterizes potential risk to the economy and the financial markets as a whole looking ahead, it would be the following.  As you can see, the world today looks a whole lot different than it did when Fortune published the above quote in March of 1956, doesn't it?  In fact, ironically enough, 1956 just about marked one of the lowest points for this relationship between total credit market debt and GDP in a century.  Again, with all due respect to the ever-insightful folks at BCA, is now really the time to laugh off the foibles of history's debt obsessed worry warts?  As investors, we always want to keep in the back of our minds the fact that broken clocks are correct twice a day.
       

We're not trying to pick on the folks at BCA by any means.  There are plenty of pundits in the current environment who would concur wholeheartedly that leverage in our current system is manageable.  As you know, so far that's been the case in the aggregate.  Although household debt service payments as a percentage of disposable personal income rests at a record high as we speak, it's not wildly above levels experienced in the mid-1980's.  Of course this line of thinking addresses current P&L issues and to a point ignores a separate issue that is the balance sheet.  The collective household balance sheet, corporate balance sheet, and although not conforming at all to GAAP principles, the federal balance sheet.  Leverage and credit expansion issues have been front and center with us for a good long time now.  It's self obvious that we are living in a very special period of system-wide credit proliferation at the moment.  Judging by the chart above, it has now become a period unique to US financial history.

Maybe more importantly, when looking at the chart above we need to realize that the spike in this ratio that occurred during the mid-1930's was not driven by a significant acceleration in leverage at the time.  Rather, the graphical spike in the mid-1930's was brought about by a collapse in GDP during the depression.  Fast forwarding to the present and the spike in this graph since the early 1980's has not been driven by a collapse in GDP at all.  Quite the opposite, GDP has been expanding over the entire period since the early 1980's.  The current spike in this relationship is indeed driven solely by significant acceleration in system-wide leverage.  The two spikes in this graph have completely different root causes.  Again, without sounding end of the world-ish, the current spike is potentially much more ominous in nature.  Imagine what the current relationship would look like if GDP collapsed 30% (as it did in the depression).  

There exists an old saying that people do not repeat the mistakes of their parents, but rather they often repeat the mistakes of their grandparents.  We submit to you that this is important to remember not only from a broad social context, but also as it applies to the ongoing lessons being put forth by the financial markets each and every day.  It's no wonder at all that cries of concern over excessive debt appeared in Fortune in the mid-1950's.  Those cries were coming from folks with clear and direct memories of the late 1920's and 1930's.  Leverage destroyed many a personal fortune as the economy collapsed in the 1930's.  Today, piercing cries and worries over debt are really to be found in the bearish underground, not on the front cover of Fortune.  As we reflect on the relationship in the chart above, we have to ask ourselves, are we repeating the mistakes of our grandparents?

Organic Fuel?...As we have watched the current headline economic recovery unfold over the last few years, we continue to assess the organic nature of the numbers advance.  Hand in hand with the above chart, we need to focus on both organic and inorganic factors driving the current economy.  In traditional economic recoveries, it is not uncommon at all to watch both the Fed and Administration act to initially stimulate demand through the lowering of interest rates, implementation of tax cuts, increasing government spending, etc.  Hoping, of course, that any economic recovery will become self-sustaining as both payroll employment and wage gains accelerate.  At least so far, the most important linkages between a stimulus led recovery and a self sustaining recovery, job and wage gains, are simply nowhere to be found.  In good measure, the leverage you see in the chart above has been responsible for a big part of the advance in GDP over the past few years.  In the following table, we lay out the nominal dollar growth in both real economic indicators as well as measures of credit acceleration over the period year-end 2001 through 3Q 2003.  In essence we are looking at attributes of the most recent post recessionary period.  Is the economy growing organically or not?
         

The nominal numbers simply don't lie.  Total credit market debt expansion has outstripped GDP growth close to 4.4 to 1.  Household debt relative to wages and salaries has grown at a rate of 7.4 to 1.  And corporate debt has grown just shy of 8 to 1 relative to corporate profits.  To cut right to the chase, the numbers are clear on the fact that the economic recovery to date has been very significantly supported by meaningful acceleration in total credit market leverage, and implicitly by asset inflation in good part provoked by once in a generation lows in interest rates.  There is no question in our minds that the Fed is completely aware of the importance of asset inflation in the current environment.  In fact to suggest that the Fed isn't targeting asset values in its policies of the moment borders on complete naiveté.

Given that there has so far been zero net recovery in payroll employment since the end of the official recession, we assume that for the economy to continue its recovery trajectory ahead, interest rates need to remain low and asset prices (stocks, bonds and real estate) need to at least maintain their values, if not further expand in price.  So far, the leveraging of inflated asset values system-wide is the horse that brung us as far as the current recovery is concerned.  The table above tells us that there are very few organic vegetables growing in the GDP garden of the moment.

Weighing In On Interest Rates...We want to spend the rest of this discussion focusing on why our current economy and financial system may be more levered to interest rates than ever before in modern history.  Interest rate issues go much deeper than simply acting as a catalyst for the current recovery.  As we mentioned, US financial markets, aggregate corporate earnings, real assets and the real economy broadly are extremely dependent for now on the sustainability of low interest rates.  It's much more than just households walking away from the mortgage refi game when mortgage interest rates pop up by half a point.  Let's have a look at what we believe are very important systemic characteristics of the moment not being given enough attention by the mainstream.

THE STOCK MARKET

Starting from quite humble beginnings many decades ago, the financial sector is currently the largest sector-specific weight in the S&P 500, post the demise of the outsized S&P tech weighting over the last three to four years.  There is no question that the rise of the non-bank financial sector has driven a fair amount of this sector weight expansion.  We always like to check in on longer term S&P 500 sector weights given that reversion to the mean exerts such a powerful longer term gravitational force on financial assets of all kinds.  In the modern era, the meaningful lift off in the ratio of credit market debt relative to GDP really began in the early 1980's.  As we have mentioned too many times now, it's clear to us that we have literally lived through a period of generational change since the early 1960's with regard to the perception and use of leverage system-wide in the US.  It just so happens that the lift off in the financial sector weighting within the S&P also began more than two decades back.  From less than 5% of the total S&P in 1980, the financial sector now accounts for just shy of 22% of the total capitalization based weight of the S&P.  A financial sector that is ultimately dependent on interest rates and rate spreads for its current profitability and forward growth prospects.
       

Quite simply, the potential forward total return of the S&P index as an investment has never been this dependent on the financial sector.  A financial sector that has simply mushroomed during the greatest multi-decade bull market for interest rates in multiple generations.  Moreover, as the broader economy and corporate profits faltered during 2000-2002, financial sector earnings came to dominate sector earnings power within the S&P.  Even today, the financial sector produces more nominal earnings than any other SPX sector of the moment.  As you can see, rising interest rates at some point will not just cause academic P/E multiple compression in stocks broadly, but will cut right into the earnings and stock price heart of the S&P's most important sector of the moment.

THE CORPORATE SECTOR

An article appeared in the NY Times last week proudly proclaiming that the "Debt-Heavy Economy May Be Too Jittery About (Interest) Rates".  The author cited that by 3Q of last year, more than 70% of the debt of non-financial corporations was longer term, fixed rate debt, up from 60% in 1998.  Corporate America has basically refinanced, right?  We suggest this was a cursory analysis at best, and potentially very misleading as it applies to the forward sensitivity of corporate America to interest rates.  We cover the US derivatives markets quarterly and have done so for years.  It's a fact that interest rate swaps far and away make up the bulk of total derivatives outstanding in the US banking system.  At last count, the notional value of swaps held by the big banks totaled in excess of $41 trillion.  To suggest that interest rate swap vehicles have become important to the financial system, the corporate sector and real economy in the US is nothing short of an understatement.
      

Suffice it to say that interest rate swaps have become a key to modern corporate finance.  CFO's across the land have taken meaningful advantage of the ability to "swap" longer term and higher cost fixed liabilities into lower cost, shorter maturity floating interest rate exposure.  The ability of corporations to use derivative products to lower their total cost of capital has been a fantastic gift to corporate sector profitability and cash flow, and will continue to be so as long as short term interest rates remain low for a sustainable period.  It's when the sustainability of anomalistically low short term rates ends that these contracts are going to have to be unwound and corporate cost of capital will rise by definition.  The interest rate swap numbers make it clear that the macro balance sheet of corporate America is levered to short term interest rates as almost never before.  As you know, in the economic recovery of the early 1990's, most CFO's were just getting up to speed on the academic concept of these vehicles as only a few adventurous souls were dipping their toes into the derivatives waters.  In the early 1980's, swaps were still just that, an academic concept.  We are convinced that in the current environment characterized by the widespread use of interest rate derivatives in corporate finance, total corporate balance sheet and P&L sensitivity to interest rate movements ahead is not to be dismissed as inconsequential.  In fact, quite the opposite.

What we believe the author of the NY Times article may be missing is that even in a period of relatively low longer term cost of capital, many a corporation has still chosen to swap into floating short rate alternatives.  A case in point is GE.  A few years back Bill Gross at PIMCO pointed out the implicit risk in unbacked mega outstanding GE commercial paper.  In response, GE issued a very large 10 year bond deal and took down some of its commercial paper outstanding at the time.  In the press release that accompanied the longer dated bond issue, GE claimed that its total cost of capital would remain unchanged.  This could only have been accomplished through a interest rate swap arrangement.  Of course, on GE's books, you'll find the 10 year bond issue on their balance sheet, not the swap arrangement.  There is no question that this technique has been repeated thousands of times over across corporate balance sheets during the last three to four years.  How else would the chart above look like it does?

Lastly, we need to remember that the business of financing has become big business to corporations normally categorized as non-financial corporations.  In fact, every time we hear someone characterize GE as an industrial conglomerate, we laugh out loud.  Folks like GM have been making money on mortgage lending over the past few years as opposed to selling cars.  Even hard core capital goods companies like CAT and Deere have finance subs that are definable profit centers.  Without sounding melodramatic, we believe it's more than fair to say that corporate America has a very big stake in the sustainability of low short term interest rates looking ahead.  In fact, dependency unlike any post recessionary period in modern history.

THE FOREIGN SECTOR

A few weeks back, the US Treasury released November 2003 numbers for foreign purchases of US Treasuries.  As of October month end, the foreign community owned 41% of total marketable US Treasuries outstanding.  As of November month end it was 42.2%.  Will it be another 58 months or less until the foreign community owns all marketable US Treasury debt?  Of course this is a sarcastic comment, but directionally the increase in foreign ownership of US Treasuries has been going straight up for the past few years literally by the month.  When we broke apart the November numbers, 72% of total November Treasury buying came from five Asian countries - Japan, China, Hong Kong, Taiwan, and Korea.  As you remember, in early 2003 the Fed threatened to essentially monetize US debt (buying bonds with money that was basically "printed" out of thin air) if deflation were to become a significant problem stateside.  The Fed never had to make good on this threatened promise as Asia has been doing the job for them, deflation or no deflation.  

We've focused on foreign exchange intervention in many a discussion and necessarily this has included an examination of foreign buying of US Treasuries in support of foreign exchange interventionist efforts.  We won't go through another long explanation of the process by which this is happening in this discussion.  You already know that a declining dollar has made foreign purchases of US financial assets of all types a losing proposition for some time now.  But so far into this process, interest rates have behaved.  The losses for the foreign community have really come in the form of exchange rate losses as opposed to absolute price destruction as a result of higher US domestic interest rates.  A forward rise in interest rates would change this in a heartbeat.  Of course what we don't know is how the dollar will react when interest rates eventually do rise meaningfully.  Nonetheless, as we continue to move ahead toward the next interest rate up cycle, we do so with foreigners owning more US fixed income assets than ever before.  For now, what this ultimately means remains to be seen.  Maybe the foreign community will be completely content to suffer yet further losses in bond values as US interest rates rise.  Or maybe a meaningful trajectory of higher rates will be the straw that breaks the proverbial camels back in terms of foreign support of US fixed income markets.  In 2003, foreign holdings of US debt as a percentage of the total US debt market reached a new high.

Again, although we cannot forecast limits as to where the foreign community might eventually decide they simply own enough US fixed income assets, the following historical view of life does suggest that there might actually be a macro asset allocation comfort level at which the foreign community might undertake a small bit of asset allocation soul searching.  In fact, we sure seem to be there right about now.  As you can see, at least over the past three decades foreign holdings of US bonds as a percentage of total foreign holdings of US financial assets has not gotten much above the high 40's in terms of an asset allocation percentage.
        

Not only have anomalistically low interest rates been a big stimulant to our economy of the last twelve months or so, but low rates have also encouraged US households to continue to lever their own personal balance sheets to record levels in many cases.  The foreign community helping to keep our domestic interest rates near four decade lows has allowed US consumers to extract record amounts of equity from their ever appreciating residential real estate.  Ever appreciating for now.  Has the kindness of strangers not only facilitated, but also helped deepen the very significant and meaningful financial imbalances both in the US and global economies?  Killing us with kindness, if you will?  Given that the foreign community now holds 42+% of US Treasury debt, we have the feeling that over the intermediate term the foreign community will have much more influence over the direction of US interest rates than will the Fed.  Especially in terms of interest rates that apply to US consumers - intermediate to longer maturity rates.  Slowly but surely as the years are passing, the Fed is ceding its true power over the domestic interest rate cycle to the global capital markets.  Market participants can react in a short term manner to FOMC minutes all they want.  Go ahead and rant and rave over every change of wording.  But longer term the global capital markets are becoming our true interest rate master.  More so now than ever before.  At some point ahead, we are destined to live through a domestic interest rate up cycle with the foreign community owning more US debt than ever in history.  Like it or not, in terms of the forward relationship between US interest rates and the willingness of the foreign community to finance US credit market demand for borrowings, it's a new era.

The factors we mention above are far from exhaustive in terms of detailing what we believe to be the very significant interest rate sensitivity of the broad US economy and financial markets of the moment.  Yet these issues mentioned carry meaningful weight in our minds.  It's not just that bond values will contract or equity P/E multiples will be pressured when interest rates ultimately start to rise.  There is much more to be aware of when pondering the next US interest rate up cycle.  Much more.  We believe it will cut more broadly and deeply across the economy than possibly anything seen in the collective memory of the current generation.  Just maybe, we should be asking our grandparents how they feel about the relationship between debt, the economy and interest rates.  You remember, the same grandparents that probably paid cash for their first house.