I was on The Kudlow Report last night. Here are the notes I sent to the CNBC producers for the show:
On Corporate Bond Spreads:
1) Corporate spreads are at post-collapse lows, but mortgage spreads are at all-time lows. There actually is an implosion of spread assets outstanding: the total universe of non-Treasury securities fell by 1% during 2009, compared to a gain of 8% during 2007.
2) Much of this is due to massive purchases of mortgage-backed securities by the Fed, which has bought $1 trillion worth of MBS since January 2009.
3) Total bank credit has also fallen by nearly $600 billion since September 2009 and continues to shrink at an unprecedented rate.
4) Corporations are hoarding cash rather than investing so credit quality has improved in some cases. S&P’s upgrade to downgrade ratio accordingly improved:
The improvement in balance sheets has occurred much faster than the recovery in profits:
This reflects cash hoarding. JP Morgan reports that non-financial corporations held $708 billion in cash at the end of 2009, compared to about $500 billion between 2004 and 2008.
5) Savings are increasing (personal savings running at 3% to 4% from 0% in 2008) so there is greater demand for securities.
6) As the baby boomers retire, savings demand will continue.
Conclusion: a combination of massive Federal Reserve intervention and a collapse in credit demand has reduced the total supply of spread assets by previously unseen margins just as the demand for savings instruments has risen.
1) The Chinese economy is doing well. The headline numbers are strong. There is some indication of overheating. Many manufacturing companies in Guangdong, for example, report labor shortages following the Chinese New Year as migratory workers did not return from their vacations. This reflects the success of the Chinese government’s efforts to push capital towards the interior of the country.
2) China’s banking system is a blunt instrument. The country lacks credit ratings, consumer credit reports, and all the other mechanisms that banks use to evaluate credit quality. The government responded to the 2009 crisis by ordering the banks to lend. Because the banking system lacks the infrastructure to evaluate credit (and we have seen that banks can get into enormous trouble even with all the credit information in the world), the result is a dangerous buildup of bad credit.
3) Both because of overheating and inflation risk, and the buildup of nonperforming loans on banks’ balance sheets, the government will turn the spigot off.
4) China’s economy will continue to grow but it simply lacks the infrastructure and financial mechanisms to grow at a rate sufficient to move the needle in the US economy.
5) Part of the manufacturing sector in the US will continue to benefit from rising export demand in China but the overall impact on the US economy will be limited (manufacturing is only 15% of total employment).