The Magical 'Second Half'

Includes: DIA, QQQ, SPY
by: Acting Man

No matter where one looks, or what year it is for that matter, the constant refrain of economic commentators is that there will be an economic recovery in the "second half." For instance, as Michael Lombardi points out, Goldman Sachs has ratcheted up its targets for the stock market indexes based on the idea that the "recovery will accelerate in the second half." This idea is not only suspect on the grounds that it assumes that stock market prices will necessarily follow developments in the economy. Given the massive monetary inflation of recent years, it makes far more sense to attribute the vast bulk of the appreciation in stock prices to the increase in the money supply rather than any real economic factors. The proof is in the pudding: Stock prices have risen sharply in spite of stagnating earnings.

The idea is also suspect because there is very little reason to believe that this year's second half will be any better at meeting these optimistic expectations than the second halves of previous years have been. Consider for instance the data on U.S. bank credit growth shown below. While recent Fed surveys indicate that bank lending standards have been loosened, the fact is that credit growth is decelerating:

U.S. Bank Credit Growth, Year-on-Year Percentage Change

Shrinking Liquidity

What might be the reason for this deceleration? For one thing there is probably a dearth of credit demand, but there are also growing problems with liquidity, which are caused by new regulations that aim to make the financial system safer. In fact, liquidity is drying up in a number of markets, undoubtedly an unintended consequence. Consider for instance the repo market, the size of which has shrunk from over $7 trillion of daily outstanding transactions in early 2008 to $4.6 trillion today, a fact that according to Bloomberg is "raising alarm":

Regulations aimed at reducing the risk of another financial crisis are starting to upend a key part of the bond market that expedites trading in everything from Treasuries to junk bonds. The U.S. repurchase, or repo, market where banks and investors borrow and lend Treasuries and other fixed-income securities shrunk to $4.6 trillion daily outstanding last month, down 35 percent from a peak of $7.02 trillion in the first quarter of 2008, based on Federal Reserve data compiled from its 21 primary dealers.

From fewer repos to lower inventories of bonds, financial institutions are responding to more stringent capital standards imposed by regulators around the world. Already, the group of dealers and investors that advise the U.S. Treasury say that they see declines in liquidity in times of market stress, including wider gaps between bid and offer prices and the speed of completing trades. The potential consequences are higher borrowing costs for governments, companies and consumers.

'During the market selloff over the past few months, those rules, a lot of which are just proposed or not yet taken effect, already impacted dealers' willingness to take on inventory of Treasuries, investment grade corporates to emerging market debt,' Gregory Whiteley, who manages government debt investments at Los Angeles-based DoubleLine Capital LP, which oversees $57 billion, said in an Aug. 14 telephone interview. 'That exacerbated the intensity of the sell-off.' (emphasis added)

It is quite ironic that regulations that were supposed to make the system "safer" seem to be making it less safe. The drying up of repo market liquidity will also render any mooted exit from QE extremely difficult. If the Fed were to begin draining liquidity via the repo market, it could lead to a cascade of falling bond prices. The bond market sell-off referred to in the excerpt above has also led to liquidity drying up in corporate bond markets. Holders of concentrated positions have difficulties to sell them without moving prices and creating sizable losses for themselves. Many large holders of bonds are now trapped:

The lowest volumes for U.S. corporate-bond trading since 2008 are underscoring the potential for market disruptions as regulations prompt dealers to retreat. August trading volumes have plummeted to a daily average of $14.1 billion, down 9 percent from the corresponding period last year, even as the amount of company debt outstanding has soared by 12 percent.

Bonds have lost 5 percent since the end of April on the Bank of America Merrill Lynch U.S. Corporate Index, the worst stretch since the credit crisis as the Federal Reserve considers curtailing its record stimulus. Exiting from fixed-income securities is getting tougher as the world's biggest bond dealers respond to new capital standards, reducing inventories of the debt by 76 percent since the peak in 2007. Even as lenders from Goldman Sachs Group Inc. to UBS AG create electronic-trading platforms, investors are failing to find relief from waning liquidity, according to a July report by the Treasury Borrowing Advisory Committee.

'You've got to be very wary of getting into a crowded position,' Stephen Antczak, the head of U.S. credit strategy at Citigroup Inc. in New York, said in a telephone interview. 'If everybody has the same mandate, who's going to take the other side of the trade? If far more guys are mark-to-market sensitive than they used to be and you overlay the lack of liquidity, that kind of exacerbates the problem.' (emphasis added)

To this witches brew add the fact that there are many players in the bond markets who are using a lot of leverage and the potential for major problems to emerge in these markets becomes rather obvious. In spite of the huge increase in free bank reserves due to QE, bank credit expansion is hampered by the new capital regulations as well. Ultimately this is of course a good thing, but it is likely to be a near term negative for the economy in terms of aggregate economic data, as activities that have sprung up on the back of the Fed's inflationary policy are likely to come increasingly under pressure.

Random Data Watch

As Mish points out in a recent article, the seasonally unadjusted U.S. unemployment rate compiled by Gallup has risen by 100 basis points over just the past 20 days. This is not the only data point that should concern "second half" bulls. Here is a chart showing what has happened to mortgage refinancing and purchase applications since the recent sharp rise in long-term interest rates:

Both Refinancing and Purchase Applications Plunge

Via Marketwatch.

Today it has come to light that with fixed-mortgage rates reaching a two-year high recently, new-home sales have "unexpectedly plunged" (a decline was, of course, expected, but not a 13.4% nosedive):

Sales of new homes slumped in July with each region seeing sizable drops, in a move that raises questions about the recovery in the housing market. New-home sales fell 13.4% to a seasonally adjusted annual rate of 394,000 in July, the lowest rate since October, the U.S. Department of Commerce reported Friday.

Rising mortgage rates may be behind July's drop, though the monthly data are quite volatile and economists had expected some pull back after sales gains in recent months. Longer-term trends point to continuing growth: new-home sales in July were up 6.8% from the year-earlier period.

'This was an unambiguously weak report, and it reflects in part some of the negative impact of higher mortgage rates,' said Millan Mulraine, director of U.S. research and strategy at TD Securities. Economists polled by MarketWatch had expected a July sales rate of 485,000, compared with an original June estimate that pegged the rate at 497,000. On Friday the government revised June's rate to 455,000. (emphasis added)

This is a sign that the "echo bubble" in housing is standing on a very weak foundation. It seems to be largely dependent on the Fed successfully suppressing long-term interest rates, a scheme that has lately failed to work. Housing and car sales are among the two main recent drivers of improvements in economic data, and both are somewhat suspect at the moment. The production of cars has been ramped up quite a bit, but one keeps hearing rumors that there is a lot of "channel stuffing." Moreover, there are bubble conditions in the sub-prime lending market for cars -- we have first discussed the topic here back in April, when we pondered a number of "sectoral bubbles," many of which apparently remain below the radar of most observers or are considered not to be particularly important.

European Woes

There has been much talk about the budding recovery in Europe lately, and readers will recall that we have stressed in several recent missives (see, for example, this comment on euro area PMI data) that an easing of Europe's contraction was to be expected in light of a notable acceleration in year-on-year true money supply growth from near zero in 2011 to a recent 8%. However, this does of course not mean that this renewed activity is really conducive to genuine wealth generation. On the contrary, to the extent that such activity springs up on account of credit expansion, the opposite must be expected: More scarce capital will be malinvested. Ironically, such periods of malinvestment are then hailed as representing economic growth, as they tend to expand aggregates like GDP. However, even building a bunch of pyramids would increase GDP; no one would argue though that it would be anything but a waste of resources (OK, perhaps not no one. Hard-core Keynesians generally tend to believe that pyramid building, ditch digging and similar activities make us better off).

European banks are also subject to much stiffer capital adequacy rules these days and the biggest ones are already reducing the size of their balance sheets, as their leverage ratios are much too high. As a result, the recent period of credit expansion may not continue at the pace that was seen over the past year. In fact, credit distress in the periphery continues to rise as recent NPL (non-performing loan) data from Spain reveal. In spite of the dip seen in the data series after the transfer of a huge chunk of non-performing assets to Spain's "bad bank" SAREB, NPLs in Spain's banking system have just risen to a new all time high:

Spain's NPLs Rise to New All-Time High Despite Dip Occasioned by SAREB's Intercession

Concurrently it is becoming increasingly clear that Greece will require even more aid, lest it default again:

European officials are laying the political groundwork for fresh Greek aid as Chancellor Angela Merkel, who has led bailout-weary Germany throughout the region's debt crisis, battles to win a third term in office. German Finance Minister Wolfgang Schaeuble said yesterday for the first time that there 'will have to be a program for Greece once again,' referring to previous euro-area pledges to provide 'further measures and assistance' to ease the country's debt burden.

European Union Economic and Monetary Affairs Commissioner Olli Rehn said today that the 'possible continuation of Greece's bailout program and its financing' will be assessed after a review next month by the so-called troika that oversees euro-area bailouts. European Central Bank Executive Board member Joerg Asmussen is in Athens to gauge the government's progress on economic reforms.

More than three years after its first 110 billion euro ($147 billion) rescue, question marks remain over Greece's ability to pay its bills. The country is mired in the sixth year of a recession that has left six in 10 young people without work. The International Monetary Fund predicts the economy will contract 4.2 percent this year before returning to growth in 2014. (emphasis added)

This admission by Schäuble has made the Greek bailout a bone of contention in Germany's election. We were wondering why he made that admission and our conclusion is that it was meant to be a preemptive strike. It probably is supposed to take the wind out of the sails of critics in the event it becomes overly obvious prior to the election that the Greek government will require more aid (moreover, the Bundesbank has already made clear that its assessment of the situation is that the current bailout plan amounts to a mathematical impossibility). Greece's dire employment situation can be seen here:

Greek Unemployment by Age Group: Still Rising

France is also presenting a decidedly mixed picture recently. For instance, while the pace of the contraction in PMI data has slowed markedly (no expansion has been recorded yet), industrial production has fallen off a cliff and recent payrolls data have come in quite soft as well:

France, Payrolls Data -- Still Weakening

As we have pointed out in a recent credit market charts update, there are also a few preliminary signs of credit tightening in Eastern Europe, where credit default swap spreads have begun to trend upward again. However, the lagged effects of the money supply expansion in the euro area should continue to play out for a while, likely benefiting mainly the already economically stronger nations like Germany. In this context, it is interesting to see that the direction of inflation expectations has recently begun to turn in favor of Europe.

U.S. Vs. European Inflation Expectations: Turning Down in the U.S., Turning Up in Europe

This must, of course, be taken with a grain of salt, as the U.S. data on market-based inflation expectations may be distorted by the fact that leveraged speculators have been forced to sell holdings of TIPs in the course of the recent bond market rout. Still, it is noteworthy that whereas euro area inflation expectations were leading to the downside earlier this year, they seem to be leading to the upside recently.


The magical second half may once again disappoint this year, especially in the U.S., where expectations are quite high that the recovery in economic data will accelerate (note that we are differentiating between data recoveries and actual ones). Apart from the decline in credit growth discussed above, there is one more reason to suspect that the U.S. economy will have problems in the not-too-distant future.

Below is a chart we have often shown in the past: the ratio of capital goods (business equipment) production to the production of consumer goods. This ratio has been stuck at a record high level for some time now. It is a rough guide that currently shows that resources have been increasingly allocated toward higher order goods production to the detriment of consumer goods production. Extremes in this ratio are usually coincident with the peak of economic expansions as measured by aggregate data such as GDP.

The reason is that many of these allocations are a result of artificially suppressed interest rates that do not properly reflect the time preferences of consumers and the true state of the economy's pool of real funding. We can thus infer that whenever the ratio goes to an extreme high that a lot of capital has been malinvested due to monetary pumping. The structure of production that has been erected will prove to be unsustainable, as it ties up more consumer goods than it releases (the problem is that those working in the longer-term higher order goods projects that have been inaugurated due to low interest rates need to be fed, sheltered, clothed, in short provided with present goods, even though the overall demand for consumer goods has not declined in favor of saving).

Ratio of Capital to Consumer Goods Production in the U.S. Economy

All that is required for a bust to arrive is a slowdown in money supply growth -- and although money supply growth has remained historically brisk, it has indeed slowed down in the course of this year compared to the period late 2008 to late 2012. This may be partly due to the Fed perhaps buying fewer securities from non-banks (which creates both new deposit money as well as additional bank reserves, whereas in the event securities are bought from banks, only bank reserves increase), but mainly the above-mentioned decline in the yearly rate of bank credit growth. It is unknowable how much of a reduction in money supply growth is required to induce a bust, but we suspect it won't take as big a reduction as that observed prior to the 2008 crisis, as the economy overall seems far more vulnerable.