Economy and Equities Still Vulnerable: It's a Matter of Credit

Some clients have kindly told me in recent months that I accord too much importance to monetary figures, such as M2, M3, the Commercial Paper market or bank loan volumes, and that while these data were fundamental to understanding the macroeconomic outlook, they could not predict the near-term behaviour of financial asset prices, which fluctuate under the more decisive influence of cash flows and, thus, waves of optimism or pessimism.

Their point is perfectly valid, but I pointed out that if I had found the right mix between macroeconomic analysis and short-term trading strategy, I might today be happily practicing another line of work.

If I insist on closely studying the mechanism of loan circulation in the economy, it is because, to paraphrase Milton Friedman’s often bantered about statement in recent times, “only money matters”.

This quote has indeed been used by certain paranoids, who draw a strange parallel between the doubling of the Fed’s balance sheet and its supposedly logical consequence: (hyper) inflation.

I would just like to point out that Mr Friedman, who was awarded the Nobel Prize in Economics in 1976, claimed in his debate in 1968 with Walter Heller, the leading economic advisor to the Kennedy and, later, Johnson administrations, that it is an “absurd position, of course, and one that I have never held”!

This same Milton Friedman in 1997 criticised the Bank of Japan’s monetary policies as “inept”, and stressed that Japan needed to “accelerate its money supply”.

So why this obsession with credit?

The ease of obtaining credit and its cost are the sine qua non condition for economic growth

Most business projects require borrowing to finance the capital investments needed to produce their future revenue flows.

If credit is unavailable, oligopolistic situations are reinforced, because under such conditions only companies with sufficiently large cash reserves can continue to invest. Such a situation spells the death of innovation and productivity growth.

This hard truth is not limited to manufacturing firms, but to all businesses, be they in services or manufacturing.

A healthy credit system is also needed on the consumption side of the economic equation, because buyers of homes or costly durable goods (cars) also need to spread their cash expenditures over time in line with their anticipated future income.

On the basis of these principles, we took a very pessimistic view on the economic situation during the “death of securitisation” with the implosion of the Bear Stearns hedge funds, and we believe that today’s stock market rally will be hard to sustain, given the evolution of macroeconomic parameters.

As an illustration, check out the graph, below, tracing the curves in Europe of the Eurostoxx 50, the unemployment rate and the growth of M3, as well as bank loans to households in the eurozone.

In the first place, M3 in the eurozone has not been so weak since the post-reunification period of 1993-94, while the ECB is using all the “unorthodox” methods at its disposal to counter creeping deflation.

Moreover, the volume growth of loans to households has collapsed to 0% from an average of 6% to 8% (+5.2% at the lowest point in 2001).

We see the same phenomenon in loans to non-financial businesses, which fell to 1.5% in July from 15% in 2008 (low point of 2.7% in November 2001, not included in graph for readability reasons).

The eurozone unemployment rate, out Tuesday morning, now stands at 9.50%, the highest in a decade …

These elements are obviously correlated, because this decline in loan circulation is not simply the result of banks’ reticence to lend as they struggle to bolster their balance sheets.

It is also a consequence of the now familiar Debt Deflation process.

On the one hand, households with the means to do so are doing everything they can to pay off their existing debt, as they struggle under the weight of, what have become prohibitive real interest rates, instead preferring to place their available cash in money market funds which offer almost no yield.

On the other, lending terms have hardened for the weaker loan applications.

When officials explain that unemployment will continue to rise, households react by putting off purchases. It is hard to justify agreeing to future monthly payments when your income visibility has disappeared.

These same officials like to talk up the positive aspect of lower prices on real household income, but who wants to rush out and borrow under such conditions, particularly, if we believe that prices will decline in the future?

The $1 trillion question is thus: how can we determine if the stock market rally since March 2009 is simply a reaction to the preceding very steep fall in a very short lapse of time, or if it is simply anticipating the success of fiscal and monetary stimulus plans and the rebound of the other curves a few quarters down the line?

Europe: Eurostoxx 50 and fundamentals

Are stock markets anticipating an economic turnaround?

Access to credit is not improving

We will need to keep a close eye on these different credit indicators, and I must admit that the latest available data does not leave me all that optimistic.

In the US, the Atlanta Federal Reserve has just confirmed that banks continued to tighten lending terms in the second quarter, citing greater future uncertainty and less risk tolerance, but the Fed also says demand for new loans is down.

In the United Kingdom, the association of business executives, EEF, has just stated that the hardening of lending terms will undermine moves toward economic recovery.

Since we’re on the subject, let’s not forget China, the world’s main credit pump in the first half of the year.

Some tell me that just goes to show that it helps to have “directed” banks, but I would just like to point out that if Fannie Mae and Freddie Mac were not directed by the US Treasury, with their financing ensured by the Fed, it would be hard to imagine what the US home loan market, or the property market in general, would look like today.

In any case, it was confirmed this morning that Chinese banks granted only 300bn yuan in new loans during August, down from 1.53 trillion yuan in June, which goes in the direction we had anticipated.

However, I remain convinced that, should the Shanghai stock index fall too steeply or if the contagion hits the real estate market, the Chinese government will order banks to step on the lending accelerator once again.

That will change nothing in the downward spiral, as laid out in the Minsky ladder, but whether it occurs with a SHCOMP at 5 000 or 3 000, god only knows.

It is important to understand that the Chinese stock market is purely speculative. It is a momentum market, operating on credit.

Who really believes that the country’s individual investors, which make up the bulk of the market, are interested in macroeconomic analyses or company balance sheets?

That is not yet part of the domestic stock market culture, which also needs reliable data.

We continue to believe that the stock market rally, understandable when short-term rates are at 0% (extension of capitalisation multiples), but difficult to reconcile with our macroeconomic scenario for the coming years, is not worth betting on, except for trend-follower investors, to the extent that they are vigilant enough to know when to pull out.

But we advise our customers to avoid this bet.

AS for government fixed rate instruments, although we would prefer taking advantage of a slight correction to suggest new downward interest rate strategies, we remain positive on this asset class, which has come out of the last six months fairly unscathed on stock markets.

Disclosure : Long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%.

Comments

[Davewmart:]

Thanks for the article.
I would be grateful if you would expand on the following point:
'This quote has indeed been used by certain paranoids, who draw a strange parallel between the doubling of the Fed’s balance sheet and its supposedly logical consequence: (hyper) inflation.'

So if not hyperinflation, what are the consequences of this expansion in the balance sheet?
Cannot at least a great deal of the present rise in the stock market be put down to loose liquidity, in a form of asset price hyperinflation?
BTW this is a genuine question, not an attempt to pose a counter theory.
Something is going to happen to all this money, so if there is no hyperinflation, where does it end up?

Sep 02 06:55 AM

[CautiousInv...:]

We have had this discussion before and yesterday there was in interesting article in the FT commenting upon the curious disconnect between bond and equity markets. While the yield curve is sloping up, it is only doing so because the short end has the weight of the Federal Reserve sitting on it. The long end, with the ten year at 3.4%, is dimissing a recovery of any strength; the prospects of a more robust recovery would stoke inflation expectations, making the yield rise on the bond curve further out.

As you say, the banks are sitting are sitting on piles of reserves enabling banks to make money simply by parking these reserves in the Fed vault. If the Fed were serious about transforming reserves into loans, they would not be paying any interest on these reserves which would give banks more incentive to find other uses for the funds. The truth, though, is by paying interest on these reserves the Fed is simply giving money to banks knowing their balance sheets are still weak and challenged after passing Timmy's stress test.

There are early signs that M2 may be contracting but it is a rather recent development and nothing to make much about. Loan volume is another story, though, and private sector borrowing/lending is contracting for two reasons: consumers wish to liquidate debt and many businesses are being denied debt, particularly small businesses. The latter, who have to pay more quickly when purchasing inputs, are waiting longer longer to be paid by larger businesses buying their output; they are in a horrible credit squeeze which is drying up their working capital.

Of course, the oligarchs, Washington and MSM overlook their inconvenience while conveniently ignoring the fact that small businesses, which are primarily owned by Republicans, have in the past served as an engine of job growth. You would think any sentient human being with active neural activity would start connecting dots and realize many small businesses are about to go under.

Sep 02 07:51 AM

[Drew Horn:]

Good analysis, thanks. However, you neglect the potential pull of the remaining stimulus funds.

The major change in consumer behavior, savings from -.05% to +5%, is probably corelated with, but more influential than, the trend toward paying off debt. It's my impression that the future or the equities market in the US can be predcited based on how consumers will behave over the next two years. Now all we need is a PHd in consumer psychology.

Sep 02 09:48 AM

[Asbytec:]

I have to agree with the author, deflation will keep hyperinflation suppressed for the foreseeable future.

On credit, I am all for investment credit. As the author points out, this is good for business and employment. However, (excessive) consumer credit is a horrible thing. It is used for consumption and rarely provides any return. The end result of excessive consumer credit is to indenture consumers to banks. We feel wealthy because we can borrow that wealth from those who really own it. When you (we) cannot get a loan, now, how wealthy are you? Answer: as wealthy as you (we) really are. Joe six pack is flat broke, he just didn't know it...until now.

But, that's the banking system for you...it doesn't pay to save nor to borrow (for consumption.) Savings interest rates do not keep pace with inflation, even mild inflation, and borrowing your wealth simply robs you of money over the long haul. We need a new banking system, rather our old one would be fine...without a Federal Reserve...it is neither.

Okay, off my high horse. The economy should wind down a bit more. First, the hard lessons learned of easy credit will preclude those who have wealth from lending it to Joe Six Pack on the same scale. My guess is, the days of getting a plethora of credit card applications in the mail are over.

Second, the financial markets will be highly regulated. Derivative money will not be as plentiful as decades past. Third, the consumer has learned a hard lesson, too, about excessive debt...once bitten, you know. Coupled with the deflation that has already occurred, there is not nor will be anytime soon enough liquidity to drive the global economy we knew and loved during the 90's.

Anyone who thinks the recession is over and the market will soon reach it's highs needs to step back and look at the bigger picture. What is the face of the American economy? It's Joe Six Pack who flips burgers in the service sector and spends large portions of his income to pay off consumer loans. That money creates wealth for the few trough feeders.

We have a failing auto industry, but we build a few aircraft. Basically, we make little the world wants to buy, like hydrogen cell technology. The lawyers see to that, it's cheaper to buy it from France than to hire a fleet of scientists and engineers. We consume...we are gluttons...and we run huge deficits. That system has about reached it's limit. I see a possible major change in American consumer habits, whether by choice or otherwise, if the banking system will allow it.

I assert, the US consumer will place less global demand for goods and services. Who will pick up the slack? China's immature middle class? Europe's aging population? Mexico? (Why is Mexico even mentioned in the North American Union?) I don't see anyone feeding the global economic machine with the veracity of the employed American worker and his credit limit. And there are a lot less of them (us) around...who've also lost their homes. Well, maybe the middle east can spend some oil revenue. Maybe, but it's not likely to sustain growth of the past two decades.

It does have to do with credit, and "they" ain't handing out much "wealth" to broke and indentured Americans, Canadians, et al. I believe the recent rally was driven by green shoots (amidst the thorns), investors following government stimulus money, and many just being tired and too eager to get back on the business as usual band wagon.

We're still in big trouble, folks, and the author correctly asserts it's all about credit, as well as the liquidity damn burst and weaker global consumer demand in the coming decades. Some extreme views will say the entire crisis was engineered for whatever ends. (Who knows...) I wish the system could just fail and be replaced with our constitutional system, if it weren't for the millions of indentured Joe Six Packs who rely on our current system for basic survival.

Anyway, it ain't over.

Sep 02 12:47 PM

[Erwan Mahe:]

Drew, if you have a pHD in consumer behavior, please help us.
Dave, as written by cautious investor, the reserve paying sytem of the FED changes everything.
banks may now increase their liquidity (reserve) without balancing, because of that. Study the experience of RNZB, you will see this is non-inflationary.
thanks for your comments guys.

Sep 02 12:53 PM