12/12                                                                                           

FED MEN TELL NO TALES
UPDATE: 3Q 2000 FED FLOW OF FUNDS REPORT

"D" Day?...Well, today is double D Day.  The two big D's on our mind at the moment are debt and deflation.  The quarterly Fed Flow Of Funds statement for the period ended September 2000 has hit the Street.  As you know, we review the contents each quarter as a routine matter of course.  This time around, we believe the report deserves special attention because of the deflation we see occurring in the equity market.  On a stand alone basis, leverage can create problems, plain and simple.  End of the world problems?  Not usually.  Deflation on a stand alone basis is also not a pretty sight, but can often be contained and managed.  Put debt and asset price deflation together and you have the makings for a potentially geometric spiral of  negative financial consequences.  The deflation we have witnessed in the equity markets over the last eight months is spreading to the real economy.  Retail sales growth is deflating.  Corporate earnings growth is deflating.  Global economic growth is deflating.  On our present course, it's only a matter of time until prices of physical assets such as real estate also deflate.

In our book, deflation is a phenomenon ultimately borne of a prior excess.  So often we see this in attractive growth industries.  Risk capital rushes into the industry, usually building capacity to the point where price competition destroys above average profitability.  Industry asset values deflate as excess returns shrink and marginal capital departs.  Possibly in its pure form, the capitalist system can be partially characterized as the broadly swinging yin yang balance between cyclical inflationary and deflationary forces.  Before we wander too far down the path of philosophical economics, our concern regarding deflation at the moment is set against the backdrop of a rapidly decelerating domestic and global economy, and an ever increasing system wide appetite for credit.  Debt and credit growth rely on asset inflation to justify confidence.  Asset deflation is the mortal enemy of the debtor.  In today's world where so much debt or credit has been securitized against the assumption of ever higher asset values, we have the feeling that our current financial system would fare very poorly in an environment of asset price deflation.  That very environment may be upon us.  Surely as the economy moves ever closer to the inevitability of a recession, pressure on debtors will build.  In the fourth quarter, we have the feeling that BofA can give you 1.2 billion reasons as to why this can happen.

To us, the importance of the data revealed in the Fed Flow of Funds report grows ever more significant as the economy continues to slow.  Let's get right to the numbers.  In the third quarter of 2000, annualized debt growth in virtually all sectors of the economy outpaced growth in the generic macro economy by a mile:

The drop in Federal debt growth is more than understandable given the Treasury buybacks completed this year.  As you know, a changing economy will change government fiscal dynamics, ultimately arguing that this prop to prices will at best be reduced or eliminated, and at worst reversed.       

HOUSEHOLD DEBT

It's no secret that real estate prices have been booming across the US, accelerating particularly in 2000.  Household mortgage debt outstanding grew by over $100 billion in the 3Q alone after setting a one quarter record in 2Q.  Household mortgage debt outstanding in the 1990's has literally doubled to stand at close to $5 trillion.  The real estate recession and corresponding S&L debacle of ten short years ago is all but forgotten.  The former cycle of real estate credit excess ultimately leading to price contraction is a lesson lost in the current environment.  Unlike financial sector IPO's and VC investments, capital continues to be plentiful in the mortgage arena as asset price deflation has not yet arrived at the party.  Fashionably late, mind you.  

We currently have the luxury of living through one of the longest economic expansions in US history.  Consumers have enjoyed the benefits of a tight labor market, rising real estate and financial asset prices, and incredibly easy access to credit.  Acting accordingly, consumer credit outstanding in this country has almost doubled in the past decade as consumer's perceived need to save has correspondingly shrunk.  As the following chart clearly displays, growth rates in consumer credit expansion have been cyclical over time.  In fact a perfect picture of cyclicality (investors in card issuers please take note).         

In the last recession of the early 1990's, the growth rate in consumer credit actually went negative as consumer credit outstanding dipped slightly in 1991 and 1992.  As late as 1995, household mortgage and consumer debt outstanding stood at 83% of disposable income.  As of 3Q 2000, that number is above 91%.  Although consumer confidence surveys are an indication of public sentiment, we prefer the following chart as a barometer of public exuberance and potential complacency.  Consumer confidence surveys are for show, the following is for dough:

In very rough numbers, every 1% change in the US savings rate equates to about $90 billion in real economic activity.  Imagine a rise in the US savings rate to just 3% (well under any historical average experience).  We'd be talking about a negative swing close to $300 billion in consumption.  We told you last week that one week retail sales figures for the first week of December were the lowest in four years.  Today's Mitsubishi retail sales figure was anther negative experience.  For the retailers, God forbid consumer credit expansion slow or the saving rate turn positive from here.  Is there any clearer a message that our economy is dangerously dependent on credit expansion for growth?

CORPORATE DEBT

We find the experience of corporate debt reported in the 3Q Flow of Funds report as extremely telling.  After flat lining in absolute dollar terms during the recession and credit crunch of the early 90's, with corresponding annual rate of change declining into negative territory, corporate debt expansion went on a rampage in the 1990's, almost doubling from early decade levels.  Natural business expansion was a partial driver.  Low interest rates early in the decade favored raising debt capital as an alternative to equity financing.  But what was clearly different during this expansion was the voracious appetite of corporations to repurchase their own stock.  We have argued to you before that the misallocation of capital in terms of almost limitless funding of dotcom's during the early stages of Internet growth will go down in history as one of the classic foibles of human decision making.  Hot on its heels may be the money thrown at stock buybacks.  The complete irony of the exercise is that corporations were more than willing to repurchase shares when their valuations were much higher than today.  Now that many equity valuations have plummeted, shouldn't we see buyback after buyback being announced?  Isn't that what buy low sell high is all about?  Where are the buybacks now?  The following chart suggests that possibly corporations have already stretched their balance sheets a bit too far.  As we stated at the outset, when levered balance sheets meet asset deflation, the double edge of the sword of leverage is revealed.  Behold Excalibur:

The slowdown in corporate debt expansion is also the very first place we would expect to see a slowing economy effect generic credit expansion.  Being hyper sensitive to quarterly corporate profitability, contraction in leverage expansion is the first tourniquet applied to a deflating top line, gross margin and bottom line.  As you know, plant shut downs and layoffs come next in the continued evolution of an economic slowdown.  GM announcing the shuttering of Oldsmobile today is simply prima facie evidence of this progression.  When/if layoffs become widespread, just how do you think consumers will act in terms of the continuance of personal credit expansion?  Just ask Mercury Finance.  Oh yeah, that's right, they filed bankruptcy a number of years ago.  (No wonder they don't want to talk about it.)

THE FINANCIAL SECTOR

The financial sector has just about been ground zero in terms of credit expansion over the last half decade plus.  Whether it's the non-bank financials (including the brokers) or the government sponsored enterprises, growth in financial sector debt has simply been off the charts.

Since 1994, the financial sector has taken on leverage at double digit annual rates.  Unlike the doubling in debt outstanding in the household mortgage, consumer credit and corporate sector, financial sector leverage has increased 339% since 1990.  During the third quarter, the GSE's kept up with their 2Q double digit balance sheet expansion.  You may remember that the GSE's were relatively quiet in 1Q, of course that was the exact period where Baker's political spotlight was shining brightly.  Now that the FNMA/Freddie deal has been cut with Baker, it's time to go for it again?  As a quick tangent, today marks a very special occasion in government agency history.  Today, Freddie Mac announced the largest singular bond offering in the history of the GSE's.  Ten billion dollars.  Oh well, what are a few more zero's among friends, right?  As of September, Fannie and Freddie's equity underneath their liabilities looked as follows:

With roughly 3% equity relative to total assets, Fannie and Freddie have zero room for mistakes or really anything but an orderly financial environment.  As you may remember, this is exactly what many S&L's looked like just ten short years ago.  Unfortunately, their world became a bit disorderly.  Of course that was shortly before complete disintegration.

The broker dealer community came back with a vengeance during the 3Q in terms of credit expansion.  Finance companies also hit record credit expansion numbers.  It is more than quite interesting to note that the level of credit expansion seen in the aggregate that we have shown you was not able to provide enough general liquidity to hold up the stock market in any significant manner.  Likewise GDP growth moderated well below initial analyst expectations for the quarter.  Is growth in credit having a continually smaller impact on asset inflation and the tone of the general economy as credit in general continues to expand?  If nothing else, it sure appears that the translated effects of increasing credit expansion on economic health are diminishing.

The Chain Gang...Last quarter, we concocted the following charts which we hope will add a little perspective to the history of credit expansion over the last few decades.  The first chart is the chain linked growth in non-federal/non-financial debt in the US relative to growth in the Dow Industrials using a base year of 1964.  As you know, the broad use of household credit really got going in the early 1960's with retailers allowing their customers to purchase items and pay for them over time.  The early issuance of credit cards.  Just in time for the baby boomers to become educated about credit at a relatively early age.  Not that this means that the world is coming to an end, but growth in household sector and corporate debt over the past 35-plus years has far outstripped the growth in the Dow over that time.  (As you know, credit expansion has rarely, if ever, had a down year.  It's a shame that the same cannot be said for the Dow.)

The next chart is a bit more telling and meaningful for us.  In this we track the chain linked growth of the Dow and the NASDAQ relative to total financial sector debt since the early years of this bull market in the 1980's.  The growth in financial sector debt has very closely paralleled the growth in the Dow over time.  The NASDAQ diverged in growth rate in a blow off fashion for a brief while.  As of 3Q, a NASDAQ at a price point of 2000 would equate the compound 17 year growth in the NASDAQ index value exactly with the 17 year compound growth in financial sector debt.  Clearly we are not at 2000 on the NAZ yet, but we may be headed in that general direction quite soon.  Does this mean that the stock market needs financial sector credit expansion for its own growth?  Not necessarily, but the correlation in growth sure suggests to us that credit expansion plays a huge part in financial and real asset price growth over time.  You draw your own conclusions.  It's simply an exercise in perspectives.  See?

That Ol' Black Magic...That wraps up our little initial stroll through the 3Q Fed Flow of Funds report.  We will be coming back to this in the next few weeks with more discussion on the investments of pension funds, insurance companies, etc. in equities.  The history of household sector financial characteristics, etc.  This report is a wealth of information.  We wanted to start with the broad highlights for now and point out our sincere view that deflation may become a larger concern as the domestic economy slows in the quarters ahead and as deceleration in the global economy continues to unfold.  Unquestionably the domestic and global economies hold the key to mild deflation becoming something more.

We have to believe that the current consensus clings to the view of a soft landing.  But, just as every bear market begins as a correction, so too does every hard landing or recession begin as a hoped for soft landing.  In his speech last week, Dr. Greenspan whipped out his prescription tablet.  He's writing an economic amphetamine script as we speak.  The patient has just not filled the prescription yet.  It's a good bet that the Fed bias will be changed next Tuesday, but we certainly would not put it past the Fed to slice rates a touch as a show of good faith.  Greenspan's focus must clearly be on maintaining price stability in many arenas.  Price stability in the general economy, financial assets and real estate assets.  Nothing could be worse for the Fed than a potential bout of deflation set against the backdrop of current personal, corporate and financial sector balance sheets.  Skirting or falling into a recession in the quarters ahead would surely send deflation scares through the economy.  The question is, will the old liquidity black magic have the same effect as in the past, or is the patient building up a tolerance to the medicine?  At some point, excess liquidity is put in the bank for fear its value will erode in an alternative asset.  We have only to look at the experience of Japan for validation of this particular human response.

Cause And Effect?...We're not out of energy quite yet.  In fact, far from it.  By now most of you are reaching for your thermostats, cranking up the dial and depleting your piggy banks one mcf/btu at a time.  Tim has prepared the following study in perspectives for us that warrant attention.  As you know, capital always seeks the area where it will be treated most warmly:

Fourth Down And Gore To Go?...The Naz and the S&P are sitting very near their 50 day moving averages.  An initial point of resistance to be broken to the upside?  Or a point of a turn back for the home team?  We should know in short order.  Although we believe it would be short lived were it to develop, a rally from here would not surprise us in the least.  Tax loss selling will be abating (is that why LU, WCOM and T were up today?).  The Fed should be uttering nothing be Christmas kindness to the financial markets.  Lastly, do you really expect the mutual fund community to sit back and see what happens?  Or do you expect them to spend your money in a last minute attempt to ease the price pain of 2000?  After all, you've assured them you are a long term investor, haven't you?