So far, for the first quarter the earnings picture has been decent. But, there is something lurking and I am betting that the next quarter's numbers are going to be starkly different. The U.S. economy is driven by the consumer. However, the consumer has been using credit as the fuel to push the economy. Last week, Capital One Financial Corp. (NYSE: COF) released their earnings that fell way short of expectations. The reason was loan losses. It is looking like the economy is sputtering as it runs out of gas. The stock market will follow.
Credit growth has accelerated over the past year. However, the pace is beginning to decline. At the end of the fourth quarter the Federal Reserve reported total consumer credit increasing year-over-year of 6.45%. In two months the growth rate of credit debt has declined to 5.43%; a full one percent decline. Maybe that is the consumer reigning in their credit spending, or maybe it is the consumer being reined in by the banks.
During the same time of the credit increases, the wage growth has increased by only 4.5% year-over-year, not seasonally adjusted. Translation: The rate of debt is accumulating faster than the ability to pay for the debt. And, it is starting to manifest itself throughout the economy;
The signs the economy is slowing are starting to mount. On Friday, the GDP report came in around 0.7% growth, year-over-year. On Monday, the ISM Manufacturing Index arrived lower than expected dropping to a four-month low (Charts following). The previous month, the non-farm payrolls printed only 98,000 new jobs created for the month. These economic releases are not subtle. They are getting obvious. And, they are getting more frequent.
When you look at the GDP growth rate you can see that despite there being a large move upward last summer, the growth rate crept right back down to the previous levels that failed to really inspire economists. The U.S. economy is driven by the consumer, accounting for some 70% of the economy. The consumer is having a hard time driving the economy.
Capital One is a perfect example of the "writing-on-the-wall". Earnings expectation were around $1.96. The company missed by over 10%; Capital One's earnings missed by $0.21 to $1.75. The company had to take bigger than expected charge-offs for loan losses to their portfolio because losses are mounting up. The company is also having to set aside provisional funds for potential future loan losses. The tea leaves on this are simple: The consumer is unable to keep up with the spending that has fueled what is only a lackluster economy to date.
Capital One Financial Corp. is no lightweight. The company accounts for some 9% of the American credit card business. They are a fairly good representation of how the rest of the America's credit profile looks. Given the steep losses by Capital One the company will likely restrict credit and new customers. This will, in turn, limit growth in the economy even further.
We have two significant economic events this week, ISM Manufacturing, notwithstanding. The first is the Federal Reserve meeting on Wednesday and the second is non-farm payrolls on Friday. Given the inflation levels I do not see a necessity of the Federal Reserve to be pushing interest rates too high from that side of the economy. Jobs, however, are a far different story. The Fed will not have blinders on with regards to the last number of 98k.
But, the Fed has to be fully disconcerted with the latest GDP numbers. 0.7% growth will not compel the board to push further with their interest rate increases. But, the one thing I am most interested in is the roll-over of bonds In the Fed's balance sheet. I believe this to be a far bigger storyline than future interest rate increases. Whatever interest rate increases we do get, and I think we will likely see a soft increase in June, the balance sheet situation is far more prevalent. With the Fed removing the policy accommodation by shrinking their balance sheet this will act to restrict available money to the banks. The Fed will, in essence, compound the liquidity situation by shrinking its balance sheet.
However, the Fed will not have to raise interest rates merely because as they shrink their balance sheet, the demand for money will push up rates on its own.
For a few reasons, I see the Fed getting modestly dovish on Wednesday. I see the in-kind move of interest rates heading slightly lower from the news. As for the equity market, if enough companies miss their earnings or call for lower guidance then the stock market will finally come off its lows
As for my trades, I got out of the short bond positions a few weeks ago seeing that the economy was pausing as it is. I am intending on getting back into the 10-year shorting calls out-of-the money once the interest rate levels drop below the 2.20% level. I will be shorting the S&P going in to the Wednesday meeting and Friday's jobs data. Given the he recent data on the economy I think we have seen the highs in equities for a bit. Might as well make something as the market moves lower.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.