Seeking Alpha
Long/short equity, value, growth at reasonable price, contrarian
Profile| Send Message|
( followers)  


  • Apparent increase in liquidity merely dormant bank reserves and not transmitting through into the economy. Personal saving rate remains low.
  • Net wealth growing strongly but distribution and allocation not supportive of acceleration in short-term consumption expenditures. Personal income disposition reveals similar trends.
  • Unemployment falling but more as a result of benefit expiry rather than increased employment. Job creation remains of low quality.
  • Lending growth poor and related seemingly-positive metrics likely artificial. Mortgages and housing market weak.
  • Capital expenditure sluggish and likely to remain so due to structural, not cyclical, factors.

This article was motivated by the typically solid and well-articulated Economic Outlook for Rest of 2014: Acceleration piece by James Kostohryz (JK), as well as his more detailed version here.

I retain the same focus on consumers and their ability and willingness to increase spending in the near future. However, I disagree with JK's conclusion that both fundamental and reflexive psychological factors will combine to provide an acceleration in spending.

(I also retain a similar structure and order for comparative purposes, considering household balance sheets, consumer sentiment, business expenditures, credit conditions and the external (international) environment in turn.)

Household Balance Sheets

M2-to-Disposable Personal Income has indeed improved considerably since the financial crisis, suggesting greater liquidity of private individuals. However, when subtracting the large QE-induced (excess) bank reserves parked dormant within the banking system, we see barely any improvement at all. In fact, the resultant dynamic is then shown to have been deteriorating over the past year.

Source: Board of Governors of the Federal Reserve System; U.S. Department of Commerce: Bureau of Economic Analysis.

Also, although individuals did initially start hoarding cash during the financial crisis, savings rates have since relapsed back towards historical lows.

Source: US Department of Commerce: Bureau of Economic Analysis.

That said, it is indeed clear that household net worth has resumed its powerful rally higher in the past three years.

Source: Board of Governors of the Federal Reserve System.

However, the allocation and distribution of that wealth is key.

Referring to the Fed's 2010 Survey of Consumer Finances (SCF), the majority of the increase in wealth has accrued to the top 10%. The 75-90% segment also saw meaningful gains but the bottom 75% did poorly, with the bottom 25% actually falling from a mean of -$600 in 1989 to -$12,800 in 2010. I expect these pronounced trends to have continued to widen further in the subsequent three years.

Source: 2010 Survey of Consumer Finances, Federal Reserve.

Further evidence of this dynamic is provided by the excellent Gini Index and 'income share of the top 1%' statistics compiled by Frederick Solt. All show ever-increasing income inequality, even after adjusting for social transfers. The powerful rise in the income share of the top 1% over the past three decades is particularly striking. And other data suggest these trends have continued further since 2011.

Source: The Standardized World Income Inequality Database, Frederick Solt.

Considering next the allocation of wealth (table below), we see that the vast majority of new wealth has been set aside in retirement accounts and pooled investment funds. As such, it is unlikely to be called upon to fund spending in the immediate term.

Source: 2010 Survey of Consumer Finances, Federal Reserve.

Continuing with the theme of increasing inequality, I next consider the disposition of personal income.

Source: Bureau of Economic Analysis.

The chart above displays an ever-decreasing contribution from wages (both private and government) and is suggestive of a 'financialisation' effect - a rentier class stripping ever more income from the productive economy through financial claims. This is more clearly illustrated in the subsequent consolidated chart. And the dynamic is arguably even more pronounced given tht occurred during a secular bull market in bonds/rates, reducing fixed income yields.

Source: Bureau of Economic Analysis.

In Jan 1959, 64% of personal income was distributed as wages, 29% was received 'un-earned' and 7% was deferred for retirement (and social insurance). By Jan 2008, the numbers were 53%, 35% and 12%, respectively. And by Jan 2014, the trend in this skew had strengthened further to 51%, 37% and 12%, respectively.

Almost 40% of economic output is now being received 'un-earned' by asset owners. By definition assets are held by the wealthy and, as we saw above in relation to household net wealth, they are becoming concentrated in ever fewer hands. Conversely, wage-earners are receiving an ever-shrinking piece of the pie, with many struggling to save anything meaningful and/or buy assets for additional income streams.

The other component is 'deferred' income - that being siphoned off for retirement spending in the distant future. Having risen from 7% to 12% over the period, this represents an extra 5% of the income pie no longer available for current consumption. (This trend aligns well with the allocation of assets table above from the SCF, which showed a large increase into retirement accounts.)

Finally, extending JK's hourly earnings chart back to 1965, we then see just how weak the current paradigm is. The recent bounce is an improvement but the trend is of lower highs and lower lows, which I do not personally expect to reverse, particularly in light of the data above.

Source: Bureau of Labor Statistics.

Pent-up Demand, Consumer Sentiment and Self-sustaining Recoveries

Having assessed household balance sheets and formed the view that the consumer has the ability to spend, JK then provides evidence to suggest the consumer is also developing the willingness. I disagree with the first conclusion (as explained above) and now articulate my concerns with the second part.

Starting with unemployment, we see the trends below. These are suggestive of a greatly recovering labour market. However, once again, we must do more digging.

Source: Bureau of Labor Statistics; JK Consulting.

It has been well advertised that recent drivers behind falls in unemployment might not be as healthy as they seem. Looking at the next chart, we see that a fall of 5 million unemployed persons has coincided with over 10 million exiting the workforce entirely.

Source: Bureau of Labor Statistics.

To support the theory that many of these 10 million are discouraged workers rather than purely new retirees, I offer the following chart. It shows that the bulk of the drop in unemployed persons has been from the segment of 'greater than 27 weeks', suggesting many unfortunate people have merely rolled off the benefit register without having successfully found work.

Source: Bureau of Labor Statistics.

We also have the further associated evidence of weakness provided by the bill Congress is currently discussing to extend jobless benefits for 2.4m persons unemployed for more than 6 months.

On a separate but related note, like many others, I remain disappointed with not just the quantity but also the quality of job creation.

Source: Bureau of Labor Statistics.

My grouping in the above chart is subjective but hopefully revealing enough. The 'low quality' segment continues to be the largest contributor, containing the many low-paid 'eat, drink and get sick' jobs (waiters, bartenders and nurses). I accept that this was also evident during the previous two bubbles and didn't prevent growth then but that merely strengthens my belief that this 'recovery' will be weaker. This issue has been developing slowly in the background over many years but is now starting to become more significant (like inequality).

Finally, consumer sentiment. I'm not particularly keen on soft indicators and survey data but accept that they can capture cyclicality and tend to trend with persistence, albeit it often with volatility and 'false positives'. It is also clear that the University of Michigan indicator has been trending up (driven by conditions with expectations lagging). However, a) I am reluctant to blindly extrapolate a continuation of a trend higher merely because it has done so in the past (and particularly in light of the evidence shared above); b) I highlight in the chart below an apparent shortening in the peak-to-trough period of the indicator. This second point suggests to me a weakening in the strength and length of recoveries.

Source: Thomson Reuters; University of Michigan.

Business Expenditures

I also don't personally buy the argument that we should soon see capex accelerate simply because that's what we typically see in the mid-stage of a recovery. The mid-stage of this 'recovery' is long overdue and the Fed could hardly have provided more favourable monetary conditions to stimulate capital spending. Also, as JK noted, companies are sitting on record-high cash balances. So why are we not seeing higher capital investment? There are a number of factors. Firstly, and most directly, US capital stock is operating comfortably within its capacity.

Source: Board of Governors of the Federal Reserve System.

Yes, capacity utilization has recovered well since the financial crisis but it remains low by historical standards and is arguably in a multi-decade downtrend.

This segues neatly into my second factor: globalisation. With ever-freer movement of physical and financial capital, there is ever less friction to moving operations to lower cost bases. Much ink has been spilt regarding the loss of US jobs to China, and the following chart illustrates the severity.

Source: World Development Indicators (WDI), World Bank.

A pronounced phenomenon, and more pronounced now than in previous business/credit cycles. Naturally, this dynamic also leads to results such as this:

Source: Bureau of Labor Statistics.

A reduction of ~5m manufacturing jobs and little recovery post-Great Recession (versus expansion/recovery in other sectors both pre- and post-Great Recession). The loss of manufacturing jobs to the US economy is indeed nothing new but my point behind the three charts above combined is that the wider production, trade and employment problem is structural, not cyclical. As the globalisation trend continues, the majority of capital investment will be allocated to regions with lowest labour costs, with those production facilities meeting any increases in global demand and those local economies gaining the additional jobs. Simply cheapening the cost of money in the US will do little to fix this issue, no matter how excessive. And should TPP, TTIP and other such trade treaties be passed, the problem could escalate even more.

This 'off-shoring' trend is also not new. Corporations have been doing so for decades and capital stock is now well established in low-cost economies, even to the point where they too have excess capacity. As JPMorgan economist, Haibin Zhu, noted last week (referring to inflation in China), "the lingering deflation trend in the PPI seems more worrying as it reflects structural overcapacity in a number of sectors as well as the cyclical downturn in the industrial sector." And this is in China, let alone the US.

Consequently, I do not believe we have strong foundations for an acceleration in US capital expenditures.

Focusing next on the recent modest improvements in capital spending that we have actually witnessed, I offer this chart:

Source: Thomson Reuters.

The data quality isn't perfect, particularly regarding future projections. However, based on what it offers, both the current picture and the future outlook appear weak across the majority of industries. Of the 2009-12 growth, $21bn/16.5% came from Communications (mainly Apple) and fully $45bn/35% from Energy. The latter was, of course, largely motivated by a structural change in the energy market with the advent of shale gas and associated drilling investment, not a cyclical recovery.

Credit Conditions

At first look, consumer credit appears to have been expanding quite positively since 2011 (blue line). However, once again we see government footprints (orange line). The government contributions here include student loans and Federal Family Education Program loans, which again mask a far weaker 'organic' lending picture beneath.

Source: Board of Governors of the Federal Reserve System.

I will accept that banks have been loosening lending standards and some growth has been evident. However, it has been sporadic and weak, as exemplified by JPMorgan's recent disappointing 1Q14 results. JPMorgan CFO, Marianne Lake, stated on the conference call: "… [we are] not chasing growth at the cost of liberal credit structures and overly aggressive pricing." And "…we are just going to hold the line on discipline."

It's not that they are unwilling to lend; more that they are struggling to find the right credits at the right price.

Another seemingly positive trend is delinquency rates, as JK notes. However, I have two caveats: 1) I suspect the Fed's involvement in the market is suppressing rates, particularly with student loans; 2) the level really is low, more consistent with the over-extended late stage of the cycle. When I look at the chart below, rather than seeing an improving scenario, it suggests to me that a reversion is due (similar to those seen during the periods 1995-1998 and 2006-2009).

Source: Board of Governors of the Federal Reserve System.

A related area of the economy that doesn't fit the 'acceleration' thesis is the housing market. As JK highlights, debt affordability has indeed been improving, and mortgage debt more so than consumer loans.

Source: Board of Governors of the Federal Reserve System.

However, this has failed to translate into a particularly inspiring housing market recovery. After a slow and modest recovery through 2011 and into 2013, existing home sales have tailed off sharply over the past year and mortgage originations are now at 18-year lows. New home sales remain subdued. And, to repeat, this is despite affordability being at historical lows (at least as measured by DS-to-DPI above).

Source: US Department of Commerce: Census Bureau.

Furthermore, the 'quality' of the recent shallow recovery is further questioned by the increased levels of institutional buying and all-cash sales - the latter doubling from ~20% to ~40% of total. Blackstone has been one huge buyer (~43,000 homes nationwide) and institutional investors in total have bought as many as 200,000 homes in the past two years. Also, anecdotally, a large portion of the non-institutional all-cash sales are said to be wealthy Chinese (rather than wealth generated organically from within the US economy). Yet more factors artificially improving the top-level numbers.

Source: RealtyTrac.

JK also highlights the historically-high age of consumer goods, which he views as "pent-up demand." To me, however, this dynamic could equally likely suggest 'pent-up delinquencies' as cash-strapped 'non-consumers' are forced into debt to replace worn out goods. Also, arguably, serviceable ages of durable goods should rise as build quality improves with technology. Further, I'd also argue that those technological advances in durability have accelerated in the last couple of decades as a result of the advent of computing power and sophisticated production processes.

External Environment

I largely concur with JK regarding external risks and don't have a great deal to add. I possibly envisage a little more risk in Europe with increasing signs of civil unrest beneath the shiny veneer of oodles of liquidity and various calls for referenda on independence from parent countries (Veneto, Catalonia, Scotland, Flanders). None threaten the euro presently but there's a small chance these events could set precedents and similar demands could spread. There are also EU parliamentary elections in May, which could herald a lurch to the right.

I also see rising risk for the dollar on the horizon as 'the East' takes further steps to trade on alternative terms and develop its own systems, platforms, instruments, vehicles and markets. These developments will take considerable time and I do not yet see any reason for concern in 2014. However, I could envisage announcements of certain future plans causing uncertainty and discounting.

Europe could potentially also provide a positive externality. Many of the negative structural issues described above exist in Europe as much as in the US, arguably even more so. As such, I expect it to be only a matter of time before the ECB engineers its own form of quantitative easing, if only to reduce the value of the euro. Over the weekend, Mario Draghi cited the euro's strength as being an important factor in causing inflation to drop and prompting fears of the dreaded deflation.


Arguably, many of the highlighted unfavourable trends in distribution and allocation of wealth and income, as well as globalisation and employment, were well established during the previous two bubbles (dot-com and housing) and didn't prevent them then. However, the dynamics of all elements have become increasingly pronounced and more of a burden to the wider economy than at any other time in recent history. As such, increasingly less money is reaching the hands of middle- and lower-income percentiles and consumer spending capacity is continually contracting.

It may actually prove that the economy does strengthen from here in the medium term as reflexive psychology takes hold, risk-aversion continues to fall, and consumers resume debt binges. However, as above, my core argument is that consumers' capacity to do so is continually shrinking. As such, this will likely dampen the magnitude and sustainability of any reflexive effects and I expect persistent sluggishness.

Hence, I expect the Fed to continue with its one-size-fits-all approach of QE, opting to reverse tapering and return its foot on the monetary accelerator. But, having largely continued stalling for the past five years, I also expect the gears of the economy to remain stuck in neutral. A stagnant economy that is held up artificially and not allowed to correct naturally but that also lacks the inherent energy and dynamism to grow with any persistence and sustainability.

Investment Implications

I expect the continued presence of the Fed (and possibly ECB) to keep a cushion under risk assets, with excessive liquidity continuing to seek returns. However, a stuttering economy will likely introduce bouts of volatility along the way, before investors buy the dips and/or central banks continue to step in, leaving markets somewhat range-bound.

More specifically:

Equities (NYSEARCA:SPY): Despite current valuations remaining elevated, the highly liquid monetary economy will likely keep prices supported and the trend generally intact. However, upward trending will be at a slower pace with periodic spells of volatility (and dips), owing to uncertainty about the economy and monetary policy.

Rates/Credit (TLT, HYG, JNK): Rates not set to rise significantly. Both a lack of real economic growth and an inability for private agents and the government to afford higher rates will likely retain a strong bid for safe assets. And, with central banks continuing to provide support and excess money seeking returns, credit spreads will remain low.

EM (NYSEARCA:EEM): The venue for a multi-faceted economic tug-of-war and hard to predict. Likely to be strong winners and losers (at the country level), determined by the hot money flows of globalisation.

Commodities (NYSEARCA:USO): Also subject to an economic tug-of war as demand expands in developing economies and stagnates in developed economies. Result: more range-bound trading in the medium term.

US dollar (UUP, FXE): Stable and range-bound as domestic weakness is likely countered by European QE. A slither of headline risk around the East declaring intentions to move away from the current world reserve currency but likely not for 2014.

Precious metals (NYSEARCA:GLD): A modest recovery as QE is resumed and rates remain low but not the major rally some are calling for unless we see the aforementioned major announcements from China, Russia and maybe other world powers around a future change to the world monetary system (low likelihood).

Source: Economic Outlook For The Rest Of 2014: Stuck In Neutral