2014: Stealth Tightening, Hidden Austerity, And The Potential For Recession

Includes: SPY, VNQ
by: Jake Huneycutt

Predicting recessions can be a foolish business. The US economy is akin to a giant puzzle with millions of tiny "micro" pieces. None of us can see more than a small fraction of this puzzle. Yet, we try to extrapolate the whole based on what we can see.

If you're familiar with Facebook, one of the relationship status options is "it's complicated." That's an apt description for the US economy right now. CPI and PCE show low inflation, while real estate prices are surging and corporate profit margins are at record highs. Lending is weak and many economists support quantitative easing due to deflationary fears; yet margin debt is at elevated levels and the stock market is on one of the greatest 4.5 year runs in American history.

What on Earth is going on? Have there ever been more conflicting economic indicators? If we look at one set of stats, we should be terrified of inflation and a potential "bubble", and if we look at another, we should be terrified of deflation.

In this article, I'm going to argue we should be afraid of both. I will examine the "mainstream consensus" and take a few contrarian stances:

(1) Inflation is not low; it is actually quite high,

(2) The primary driver of inflation has been fiscal deficits, not the Federal Reserve,

(3) QE is not creating real economic growth, but is creating real problems for the Social Security system and retirees,

(4) Stimulative (inflationary) policies often result in a deflationary boomerang, and

(5) Monetary policy and fiscal policy will tighten in 2014 unexpectedly

Most importantly, while it's difficult to predict the timing of a recession, I want to show that the odds for a recessionary contraction are elevated in 2014 and 2015 due to three major policy shifts: higher taxes, Dodd-Frank, and the troubled Obamacare exchange rollout.

Inflation is Moderately High

In a recent article, "Maybe It's Time To Worry About Deflation Rather than Inflation," James Pethokousis of the American Enterprise Institute argues that inflation is very low and that quantitative easing is the solution. While I share James' fear of deflation, I disagree with him on the particulars. Not only is inflation not low right now, but it's actually quite high. Moreover, quantitative easing is increasing the odds of a deflationary future (I'll get into that towards the end of the article.)

Pethokousis' views are close to the economic consensus right now. He uses current CPI, PCE, and GDP growth data to showcase his point on low inflation. Yet, I see this analysis as flawed.

The chart below examines CPI since 1990, and compares it to the 23-year average (2.7%), as well as the 100-year average (3.3%). You can quickly see why James and other economists have concerns about potential deflation.

YOY growth in CPI is currently at 1.5%, well below both the 23-year and 100-year averages. We can see a similar picture in Personal Consumption Expenditures (PCEPI). YOY growth in Aug '13 was a paltry 1.1%, compared to the 23-year average of 2.2% and the 53-year average of 3.5%, as you can see below.

However, as I've argued before, both CPI and PCE are misleading proxies for inflation. That's because they tend to only measure the price of goods, services, and energy, and ignore asset prices. This is critical because inflation tends to manifest itself in assets first, such as housing and real estate, as well as the stock market, before trickling down to goods and services.

Prior to 1983, the Consumer Price Index included housing prices. Since 1983, the CPI had used a concept called Owners' Equivalent Rent ["OER"] to replace housing prices. This has had a significant impact on CPI since that time. You can compare OER to the Case-Shiller 10-City housing price index in the chart below. The problem with CPI becomes apparently quite quickly when comparing the two measures.

The Case-Shiller index is much more volatile than OER. In fact, since the early 90's, OER has rarely ventured outside the 2% - 4% range. At the height of the housing bubble in July 2004, Case-Shiller showed 20.5% YOY growth, while OER increased a mere 2.5%. Likewise, when housing prices plunged 19.4% YOY in Jan 2009 via Case-Shiller, OER showed a 2.1% increase. The takeaway is OER always seems to increase 2% - 4% regardless of what is happening in the housing market and the overall economy. It is one of the least useful economic statistics created and it's a major part of CPI.

While there's a legitimate case to be made that CPI understates inflation over the long-run, the bigger point here is that CPI has been artificially stripped of any volatility due to the OER substitution. That makes it completely useless as a short- or even medium-term proxy for US inflation. Once you factor housing prices into CPI, a dramatically different picture emerges. The chart below shows housing-adjusted CPI, which substitutes Case-Shiller for OER.

Under this alternative measure of inflation, the 2000 - 2005 period appears highly inflationary, while the 2007 - 2009 period appears very deflationary. Yet, you'd never known there was a housing bubble or crash from glancing at the official CPI stats. CPI showed a modest 1.9% YOY growth in April 2004 (during the height of the bubble) and 5.6% YOY growth in July 2008 (during the middle of the crash), leading the Federal Reserve to enact too loose policies during the boom years and too tight policy from 2006 - 2008.

But there's also another problem with the CPI and that's energy prices. Energy prices are much more global than housing prices. Yet, energy prices have a much greater impact on CPI ("CPIAUCNS") than housing. The chart below examines CPI energy prices from 1990 - 2013.

You can also see a bit of how energy and commodities impact CPI by comparing the primary CPI measure to CPI excluding food and energy ("CPILFENS").

From about 2003 till late 2008, CPI is significantly higher as a result of food and energy prices rising more rapidly than the rest of CPI (with a few exceptions in 2007). In late 2008 and 2009, this trend totally reverses as energy prices plunged. Energy prices rebounded sharply from late 2009 to 2011, and then somewhere around 2012, the two measures started to harmonize again.

From about 2003 onwards, world commodity prices, particularly food, metals, and even gold, have been highly correlated with China's market cycles. For some commodities, such as copper, virtually all growth in demand has come from China. I bring this up to make a point: the CPI index may be showing us weakening demand for commodities from China, rather than weaker inflation in the US. The CPI's flaws thus give us a skewed perspective of reality. I would look more at US real estate to gauge inflation than CPI.

Budget Deficits are Primary Driver of Inflation

While there has been a major focus on the Federal Reserve in recent years, the budget deficit might be the bigger driver of inflation this time around. Below, you can see the US Federal budget deficit as a percentage of GDP since 1900. The recent spike began in 2009 and has tapered off since then. It is the third largest in the entire series, trailing only the World War I and World War II spikes.

To add more perspective to this, here is the cumulative budget deficit since 2008:

At 42.4% of GDP over six years, this is actually the second biggest deficit spending splurge in American history. It even surpasses the World War I surge, which only lasted for two years before a return to balanced budgets. It's noteworthy to point out that one of the worst spells of deflation in American history followed that World War I splurge and subsequent tightening.

If the true level of inflation, once we account for housing prices, is closer to 4% - 5% than 1% - 2%, then it's possible that some of this inflation is the result of this massive spending surge. Indeed, this spending binge has also led to a surge in corporate profit margins, which are now at record levels.

This is all to say that the market of the past several years has been artificially pumped via massive deficit spending by more than most people realize. Once this stimulus ends, it's completely possible that economic growth slows or collapses. This is what I'd call a "deflationary boomerang." Artificial stimulus creates inflation, but political pressures will eventually weaken the stimulus, which results in a boomerang impact, which can be deflationary, and at the very least, recessionary.

The Stealth Tightening of Dodd-Frank

There's been a lot of talk about the Fed and QE, but Dodd-Frank's tighter lending standards could actually be a bigger issue in 2014. One of the more interesting articles I've read lately comes from Economist Steve Hanke who argues, in spite of perception, that Janet Yellen is a "hawk". Hanke points out that the Fed only controls "state money", but the vast majority of money is created via banks. When it comes to "bank money", Yellen shows a definitive bias towards heavy regulation and higher capital ratios.

Yellen's approach is shared by the President and the Congressional Democrats. This brings us to Dodd-Frank's new lending restraints for 2014. Under these new standards, debt-to-income ratios for borrowers will fall from a maximum of 50%, down to 43%. A new study by ComplianceEase estimates that 20% of mortgages made today would be eliminated under the tighter standards.

How will this translate to the broader lending market? It's difficult to say for certain. The chart below examines the lending of four major banks: Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), PNC Financial (NYSE:PNC), and SunTrust (NYSE:STI). You can get a sense of how much of the banks' lending is drawn from residential mortgages.

Wells Fargo is the biggest player in mortgage lending and not surprisingly, residential mortgages account for 30% of their total book, while home equity loans make up another 10%. Bank of America has a similar profile, while SunTrust isn't that far behind at 24% residential and 12% home equity. Meanwhile, PNC is more focused on the commercial side with only 8% of their loan book being mortgage loans, but 19% in home equity.

You can draw your own conclusions, but if we're being conservative, we might guess that somewhere around 20% - 30% of the lending market is driven by residential mortgages and that Dodd-Frank will wipe out somewhere around 10% - 20% of that next year. That would suggest that anywhere from maybe 2% - 6% of the lending market could simply disappear in 2014. Let's not forget that this isn't the only regulation (or regulatory body) that might hamper lending, so there could be more stealth tightening, as well.

Raymond James put out some interesting research a few months ago forecasting MBA mortgage originations for 2014. As you can see below, the forecast for 2014 is horrendous. In fact, the projections suggest that mortgage lending in 2014 will fall below already depressed 2008 levels. You have to go back into the late 90's to find similar mortgage origination numbers.

Of course, residential mortgages are only part of the lending market. It's possible that a pick-up in commercial lending could offset Dodd-Frank's tighter rules and other regulatory tightening. (In which case, PNC Financial will make an excellent investment!) But don't be too surprised if this "stealth tightening" ends up having a negative impact on the overall economy in 2014.

Hidden Austerity: The Failure of the Obamacare Exchanges

Now let's talk about the other danger in 2014. For the past few years, I've warned that the Affordable Care Act (commonly known as "Obamacare") could cause significant economic damage in 2014. While I've expected the law to have a negative impact, it had always been an open question for me as to how it would manifest itself. Given the early data on the law, I expect that the recent failure of the Obamacare exchanges could function as a form of "hidden austerity" in 2014.

Let me explain the rationale. Back in February, I wrote about how the ACA could lead to skyrocketing insurance premiums and potential death spiral in costs. I argued that this could act as a stealth tax on American consumers. Early data suggests this prediction was accurate. The Manhattan Institute projects that the average individual market premium has increased 62% for women and 99% for men.

As an example, in the state of North Carolina, the average monthly premium for a 27 year old male has increased from $80 to $214. That's an annual increase in cost of about $1,600. For an individual making $40,000 per year, that's roughly 4% of their total income. Remember that a smaller payroll tax increase of 2% of income had a significant effect on consumer spending in 2013. For this reason, the ACA could potentially hamper consumer spending even more in 2014.

That's only part of the law, however. The ACA is projected by the CBO to cause a $180 billion increase in spending in 2014. Most of this comes from the exchange subsidies ($108 million), while the other big cost is the Medicaid expansion ($71 billion).

In order to pay for the ACA several tax increases have been passed, including an estimated $25 billion in new taxes that will go into effect in '14.

Many skeptics of the CBO projections have argued that the true costs will be higher, and the revenues will be lower. I agree with much of the logic behind this criticism. However, there's one big issue with this analysis for 2014. Most of the skeptics, including myself, never expected so few people to sign up on the exchanges.

If people aren't signing up on the exchanges, then the Federal government does not have to pay the subsidies. This essentially means that a large chunk of that $107.5 billion in exchange subsidies might never be spent. Next year's budget deficit is projected to be around $400 billion. If only half of the projected exchange subsidies are spent, then the figure could drop to $350 billion.

Also keep in mind that many states aren't participating in the Medicaid expansion. In a 2012 Washington Post article, Sarah Kliff examines the Medicaid expansion costs under two extreme scenarios: (1) all states expand Medicaid and (2) no states expand Medicaid. The "all states" scenario projects annual costs of about $95.2 billion. The "no states" scenario projects annual costs of about 15.2 billion, which would be the natural rate of increase in costs without ACA. The incremental difference is about $80 billion.

As of right now, 25 states (plus DC) have expanded, while 4 other states are considering expansion. The "expansion" states include some of the more populous states such as California, Illinois, and New York. It's completely possible that the Medicaid expansion comes in under cost if 20+ states refuse to sign on. That could knock out another $10 or $20 billion in costs.

This isn't a huge impact to the budget deficit, but given the significant tax increases in 2013 and 2014, coupled with the stealth tax increase from higher insurance premiums, $40 - $70 billion in unexpected spending cuts could have some impact on the economy.

Don't get me wrong; I'm all about getting our Federal spending under control, but this is an example of "bad austerity." It's simply a potential accidental consequence of a poorly thought out bill. Long-term, it's still likely that the ACA costs the Federal government more than expected in numerous ways, even if the whole individual mandate / subsidy thing ends up not working out. Also, don't forget that much of the "cost savings" came from gutting Medicare; a move that may not ultimately prove unsustainable.

Yet, that brings me to the next issue, and it's another negative long-term consequence of our 5-year mega-stimulus.

How QE May Be Bankrupting Social Security

While I wanted to focus mostly on 2014, I also thought it was worthwhile to take a look at how current government policies could impact the long-term future. Particularly, I want to suggest that a lot of the current government and Fed programs (which look inflationary) may actually be deflationary.

A new McKinsey study shows that the US Federal government has saved $1 trillion in interest payments due to the Federal Reserve's quantitative easing ("QE") program. That's not "free money" and it got me thinking about who is on the other side of that trade. The answer is of course, the buyers of US treasury bonds and bills.

The chart below breaks out those major buyers:

Everyone knows that China and Japan are big buyers of US bonds, but I'd focus more intently on the big US-based buyers that will be harmed significantly by QE. This list includes the Social Security Trust Fund, the Office of Personnel Management, mutual funds, pension funds, insurers, and state and local governments. But the Social Security Trust Fund ["SSTF"] is the 800-pound gorilla here.

If QE has saved $1 trillion in interest costs and the SSTF owns 16% of government issued securities, then logically it stands to reason that the SSTF has lost somewhere around $160 billion due to QE. The SSTF currently holds about $2.74 trillion in securities, so we could estimate that without QE, it would own $2.9 trillion.

This is particularly interesting because Social Security is currently projected to go insolvent in 2033. Unfortunately, there's reason to be skeptical of that date as Rachel Greszler at Heritage Foundation has shown that Social Security's insolvency projections have historically been very optimistic. If QE is lowering long-term interest rates, it could exacerbate Social Security's problems (not to mention the issues with state and private pensions) and help push the insolvency date forward significantly.

Take a look at the weighted average interest rates in the SSTF since 1990. It's basically a downward sloping line, starting over 9.1% in 1990 and slowly falling all the way to the current level of 3.6%.

Below, you can also see the current interest rates for SSTF securities, and estimates of what percentage of those securities will expire based on interest rates.

What you'll quickly notice is that virtually all of the 6%+ interest rate securities expire by 2017. Between now and 2020, the securities with interest rates ranging from 1% - 1.99% increase from 18.1% to 30.7% of the total, while the 2% - 2.99% securities increase from 17.0% to 24.0%. The weighted average for 2020 falls to 2.9%. Keep in mind that this is only showing the 'remaining securities' currently owned in 2020. New purchases, which will inevitably come at depressed rates unless we see a change in Fed policy, will push the weighted average even lower than that.

Also, let's not forget the point on CPI inflation: it tends to lags behind asset inflation. Since Social Security payments are gauged to CPI, that means that the long-term weighted average interest rate has a reasonable chance of falling below CPI inflation at some point.

What this suggests is that Congress will have to either have to raise taxes or cut spending at a future date to maintain Social Security. This is not the only major entitlement program issue on the horizon, either, as Medicare faces even bigger issues. I can't pretend to know how these events will be handled politically, but it is likely that within the next 5-10 years, some of these issues could become major drags on growth.

The Parallels to Japan

From analyzing the situation in the SSTF, I'm starting to see parallels to Japan since 1990. Many have wondered why Japan's attempt to stimulate their economy resulted in a low inflation / low growth environment. Yet, I can see exactly how such a scenario would unfold by looking at the SSTF issues. Lower interest rates result in subdued returns on investment, for both the public and private sectors. This requires consumers to cut back, and the government to either increase taxes or reduce spending. All of these actions tend to be deflationary.

Of course, the US could simply run massive fiscal deficits to pay for these programs, but that's politically unpalatable. Austerity, in one form or another, is a more likely result. Also, keep in mind that Federal Reserve's massive trove of purchased treasury securities could be a deflationary drag on future economic growth, as well.

The other argument here is that by artificially lowering interest rates, QE has stimulated malinvestment in the real economy. This results in more asset investment, which initially tends to be inflationary, but since it leads to excess capacity, will turn deflationary at some point. Indeed, a recent Matthew Bosler article examines this issue, "Is Quantitative Easing Deflationary?"

This cuts more into the heart of my view of why I'd be afraid of both inflation and deflation. Malinvestment spurs inflation, but this naturally tends to lead to deflation in most cases.

How to Invest In This Environment

My goal here isn't to depress people, but these are major issues to consider for investors, especially in an inflated market environment. I cannot predict with certainty whether we will have a recession in 2014 or 2015. As I stated in the intro, the US economy is a giant puzzle, and there are many pieces that could offset the negative issues I've highlighted in this article. Nevertheless, I definitely view the risks moving forward as being elevated.

The budget deficit is rapidly falling, with higher taxes in 2014, and potential hidden austerity via the Affordable Care Act. Meanwhile, lending standards are about to be tightened, which could potentially eliminate 5% of the lending market almost overnight. And as I detailed in my prior article, "Now is the Time to Be Fearful", stocks are looking rather expensive as an asset class given the major risks to the economy.

That said, I don't recommend anything radical such as shifting to 100% cash or going 100% net short. Those are always bad investment strategies. Rather, my recommendation is to look for reasonably-priced, conservative, blue-chip stocks that pay dividends. While 100% cash is excessive, holding a bit more cash than you might normally is a prudent idea to hedge against a falling S&P 500 (NYSEARCA:SPY). I'd also consider taking a look at a few stronger REITs (NYSEARCA:VNQ), many of which have taken a beating over the past several months; if we do have another downturn, I expect property REITs to hold up a bit better this time than the last.

A combination of a conservative portfolio with a higher cash balance should help protect you a bit from a potential market downturn. On the other hand, if the market keeps booming, you'll still be able to collect a bit of income.

Disclosure: I am long PNC, BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.