Thomas Ryan's  Instablog

Inflation is going to be a major problem; just not yet. While the government is issuing record amounts of debt, this total is being overwhelmed by deleveraging and credit destruction for households, businesses and financial companies. The Federal Reserve recently released the flow of funds for the United States which detailed debt growth for the entire US economy broken down by sector since 1974.

 

 

 

 The removal of the US dollars from the gold standard in 1971 and the liberalization of banking regulations in the 1970’s makes this an ideal starting point to evaluate the growth of debt in America. Household debt growth, both mortgage and consumer credit, ranged between 5.1% and 16.9% annually beginning from 1974 to 2007. Household debt started at 680.3 billion dollars in 1974, and peaked at 13.9 trillion in the third quarter of 2008. Household debt growth never dropped below 5% in any year during this period. The financial sector of the economy grew even faster starting at 258.3 billion in 1974 and peaking at 17.086 trillion in the fourth quarter of 2008. This sector never contracted on an annual basis from 1974 to 2008. Business debt grew from 823 billion in 1974 to 11.156 trillion in the first quarter of 2009, in which I believe was the peak. Total debt growth in the United States has always grown by more than 4% every year since 1974; and non financial debt has not declined in any period since 1974, until we reached the fourth quarter of 2008.

 

We are seeing debt destroyed in the United States for the first time in a generation. Consumer debt dropped 211 billion dollars in the last six months, and consumer credit lines have been slashed by hundreds of billions of dollars. Borrowing in the domestic financial sector dropped 448 billion dollars in the last three months. Issuance of asset backed securities dropped 422 billion in 2008 and 156 billion in the first quarter of 2009. Commercial paper issuance dropped 278 billion in 2007 and 2008. This is unprecedented in our lifetimes. The United States banking system currently has negative tangible common equity if financial assets are marked to market, and non performing loans are increasing at the fastest pace on record. One trillion of additional losses would create a 10 trillion dollar pullback in lending. We could see far greater losses than this in the US banking system during the next few years. The banking system is technically insolvent, which is shown by the first drop in lending in 35 years. Household assets and nonprofit organizations dropped 12.417 trillion since the end of 2007. These entities are all highly deflationary. Adding two trillion to the national debt and another two trillion to the Federal Reserve’s balance sheet is not enough to overwhelm the deflationary pressure created by the massive contraction in credit, debt and asset prices.

 

The run-up we have witnessed in commodities, which started with Chinese stockpiling, is mostly investor driven. Investors concerned about government policies like double digit deficits, quantitative easing and 0% interest rates are looking to protect themselves from the inflation that will eventually come. This trade has attracted trend followers because it is working. According to Bloomberg, net long positions on the 20 most heavily traded commodities reached 854,743 contracts this month from as few as 86,220 contracts in December. The fundamentals tell a very different story however. Jobless claims remain above 600,000 a week, where 400,000 claims are considered the dividing line between expansion and contraction of the labor market. Home starts in the first quarter were the lowest on record, and almost no companies are planning to start new commercial real estate projects.  Home starts are down 500,000 units from 2008 creating a massive drag on the economy. Where I live in South Florida, many homes are selling below replacement cost. You cannot buy the land and build a house profitably at the current market price. Rental rates on new condos in downtown Miami are less than half of the annual carrying cost for owners. This story is the same in all of the bubble states, Arizona, California and Nevada, as well. I expect new home starts to be anemic for a long time for these reasons. Unfortunately the housing bubble was a worldwide phenomenon as well. We saw the same boom throughout Europe, Asia and the Middle East. New construction should be depressed in all these regions.  Car production is off a cliff, and vehicle sales are down 40% from 2007 levels.

 

Housing Starts

 

US Car Production

Stockpiles of commodities have surged worldwide during the past few months. Stockpiles of lead, aluminum, and tin have risen 88% since the start of the year according to the London Metals exchange. Even though crude oil imports to the US have dropped over a million barrels a day from 2007, stockpiles are the highest since 1990 and may reach record levels this year. Rotterdam, the largest port in Europe, ran out of storage capacity a few weeks back and began turning away oil tankers. Gasoil stocks are at record levels in Rotterdam as well. Stockpiles of Iron ore in China increased 33% year over year, and hit a record this year of 57 million tons. The Chinese government recently ordered banks to cut lending to steelmakers and publicly scolded the industry for failing to “correctly control the volume and pace of iron ore imports in line with the actual demand of domestic steel production," according to state media. China increased coal and copper imports 168% and 64% respectively in the last year. Electricity consumption, a good proxy for manufacturing activity, is down 3.23% from a year ago and 11.16% from its peak last summer. Commodities that are not actively traded on exchanges such as coal and steel have not experienced the recent price gains that we have seen in oil and the base metals. We firmly believe that Chinese stockpiling will stop as investors push up the price of commodities, triggering a rush for the exits by investors. Real demand is simply not there.

US Oil Imports

 

Oil Products Inventory

Chinese Electricity Usage

 

While the US debt is not unreasonable today when compared to the GDP, we believe inflation will result from the absurd assumptions the Obama administration has made regarding future deficits. The unemployment rate is supposed to average 8.3% in 2009 and 9% in 2010. Someone forgot to inform them that we were at a 9.4% unemployment rate at the end of May. Real GDP is supposed to only drop .5% this year and then grow 3% next year. The economy is then supposed to grow at 4% on average for the next four years. US GDP growth has officially averaged just 2.8% growth since 1980, and was fueled by debt growth. Wages and salaries, which have increased just 33% during the past eight years, are expected to be 28% higher than today on average in the period from 2011 to 2014. Wages are supposed to be 59% higher than today in the period from 2015-2019. Hours worked is are already the lowest on record, and underemployment is the highest since the great depression at 16.4%. Both lower hours worked and high underemployment retards wage growth.  The exhaustion rate, percentage of people who drop off unemployment without finding a new job, is the highest on record. The Obama administration is planning on cutting the annual deficit in half; with impossible assumptions. We are not going to grow our way to prosperity with an insolvent banking system, and a tapped out consumer. The assumptions are just ludicrous.

Wages and Salaries from GDP Report

US Hours Worked weekly Average

 

Labor Board Exhaustion Rate 12 Month Average