July 2005

The Ultimate Squeeze Play?

Survey Says…It’s no huge secret that the US Treasury yield curve has been flattening for some time now.  And it’s not like we haven’t lived through prior historic periods of both severe curve tightening as well as outright yield curve inversion.  It’s all part of the normality of economic cycles.  But this go around, we believe it takes on a bit more significance in that the financial services industry is a much larger part of the total US economy at the moment than has been the case in cycles past.  In fact bigger than in any cycle past.  In other words, as an economy and broader financial system, we've experienced a literal explosion in financial services capacity over the approximate last quarter century.  Is it really any wonder that the domestic credit cycle over the last half-decade has gone to such extremes?  In our minds it’s no big mystery at all.  In any industry where we find excessive capacity, it seems it’s only a matter of time until profitability is squeezed and the weak players shaken out.  But during the recent cycle, the demand for credit has been so large that there has only been increasing financial services capacity as opposed to any type of shake out or reconciliation.  Although it’s ultimately to come, it has in no way arrived just yet.  It's pretty simple to understand continuous capacity expansion within the context of a two-plus decade declining interest rate environment, isn't it?  Thank you Federal Reserve for facilitating such outsized growth of the US financial services industry.  Conceptually, will US financial services capacity ultimately face the same type of severe economic cyclicality potentially implicit in say China’s excessive manufacturing capacity?  We’ll see, now won’t we?

You know we have been discussing the current business cycle versus credit cycle concept ad nauseum as of late.  But what we have not yet done is question the demand side of the equation.  Simple demand for credit.  After all, we already know what has happened on the supply side.  Could it be that at some point the current US credit cycle comes to probably a rather dramatic conclusion as a result of diminishing demand as opposed to a credit crunch, or lack of credit supply?  In our minds that is certainly a possibility.  Especially given the fact that this Fed will in no way intentionally puncture the credit bubble on its own accord.  Although we clearly expect a knee jerk equity market rally when it becomes clear that the Fed is done raising short term interest rates for this cycle, it will be absolutely critical to watch credit cycle dynamics at that time.  And especially when the Fed ultimately eases once again.  As you know, the price of credit and the demand for credit are absolutely two different things over the long run.  We believe this type of demand side thinking has been virtually lost on many market participants in the present cycle.  After all, with the baby boom wind at its back, the financial services industry in the US has been in linear expansion for three decades now.  No wonder no one ever questions aggregate demand for credit.  But we suggest it’s worth some thought and reflection.  And the time is now, before it becomes a potential issue, let alone reality.  Why?  Although we may be jumping the current cycle gun for all we know, the recent Fed survey of bank lending officers reveals, at least in our interpretation of the results, that financial institutions are getting a bit desperate to make loans.  In other words, getting a bit desperate to issue even more credit than they are providing at present.  Remember, addressing demand versus supply is what we're after in this little conceptual exploration exercise.  After all, these days the banks are in competition with insurance companies, brokerage outfits, large pension funds, and even certain hedge funds when it comes to commercial lending.  Moreover, the ability to securitize loans and sell them into the secondary markets has made it appear as though the supply of credit is seemingly endless from non-traditional bank providers.  Let’s put it this way, this ain’t your father’s (or mother's) financial services environment anymore.  It’s a new world in a big way.  You don’t need us to describe all the specific changes by any means.  Again, capacity is massive.

We thought it would be instructive to have a quick peek at the character of the current Fed bank officer lending survey set against the experience of the last decade and one half.  Let’s look at a quick set of charts.  First, below we’re looking at the net percentage of banks tightening credit standards for large company C&I (Commercial and Industrial) loans.  As is clear, we're at an all time low in the history of this data.  Banks are more willing to make commercial loans today than at any time in the last 15 years at least.  Is this because they perceive an absolutely gangbusters economy dead ahead, or rather that it is imperative that they drive loan volume through in order to satisfy corporate earnings expectations in what is a very highly competitive environment for lending?  Which characterization is correct and why so lenient on the lending standards?
          

As you'll see below, banks have not relaxed credit standards for just the large companies wandering the planet, but they have also extended their benevolence to the smaller corporate fish in the pond.  As you know, at least conceptually and academically, lending to smaller companies is often much more risky than lending to the larger firms for very obvious reasons.
        

Hmm.  We wonder if these loan hungry bankers have caught a glimpse of the recent NFIB small business optimism survey?  Perhaps not.  Bankers may feel pretty darn bullish about small company financial prospects.  It's just a shame that the small companies themselves don't seem to be showing the same directional optimism as might have been the case six months to a year back.  What do small company executives know anyway, right?
        

In our minds, very telling is the fact that the percentage of banks increasing their lending spreads over their cost of funds has dropped like a rock as of late.  This is critical stuff in terms of bank profitability.  Again, for both large and small companies, the current surveys stand at new all time lows, given the near vertical descent in the recent responses.  The message is the same.  Lending competition is obviously intense and capacity is plentiful.  Perfect combo environment for a flattening interest rate curve, no?
        

In our way of thinking, the message of the two charts above is absolutely crucial.  While the Treasury interest rate curve is flattening and the cost of funds to banks is increasing rather smartly over the last twelve months, bank officers are apparently more than willing to hold the line on what have been their already contracting interest rate spreads over the last year.  Again, is this happening because the banks are dealing from a position of strength, or is it rather a reaction to aggregate loan origination competition and perhaps slowing rate of change in demand?  When we look at the surveys of loan spreads and credit standards above, it can be seen that prior bottoms in these results date back to the 1993-1994 period.  As you'll remember, the Fed was lowering rates prior to this time to basically reliquify the US banking system in the wake of both the S&L crisis and the high yield LBO loan debacle of the early 1990's that hit the large banks.  By the time the 1993-94 period rolled around, many a bank balance sheet was on the mend and bank managements were ready to get back to the business of lending.  But what they faced at the time in terms of lending spreads (ultimately the source of lending profits) was quite different than the environment we see today.  The following chart chronicles the history of the Fed Funds rate, the 5 year UST yield and the 10 year UST yield across the 1993-94 time frame.  Just as an eyeball observation, the spread between short rates (as a proxy for bank deposit rates or cost of funds) and longer maturity yields (as a proxy or index for bank lending rates) was close to 200 basis points or more, depending on the exact month in question during the period.
        

But, as you know, this set of relationships is a far cry from what we see in the current market place.  In addition to significant bank competition and very excessive financial services capacity, interest rate spreads are simply onerous for really all financial services firms.  With the Fed Funds rate at 3.25% (and climbing), the 5 year UST at 3.7%, and the 10 year UST under 4%, we're talking about a 75 basis point top to bottom maturity yield spread.  Talk about a compression in profit margin potential, so to speak, between cost of funds and use of funds.  It looks a whole lot different than life in 1993 and 1994, now doesn't it?
       

What we see today in real numbers and financial services profit potential is a whole lot different than when bank lending officers apparently felt so bullish about lending near the prior bottoms of these surveys in 1993-94.  Again, is this a sign of bank lending bullishness, or banker realization that their jobs depend on loan volume?  And in a period where lending spreads are tight, bottom line earnings become much more heavily dependent on volume.  Kind of like equity fund managers feeling the need to remain fully invested no matter what aggregate equity valuations may look like, right?  Is the apparent willingness to take increased shareholder capital risk in bank lending for diminished profit potential being driven by the all-consuming need to produce quarterly earnings results?  We think that's exactly the case.

As we step back and look at the broader macro picture, it's almost ironic that many of the financial imbalances fostered during the current cycle now seem to have begun to turn directly on the credit cycle provocateurs themselves.  The carry trade (borrowing short and lending long) literally fostered and encouraged by the Fed, is now, at least in part, acting to cap longer term interest rates while the Fed necessarily needs to restore some semblance of credibility to the short end of the yield curve by raising the Funds rate.  The recycling of trade deficit dollars back into the US Treasury market has likewise acted to temper any acceleration in longer term interest rates.  And finally, the "sea of liquidity" argument at least has some validity in terms of helping to explain that longer term yields are indeed benefiting from excess liquidity needing to find a home.  All characteristics of a credit cycle of generational proportion.  And the imbalances that have now helped contribute to a flattening yield curve at present are meeting up with financial sector capacity greater than anything we have experienced in modern financial history.  Simply put, it's a squeeze play.  And given that the credit cycle is so key to the economic and financial market outcome that lies ahead, maybe the ultimate squeeze play of the moment.  Doesn't it all come down to having to watch for changes in demand for credit quite closely at present?  We think so.  These changes won't happen in dramatic fashion overnight.  But, as in many things related to the financial markets and real economy, it's change at the margin that can be the most powerful messages.  At present, we're listening in a big way.

As a final little look at the Fed bank officer lending survey, the following chart shows bank lending officers apparently seeing a level of increased demand for C&I (commercial and industrial) loans just about as high as anything seen over the last decade-plus.
      

It's wonderful that bank lending officers see increasing demand for C&I loans.  As you might remember, C&I lending has been in decline since hitting a prior peak in mid-2001.  Corporations simply flush with cash have not needed to borrow heavily.  No huge mystery here.  It's only been in the last year that demand has indeed turned up modestly.  For now, we're still about $140 billion shy of prior highs in terms of aggregate bank C&I lending activity, despite recent loan officer survey bullishness.  But as we've mentioned many a time, bank C&I lending has simply paled in comparison to virtually parabolic bank lending to finance real estate activity.  And that the bank regulators are worried about, as has been seen in recent comments and instructions to the banking system from the OCC (Office of the Comptroller Of The Currency) regarding home equity lending terms, etc.
       

Life Has A Funny Way Of Sneaking Up On You When You Think Everything’s Okay And Everything’s Going Right…You may have seen that aggregate 1Q corporate profits were reported a month or so back.  Let’s home in on the banks for a minute, OK?  In aggregate, quarter over quarter total corporate earnings growth was pretty darn anemic (although yr/yr still looks decent).  But when it comes to the banking sector, 1Q earnings versus 4Q earnings were up approximately 10%.  But interestingly, and very telling in our minds, was that quarter over quarter net interest income for the banks as a whole actually declined!!  C'mon, let's face it, net interest income is banking business meat and potatoes in terms of profitability.  How can this be happening when reported earnings were up 10%?  Easy.  Reduced expenses and reduced loan loss provisions rode into town to save the day for the banks in 1Q.  And for a number of institutions like BofA, selling off portions of their portfolio and booking the profit in the quarter make everything OK…for now.  The fact is that the aggregate net interest margin for the banks was at a two decade low (at least) in 1Q.  If that doesn’t reflect both excess capacity (competition) and a flattening yield curve, then we just don’t know what does.  Lastly, as is implied in the chart above, real estate lending continues to be THE key for the banks right here.  Again, the chart above says it all.  It’s simply a reminder of how levered the US economy and financial system is to real estate prices at the moment, both commercial and residential.  And levered not only to prices, but to very action of the continued levering up of the asset class itself as it inflates.

So here we have an industry showing record 1Q earnings.  Moreover, loan delinquencies and charge-offs have fallen over the past few years (in our minds directly due to refinancing opportunities of a life time).  Wonderful.  And to top it all off, valuations aren’t exactly breathtaking by any means.  With a market that should begin to anticipate a nearer than not end to the Fed tightening cycle, the banks should be just the type of defensive investment institutions looking to hide money in lower valuation/higher yielding spots are gravitating toward, correct?  The table below gives us some current stats on the BKX (the Philly Bank Index).  Not many green YTD return numbers, are there?  Why not?  Financial services should be one of the largest beneficiaries of an ultimate conclusion and reversal to the Fed tightening cycle.  Just what is the market and the BKX in particular telling us?

Moreover, what are the charts below telling us about the Banks and broader financial services?  As you can see, both the BKX and the XLF (the ETF for the financial sector) have been trading in a price performance band relative to the S&P since the equity rally began in early 2003.  They have both recently broken out to the downside against the major equity average.  Do the markets sense the conceptual excess capacity issue we referred to above, along with what a flattening yield curve portends for future earnings?  Has the market “looked through" 1Q bank headline earnings to see the quarter over quarter contraction in net interest income earned?  By the way, excluding the current quarter, there have only been six quarters since 1990 (15 years) when banks have watched quarter over quarter net interest income contract.  And in the current quarter this is happening in a very favorable loan loss and delinquency environment of the moment.  During the last 15 years there have been no consecutive quarterly declines.  2Q 2005 bank numbers should be very telling, to say the least.  In anticipation of an end to the Fed tightening cycle, shouldn't the banks and broader financial services stocks be outperforming the SPX (as being representative of the broader equity market)?

Note the declining 200 day moving average of these relationships.  Declining absolute prices (in this case a relationship price) and declining 200 day MA's can be a very telling combination.  And not a pretty one.  Are these two charts pictures of broad and extended distribution of the financial stocks over the last two years?  For now, it sure looks that way to us.  We'll see what happens ahead.  As always, we're simply trying to listen to the message of the market.
        

The Weight Of The Evidence...If the banks are having trouble achieving loan growth (as measured by rate of change), which we suspect they are, this is happening in concurrence with their profit potential being squeezed hard in terms of both present and forward net interest margin possibilities.  Just what does this suggest about the broader economy and financial markets moving forward?  Without oversimplifying the issue, the current US economic recovery has been built on excessive monetary and fiscal stimulus.  It has been built on excessive credit acceleration, primarily at the household and government levels.  To see the types of dynamics we've described above set up in the banking system is not a wild positive for what lies ahead in our opinion.  It's not the end of the world by any means, but it says something about growing lack of demand for credit at the edges of the system.  More correctly a deceleration in the rate of change in demand for credit.  In one sense, it at least partially validates the global economic slowdown theme we've been discussing as of late.  Moreover, in the Fed survey, the bankers are essentially telling us that they are now willing to stretch lending standards in a low rate of return environment.  Quite simply, more risk for less return.  Sounds great, right?  This clearly suggests a certain amount of stress.  And remember, this is just data covering the banking system.  There is no question that the broader financial services industry in the US is being subjected to these same capacity pressures.

For the financial markets, we simply need to remember that the financial sector remains the leading weight in the S&P 500.  A slowing in rate of change of demand for "financial services" broadly will weigh on market averages as the financials are not only the leading sector weight, but also the leading earnings weighting in the index.  Without belaboring the point, we suggest investment sector selectivity ahead is absolutely crucial to investment success.  What we've discussed here is simply another reason as to why.
        

One last chart.  It's S&P sector performance YTD through June.  Despite the rally of the past month that has lifted such sectors as tech, individual sector performance disparity remains meaningful.  For now, a few of the meek (in terms of SPX sector weightings) continue to inherit the Earth, while a number of heavyweights remain down for the count.