- While overall money supply in the US is increasing, bank money appears to be declining, possibly due to Dodd-Frank and tighter Federal regulations.
- Tighter regulations, coupled with loose Federal Reserve policies have created an odd combination of de-leveraging in some categories and surging debt in others.
- The above-average spread between the Federal Funds Rate and US treasuries, alongside of weak loan demand may suggest that US treasuries are undervalued.
- Mortgage REITs appear attractive at current prices given economic data.
One of the most interesting economists to me right now is Professor Steve Hanke, a CATO scholar and professor at Johns Hopkins. An investing mentor once told me that "understanding nuance is the key to being a great investor." What he meant by that was that people with simplistic views ("real estate is bad, therefore all REITs are bad investments") did poorly in investment, and that the real secret to success was understanding distinctions. Steve Hanke is an economist with a sense of nuance.
Hanke has taken great pains to distinguish between "state money" and "private money" (see Yellen, the Hawk), rather than merely focusing on QE. He's also been critical of the Fed's use of money supply measures, instead favoring an alternative called "Divisia M4."
Hanke has been particularly critical of regulatory policies that have severely tightened credit (such as Dodd-Frank). Coupled with policies such as QE3, Hanke points out that the Fed under Bernanke, and now Yellen, has been engaging in loose "state money" policies, but tight "bank money" policies. Since bank money makes up the vast majority of US money supply, this can be particularly problematic.
Ugly Economic Stats
With Hanke's writings in the back of my head, I decided to take a look at a few stats regarding money supply and interest rates. What I found is increasing evidence that we are now experiencing a significant contraction (or at least stagnation) in private money growth.
First off, let's take a look at M2. It's growing at about a 5.5% clip right now; however, the growth rate has declined from over 10% in early 2012.
Nothing too shocking about that, but it's the upcoming figure that really caught me off-guard. The St. Louis Adjusted Monetary Base ["AMBSL"] could be considered M0 money supply. It consists of commercial bank reserves held at the central bank, as well as currency circulating. Since much of M0 is "state money", I decided to subtract AMBSL from M2 to see the results.
The two are compared below. What's evident is that the two figures (M2 vs. M2 - M0) are virtually identical till around 2008, where they sharply diverge, with M2 rising rapidly and M2 - M0 plunging. M2 - M0 eventually caught up with regular M2 in 2012, but has once again begun plunging over the past 12 months. M2 is now up 5.5% over the past year, while M2 - M0 has gone the complete opposite direction, now down 5.4% YOY.
For a closer look, here's the M2 - Base figure charted out by itself. The brief surge in 2012, followed by the rapid plunge stands out.
(click to enlarge)
What this strongly seems to suggest is that while state money is still growing at a rapid clip, bank money may be contracting, or at the very least stagnating due to the tight "bank money" policies that Steve Hanke has written about.
A closer examination of the data can be found by doing a quarter-over-quarter analysis, as opposed to a year-over-year version. From this, we can see that the measure contracted rapidly in early 2013, but has leveled out a bit since then, and is now near 0%. Keep in mind, however, that QOQ data (even if seasonally adjusted) may be subject to more fluctuations. For January '14, the QOQ growth in M2 - M0 is 0.1%, but for January '13, the figure was 1.7%.
Overall, from this data, we can see that from Hanke's "state money" vs. "bank money" perspective, it would appear that we're seeing very unhealthy trends in bank money. Loose "state money" could be leading to malinvestment in certain parts of the economy, while tight "bank money" could be signaling that some of the "productive investment" that we'd typically see in a recovery is not happening.
Taking Steve Hanke's suggestion, I decided to visit the Center for Financial Stability's website to examine Divisia M4 as well.
Divisia M4 provides some interesting historical results. M4 is the broadest measure of money available, and Divisia M4 adjusts this based on opportunity costs. The Divisia M4 series runs back to 1968, so we can examine the volatile 1970s and early 80s periods, on top of seeing what it told us during the financial crisis. Below, you can see the series.
I've also plotted M2 alongside of it, so the differences between the two become more apparent.
Both measures picked up the slowing money growth around 1969 / 70, as well as 1973. However, Divisia M4 shows a much more pronounced decline from 1978 - 80, as well as late '81, after Paul Volcker's measures to tame inflation. The two measures look reasonably similar till around 1992 / 93, where M2 shows extremely low growth (0%-2%), while Divisia M4 shows more moderate growth (3% - 5%).
The two series became radically different once the financial crisis hit. Divisia M4 plunged all the way to -7.3% by March 2010, while M2 fell at a much more moderate pace, bottoming out at +1.6% in that same month. Finally, we know current M2 is around 5.5%, while Divisia M4 is around 2%. Divisia M4 seems to consistently show weaker money supply growth than M2 for much of the period since the financial crisis.
While I don't have the data to subtract base money out from Divisia M4, given the 2% growth rate and the large differences between M2 and M2 - M0, we can likely assume that Divisia M4 would also suggest bank money contraction.
Shifting a slight bit away from money supply, I also wanted to examine the historical spread between the Federal Funds Rate and the 10-Year US Treasury. My assumption was that we were near the high-end of the historical range right now. That was close to being true; we are at above-average levels, but not quite up near the highest historical spreads.
This measure may only tell us so much, but what it seem to suggest is that contrary to most perceptions, US treasuries may be "cheap" compared to other investments right now.
Growing Debt, Shrinking Debt?
I also wanted to take a look at a few other measures. I've become very fascinated by disparate debt growth figures over the past 24 months. The recent release of the New York Fed's "Quarterly Report on Household Debt and Credit" sparked some interest. US household debt has been on the decline overall since 2008, with mortgage debt being the primary driver of that. Even in spite of the decline of mortgage debt, it still accounts for 70% of total US household debt. There has also been a slight uptick in the past quarter, but the overall trend has been down.
There is, however, a more disturbing trend in student loan debt. Total student loan debt has increased by 94% since the beginning of the financial crisis six years ago. As a percentage of GDP, student loan debt has jumped from 2.1% in 2003 to 6.3% in 2013.
As student loan debt has surged, so too have delinquencies. 11.5% of student loans are now delinquent, compared to 6.1% in 2003 and 9.5% at the end of 2007. This contrasts with overall household delinquencies, which have fallen about 50% since the financial crisis. As a result, student loan delinquencies now account for 14.6% of overall household delinquencies, up from 4.4% in 2003.
The student loan data is very disturbing, but seems to be an exception to the rule. The overall trend is one of deleveraging in most categories, most notably residential mortgage debt, financial company debt, and state & local government debt. There are, however, a few more exceptions. The first (and oft-talked about) is NYSE margin debt, which was up to 2.58% of GDP in December 2013. This is one of the highest readings ever and on par with the margin debt levels near the stock market tops in 2000 and 2007.
The other debt figure that seems to be passing under the radar is corporate debt. As the Federal government has tightened mortgage lending regulations via Dodd-Frank and other measures, it would make sense that banks would turn more to corporate lending. Corporate debt has grown 17.5% over the past two years, after slowing down considerably during and immediately after the financial crisis. We are now back at record high levels of corporate debt at 54.6% of GDP. That compares to 2009 peak of 52.7%, and is up significantly from 2000, when it was at 45.5%.
Of course, the real area where US liquidity has been flowing is emerging markets. While accurate and timely data on emerging market credit is more difficult to find, we can find a few great examples. For instance, Turkey's bank credit as a percentage of GDP surged from about 17.3% in 2004 up to 54.4% in 2012. While part of that growth came before the Fed's various QE programs, it's easy to see how QE may have exacerbated the situation.
Likewise, Brazil has seen significant credit growth, with domestic private credit shifting from 29% of GDP in 2004 to 68.4% in 2012. Once again, the boom started before the financial crisis and the Fed's QE programs, but there was never a deleveraging, and debt has continued to surge.
Overall, we have an interesting dynamic developing in the lending markets. We have lesser mortgage debt, lower leverage in the financial system, and declining state and local debt, but we are seeing significant jumps in margin debt and student loan debt, coupled with gains in corporate debt. Meanwhile, much of US liquidity has flowed into emerging markets, helping exacerbate the possibility of an EM crisis.
The data above is merely a peek at some of the contradicting numbers I'm seeing. While the US economy continues to chug along, there are a lot of red flags once one begins to dig into data. Economist Steve Hanke's distinction between "state money" and "bank money" is useful, and if we examine the world through that lens, we begin to see how fragile the recovery might be.
Loose "state money" policies, coupled with the Fed's attempt to knock interest rates down may be resulting in greater margin and corporate debt in the US, as well as pushing liquidity to emerging markets. This may be creating large systemic risks and even malinvestment in some areas.
Meanwhile, tight "bank money" policies, particularly in residential lending may displacing one of the primary vehicles of American wealth creation: home ownership. The Federal government's preference for non-residential lending may be preventing a stronger recovery from occurring, instead pushing money into less productive assets.
How to Invest in This Environment
For those that have followed me for awhile, I've taken a position that now is the time to take a cautious approach to the markets (even as the market continues to push upwards). That can be achieved either through hedging, higher cash balances, owning counter-cyclical assets, or even sticking to lower-risk, dividend-paying stocks (that might suffer in a downturn, but not as much).
My own strategies have largely revolved around buying into certain high-beta investments that are still high-quality, such as banks and insurance companies that appear historically depressed. To hedge against that, I have a significant cash cushion, and have engaged in some shorting as well.
As for particular stocks, one that I think would be a good way to play these themes would be via mortgage REITs. Many mREITs are now selling below book value, based on the assumption of a rising rate environment. With banks struggling to find places to put capital due to regulatory restrictions, and the spread between US treasuries and the Federal Funds Rate now at above-average levels, I suspect that US treasuries will become more attractive in spite of seemingly low yields. This could make mREITs surprisingly good investments here.
I'm a particular fan of Annaly Capital (NYSE:NLY). It's now selling at about 30% below its price in September 2012, and at a slight discount to book. While earnings are volatile, it would appear to be attractive priced based on historical figures. NLY has strong management, and there has been a significant amount of insider buying in the stock.