Wednesday, April 16, 2014

Investigating the lead-lag relationship between HPA & OER growth

Matt Boesler posted an interesting chart today showing a leading relationship between house price appreciation & OER. Expounding on this idea & data set results in some interest conclusions about the likely trajectory of core inflation in the US.

Housing, technically shelter, is the largest component of core CPI, with a 42% weight in the basket. Shelter is decomposed into primary residence rent and owners' equivalent rent (to have a smooth proxy for housing prices). OER & housing prices have seen material divergences since the Case-Shiller 20 index began being published in 2000. However, a closer look shows a strong lead-lag relationship between the % YoY changes in OER vs Case-Shiller, with some data fitting leading to 21 months as a useful time lead. Linear & polynomial (3-degree) regressions with this time lead are presented below.

Using this regression analysis to model % YoY OER, and linearly standardizing the modeled OER (to account for much wider range of % YoY rates in housing prices vs rents), a rough but useful projection of future OER, and consequently housing price inflation, is in the pipeline based on the leading indicator of housing price growth. With this, we constructed a projection for housing's net contribution to core CPI % YoY, which is presented below.

Based on current housing prices, the model suggests that housing alone will provide 100-140 gross basis points to core CPI YoY growth rates by H2 2015, or 50-70% of the way to target inflation. This includes an approximately 40bps increase in net bps contribution to core CPI YoY, in the next 21 months, implying that even if non-shelter core inflation rates stagnate at their current 0.46% YoY rates--all the way through 2015--core inflation will still return to Fed target. If non-shelter core inflation rates can simply reverse solely their 2013 deceleration, over the course of the next 21 months, the implied core inflation rate would be just under 3%, and 1yr fwd inflation expectations (the FOMC FG criterion relevant to rate policy) would likely have breached the FOMC's 2.5% symmetrical target ceiling. These scenarios serve to illustrate how impactful the extra 40bps net housing contribution to CPI can be.

Looking beyond housing, there are good reasons to believe that non-shelter inflation is poised to accelerate materially and be the driving force behind overall inflation acceleration:
  1. Less policy uncertainty & drag. Fiscal cliff and fiscal policy uncertainties, which pervaded in 2011-2013, were huge drags of federal & corporate spending, as well as crushed money supply growth despite open-ended LSAPs. These policy concerns materially diminish this year, and as should their sharply deflationary impulse. 
  2. Private sector accelerating behind the scenes. Real private wages are accelerating impressively, and the sharp disinflation phase since 2011 has been fundamentally tied to a private-public divergence on the back of austerity (public wage growth has hovered around zero since H2 2011 post-debt ceiling debacle).
  3. Supply & demand of fixed capital seeing trend shifts. H2 of last year was the first time since the GFC that US net private domestic investment went positive. Capacity has been expunged and now a combination of nascent short-term demographic tailwinds and low capacity & costs means fixed investment is likely set to return. Supply & demand of fixed capital is what drives prices fundamentally.
  4. High-velocity credit growth & capital spending is beginning to accelerate. Leading indicators for capex (which should also see a positive impulse from fiscal policy stability) are picking up for the first time since 2011, and other high-multiplier entities that have been risk-averse since 2008 (like state & local governments) are beginning to spend again after healing their balance sheets. C&I loans and consumer credit demand also heating up.
  5. Producer prices & input costs are accelerating. Pipeline inflation.
Vince Foster had a terrific piece over the weekend analyzing the recent behavior of long-term yields. Although I share his concerns about long-term NGDP potential growth rates for the US (absent immigration boom, public infrastructure investment, etc), especially regarding the question of not being able to escape ZIRP again in next recession, I think that US core inflation is set up for cyclical acceleration. I expect to write soon about some of Vince's arguments, as well as some of the near-term risks I see in the global economy.

Monday, April 7, 2014

Is the taper the bridge between the new normal & escape velocity?

2012 was a pivotal year in the global economy, as the two largest balance sheet impairments in the world (US household & EMU periphery sovereign) finally received alleviation. US housing prices bottomed in January 2012, and Draghi sold a put on euro exit/breakup risk a half-year later. This began a process of global normalization & rebalancing of BoPs & global labor competitiveness. 2012 finally gave the signal that a reversion from the "new normal" may be within sight. This was reflected best by the fact that real & nominal yields & wage growth bottomed in 2012.

Since then, the topics of growth & monetary policy normalization have been in the driver's seat of markets. Monetarists opposed the taper based on perceived efficacy of marginal LSAPs. Fiscalists downplayed any real impact LSAPs ever had in the first place. Debt deflationists expressed weariness at the prospects of a 1937-type moment with a coincident fiscal cliff & LSAP taper. However, these are all context-free assessments of the impact LSAPs and their taper can have.

Also beginning in 2012, Jeremy Stein presented a unique approach to LSAP assessment to FOMC discourse. He noted that LSAPs work most directly by altering the supply & demand curves for risk premia, like the corporate credit risk premium. Among the various second-order impacts, he identifies one with corporates as a conduit, which diminishes money velocity & optimality:
How should one expect a company to respond when its long-term borrowing costs fall not because of a change in the expected future path of short-term rates, but because of a change in the term premium? As noted earlier, many macro models--like the Fed's FRB/US model--treat the two sorts of shocks as having similar effects. But is there any reason to believe that, in reality, the response to the two might differ? 
A basic corporate-finance analysis suggests the answer may be yes. To see why, consider the following example. A risk-neutral firm faces a rate on its 10-year bonds of 2 percent. At the same time, it expects that the sequence of rolled-over short-term rates over the next 10 years will average 3 percent. Hence, there is a term premium of minus 1 percent. What should the firm do? Clearly, it should take advantage of the cheap long-term debt by issuing bonds. But it is less obvious that the bargain 2 percent rate on these bonds should exert any influence on its capital spending plans. After all, it can take the proceeds of the bond issue and use these to pay down short-term debt, repurchase stock, or buy short-term securities. These capital-structure adjustments all yield an effective return of 3 percent. As a result, the hurdle rate for new investment should remain pinned at 3 percent. In other words, the negative term premium matters a lot for financing behavior, but in this stylized world, investment spending is decoupled from the term premium and is determined instead by the expected future path of short rates.
Jeremy Stein- Evaluating Large-Scale Asset Purchases, Brookings Institution, October 2012 
Thus, LSAPs can actually incentivize corporates to prefer refinancing to borrowing, bonds to loans & equity, and buybacks & dividends to capex. The lower real rates, spreads, & risk premia (including Stein's term premium expample) cause buybacks & dividends to have artificially inflated relative EPS growth/RoI potential [1], while capex RoI potential [2] remains depressed with aggregate demand. Once aggregate demand starts normalizing, as began in 2012, any remaining LSAP-induced RoI advantage held by capital structure arbitrage becomes a net negative tradeoff for the real economy vs financial economy. The tailwinds incentivizing shareholder capital return begin to "crowd out" capex potential at this stage, even as corporates are flush with cash. [3]

Suppose that theoretical RoIs & risks for real (bank loans, capex, hiring, structures) & financial (bond issuance, buybacks, dividends, reinvestment) economy sources & uses of capital from 2009-2015 are as follows in the top of the chart to the left. [4] Similarly, theoretical return/risk ratios for real & financial economy allocations, and the ratio between real & financial economy return/risk profiles. [5] Click to enlargen.


These estimates are based on nothing but my own intuition, and may be nothing more than a practice of bias confirmation. But the key point is to highlight how real rate, spread, & risk premium normalization can drive small fluctuations in the relative return/risk profile of marginal investment, which can be sufficient to swing allocation decisions in the favor of investment into the real economy. 

The taper announcement has already been coincident with the beginning of loan growth accelerating for the first time post-stimulus. This has been driven by the commercial & industrial sector, particularly in loans from small banks, suggesting there may be a corporate balance sheet strategy shift in play in response to the eliminated prospect of downward pressure in reals, spreads, & risk premia. [7] Surely, part of this timing is likely due to coincident economic recovery being a shared causal factor. But it seems like more than coincidence, especially considering the rising-rate risks to credit growth people were concerned about. The policy uncertainty removal by the taper announcement, simply by giving a flexible yet clear timeline for LSAP exit, likely also provided much-needed guidance for capital allocation plans.

In order for escape velocity, the pathway would have to be as follows:
  1. LSAPs
  2. Cumulative retained benefit [8] for federal government, shadow & TBTF banks, & corps
  3. "New normal"
  4. Real wage growth bottoms
  5. Corporate capex unlocks retained LSAP liquidity into the real economy
  6. Private credit demand accelerates & endogenous loan/deposit ratios rise [9], helping begin a feedback loop
  7. State & local tax revenue acceleration offsets sequester of LSAP liquidity due to federal austerity by injecting a smaller, but higher-multiplier version in its place
  8. Financial lending & securitization unlocks retained LSAP liquidity into the real economy
  9. Real wages, capital goods PPI, core CPI, NGDP accelerate, furthering the feedback loop
  10. Virtuous cycle ("escape velocity") of lending, spending, & investing begins, ZIRP ends
Right now, we are in between (4) & (5), and capex has been a long time coming. I believe that a well-timed LSAP taper could be the key to moving past the new normal and toward igniting the self-sustaining process toward escape velocity. LSAP-induced corporate preference shifts have a small outright impulse on the economy, but a large one relative to the other constrained & low-impulse sectors, and enough of one to make marginal capital sourcing & allocation decisions shift from financial markets toward banks & consumers. Perhaps enough to bridge the gap between a "new normal" economy & one in escape velocity.

So far, we have seen upticks in loan growth & capex intentions, and rate-sensitive indicators are all concurrently rebounding. Follow-through in these leading indicators & their coincident counterparts will support the case for nascent escape velocity. Charts below courtesy of Business Insider / Matt Boesler / Aneta Markowitz / Societe Generale.

[1] Buybacks reduce share count, thus boosting EPS & equity share price. Depressed risk-free yields, term premia, & corporate credit risk premia inflate the spread between borrowing costs & share earnings yield, incentivizing corporate treasurers to allocate marginal capital toward collecting such risk premia via shareholder return plans like buybacks & dividends. A shift from equity & loan to bond financing also takes advantage of LSAP distortions, and further pads the RoI that eventually also boosts EPS. 

[2] These dynamics above in [1] especially relevant when the alternatives of cash (negative real return) and fixed investment (high risk) are being held back by weak aggregate demand.

[3] As the labor market recovers, the expected risk-adjusted return on marginal investment in the real economy increases. As it approaches the risk/reward profile offered by marginal investment in the financial economy, small LSAP-driven boosts to the risk/reward profile of capital structure arbitrage can be the difference between the real economy narrowly receiving marginal capital allocation and the financial economy narrowly receiving it.

[4] These are pretty much baseless values, but the exercise shows a plausible scenario in which a small increase in real yields, after a long period of suppressed reals, spreads, & risk premia, can have a high multiplier impact that sets in motion a domino effect of unlocking retained liquidity into the real economy. The impact of risk premia pricing impacts capital structure arbitrage risk/reward on a continuous scale, but the decision between capex & buybacks is a discrete, binary one, and the nonlinearity emerging from this intersection is the source of the power of the well-timed taper.

[5] The impact of risk premia pricing impacts capital structure arbitrage risk/reward on a continuous scale, but the decision between capex & buybacks is a discrete, binary one, and the nonlinearity emerging from this intersection is the source of the power of the well-timed taper. The dashed line marks the parity level of marginal expected risk-adjusted return on investment between capex & balance sheet strategies. As the green area rises above the parity line, the real economy gets a boost from nonresidential fixed investment, helping to ignite other latent sources of growth from other sectors, into a virtuous cycle of money velocity.

[6] Values to be taken with a massive grain of salt, utility of exercise to be taken with a moderately-sized grain of salt.

[7] It doesn't have to be large; it just has to be sufficient to drive capex to accelerate.

[8] "Cumulatively retained benefit" refers to the retained savings driven by LSAP-induced risk premia repricing, plus retained earnings driven by second- and third-order arbitrages resulting from LSAP-induced risk premia repricing. These are what the Fed "injects", and the "unlocking" of them into the real economy is sufficient for a self-sustaining business & investment cycle. Lower interest expense, longer duration financing, capital structure arbitrage earnings & premia accrual, and others comprise these cumulatively retained benefits from LSAPs.

[9] Real equilibrium interest rates are a reflection of money supply & demand. This is reflected by loan/deposit ratios, which is correlative with money velocity and similar metrics. LSAPs flood the system with exogenous deposits, which are created at primary dealers and credited to their clients that sell bonds that the PD turns over to the Fed via LSAPs. Ex-LSAPs, the remaining endogenous deposits show a different story since LSAPs began. Most importantly, endogenous loan/deposit ratios have implied higher equilibrium real rates during LSAPs, suggesting LSAPs suppress real rates. However, endogenous loan/deposit ratios moving higher would also reflect underlying private credit demand elasticity returning to above-ZIRP price levels.

Friday, March 29, 2013

Blog update & macro deck slides

Apologies for the prolonged absence of updates. I hope to be starting to post my thoughts more frequently again. In the meantime, here is a section from the US slides of my 2013 global macro deck. This is from late last year, but many of the themes remain just as relevant.

Monday, October 29, 2012

Households and preemptive counter-cliff defense spending offset drag from business & foreign demand

The advance Q3 GDP estimate was released last week, printing at +2.0% vs +1.8% consensus vs an unrevised +1.3% prior. Consumption re-accelerated, reflecting stronger income growth, as the durable goods slowdown from last quarter reversed. Investment continued last quarter's trend of effectively zero growth, as household demand drove residential fixed investment's composition to output growth higher, offsetting slowdowns from business sector demand in nonresidential fixed investment and inventories' delta (partially dragged down by impacts from the summer drought). Government expenditures reversed their persistent drag, as federal spending growth (particularly in defense) spiked and state & locals' drag finally shrunk to around net zero. Net exports contributed slightly negatively to output growth, but the internals included a contraction in both goods exports & imports, for the first time concurrently since mid-2008, reflecting a slowing global trade environment. With housing prices rising, household consumption and residential investment were the engines for the US economy in Q3, while corporate investment and external demand became a bigger drag. The jump in federal defense spending is likely a one-time phenomenon, with the fiscal cliff (however small or large) looming, although the stabilizing housing and labor markets could continue to propel state & local spending higher. Nonresidential fixed investment, goods exports, and federal spending remain the risks to the US economy going forward, and these, along with the still-declining core PCE deflator, are going to be important arenas to watch in the next quarter. The US continues to grow at a weak, sub-trend (some would call it new-trend/new-normal) rate, but the internal composition of growth is showing signs of shifting.

Consumption accelerated to +1.42% annualized growth in Q3, with last quarter's slowdown in autos/auto parts and home furnishings reversing back higher. Autos and housing are cyclically sensitive leading indicators to overall output growth, and so this re-acceleration in durables demand is a good sign that auto inventory isn't goosed by channel stuffing and excess housing inventory isn't still lurking in shadows. Consumables spending ticked up, as clothing demand reversed last quarter's negative contribution to growth, while services spending decelerated on the back of slower utilities and healthcare spending. Incomes accelerated in the last few months, driving core PCE to +1.5%, and it will be interesting to watch if consumption can continue powering along the US economy, particularly if housing continues its recent uptrend. The US economy continues to be consumer-led, regardless, and domestic economic policy is highly impactful at this juncture.

Investment stagnated around zero growth again this quarter, as real private fixed investment decelerated to +1.5% annualized. Nonresidential fixed investment slowed even further this quarter, to a drag of -1.04% on real GDP growth, as structures demand went negative. Equipment & software spending delecerated to zero, as IT, industrial, and transportation production factor demanded all went negative or zero. However, overall investment was buoyed by the strong +2.57% contribution to growth from residential fixed investment. This is the sixth consecutive positive data print in residential investment growth (spanning eighteen months), and perhaps the most bullish data point in the US economy presently was the +1.57% contribution to real GDP growth from single-family residential investment, the highest since Q3 2009 (which itself came off a low base after the fourteen consecutive quarters of negative single-family residential fixed investment growth otherwise known as the housing crash). The knock-on effect from external demand softness is negatively impacting corporate investment, as is the uncertainty surrounding the US fiscal picture. We expect the weak corporate investment environment to persist if we get a sufficiently signficant fiscal drag, and for it to remain muted even without due to slowing foreign sales and margin compression. However, the upside risk from policy surprises could be large, since much of this corporate investment slowdown is preemptive, although the likelihood of policy surprises are skewed to the downside. Still, residential fixed investment continues to power along, evolving from a stabilization to a new acceleration. The impact of HARP 2.0 and the new Freddie Mac CEO on refinancing accessibility have started feeding through into a much better-clearing housing market. As a sidenote, farm inventories contributed an uncharacteristically large -0.42% real GDP delta contribution, largely due to the summer drought in the midwest; about -0.25-0.30% can be relegated to drought-specific impact, which probably will be reversed over the coming quarters.

Government expenditures reversed their trend of eight consecutive quarters of drag on output growth, with a +0.71% contribution to real GDP growth in Q3. Federal spending added +0.72% to growth, driven by a +0.62% growth contribution from defense spending, the highest since Q2 2010. Given the prospects of sequestration-driven defense cuts and Obama's plan of $487b in defense cuts over the next decade, defense spending is one of the most likely components of the prospective fiscal cliff. As such, this quarter's boost is likely a one-time phenomenon, largely due to a combination of a typical spike in defense spending at the turn of a fiscal year, accelerated preemptive spending ahead of prospective sequestration, and delayed clarity to the federal defense budget itself. However, nondefense spending also grew to a +0.8% growth contribution, and more importantly, state & local spending grew to a miniscule -0.1% contribution to output growth, the highest since Q3 2009. Improving labor and housing markets (reflected in household outperformance relative to the corporate sector in recent months) have helped state & local fiscal situations, and this drag should turn into a GDP boost if the housing rebound continues. Nevertheless, the federal drag going forward is likely to be significant, and the downside risk from fiscal brinksmanship could magnify this dramatically.

Net exports had a relatively small -0.18% contribution to real GDP growth, but the internals of US trade in Q3 speak to significant risks. Goods exports contributed -0.35% to output growth in the third quarter, the category's first negative print since Q2 2009. Foreign goods demand has weakened since the beginning of 2011, but last month's +0.67% growth contribution from goods exports (the highest since 2010) provided optimism that the external demand picture was stabilizing. However, Q3's print exposes the fragility of the US post-2009 export renaissance in a slowing global environment. This is a potential contagion risk transmission mechanism through which the weakening foreign demand landscape, and weaker US economic indicators like ISM and core capex, can feed into US growth dynamics. Industrial materials and autos drove the decline in goods exports, which is reminiscent of a China slowdown. Services exports furnished an extra +0.12% to real GDP growth in Q3, partially offsetting the decline in goods demand. However, the imports side of the field presented equally alarming internals, as they contributed a positive +0.04% growth contribution in Q3, representing a reduction in YoY imports (since positive imports are a negative contributor to real GDP). Similar to the exports trend shift (first negative exports print since Q1 2009 & goods exports sub-component print since Q2 2009), this is the first positive contribution to real GDP growth from imports since Q2 2009. And again, goods were the sub-component that had the drastic decline. Non-auto capital and consumer goods drove the decline in imports, combining for a -2.76% contribution to growth in Q3, while auto imports continued in earnest, and industrial materials, petroleum, and food imports were neutral. The US economy is running on domestic foundations; it is clear global trade is slowing significantly.

Source: BEA

Tuesday, October 23, 2012

Is the US breaking out of its liquidity trap?

Out of all of the paradigm shifts that have occurred since 2007, the liquidity traps impeding advanced economies are among the most worrisome, as they render monetary policy impotent. The liquidity trap narrative is ubiquitous now: against the backdrop of impaired household and financial sector balance sheets, private sector credit demand becomes inelastic, and if policy rates are falling from a sufficiently low base, they hit the zero lower nominal bound before credit demand constraints are alleviated.

The characteristic drop in money velocity in liquidity traps reflects the weakened private sector credit demand, which is due to a combination of: liability defaults/charge-offs, diminished marginal propensity to borrow, and elevated lenders' creditworthiness standards. The twin deleveragings in the shadow banking and household sectors, both due to impaired balance sheets, impede the flow of dollars through the monetary circuit. This depresses aggregate demand, while monetary policy transmission mechanisms remain frozen.

However, the US is now five years into its private sector deleveraging, and the stock of imbalances built up during the bubble have made significant progress in unwinding. Even while monetary policy transmissions remained frozen, nonperforming loans became charge-offs, shadow banking liabilities contracted, and large fiscal deficits put a floor under aggregate demand. And all the while, the economy climbed out of its liquidity trap, slowly but stably. Although deleveragings and liquidity traps are inextricably linked, sufficient income growth and credit velocity can allow for the economy to leave the liquidity trap, even as it continues to deleverage (through the denominator's impact). This allows for a virtuous cycle to return, as traditional monetary policy regains efficacy and feeds into aggregate demand growth.

Policy rate models, such as the Taylor and Mankiw rules, illustrate the existence of a liquidity trap with negative implied nominal rates. The Taylor rule, a simplified version of which is calculated by rate = 1 + 1.5*inflation + 0.5*output gap, targeted significantly tighter policy than the Fed pursued. This is perhaps due to the calculations of inflation and output gap. Because of the replacement of housing prices with owners' equivalent rent in CPI calculations, the housing boom and bust were not proportionately accounted for in inflation gauges. Furthermore, the typical calculation of the output gap, (GDP - potential GDP)/potential GDP, falls victim to the inductive reasoning that characterizes an extrapolation of past trends into perpetuity. A better proxy for "too-hot inflationary pressures" is the total capacity utilization (TCU) rate, which tracked the output gap very closely, until diverging during the early 2000s recession (when, it can be argued, the US growth trajectory began decelerating relative to prior trend - see chart below).

Source: FRED

Substituting a housing-adjusted PCE deflator for the inflation input and a TCU-derived indicator for the output gap input, we derive a modified Taylor rule model. Given the relative hawkishness inherent to the traditional Taylor rule calculation, we reason that the inflation coefficient is too high relative to the output gap coefficient, and we thus modified the inflation coefficient to 1.25. This Taylor rule model suggests policy should have been looser going into the early 2000s recession (again, because of a deceleration in the US growth trajectory), and was very dovish going into the 2007-09 recession, implying -5% policy rates at the heart of the crisis. However, it has since turned back upward, and it recently broke back into positive territory for the first time since the recession hit, presently implying an almost 2% policy rate. This suggests that the US has broken out of its liquidity trap, and positive deviations of model rates from policy rates will, going forward, serve to offset the accumulated negative deviations during the liquidity trap, rather than add to them. The chart below presents the federal funds rate, the simplified Taylor rule, and our model Taylor rule.

Source: FRED

However, given that the Fed's dual mandate relates to price stability and employment, rather than aggregate demand shortfall, the Mankiw rule, which takes inflation and unemployment rate as its inputs, is worth investigating. The rule calculates implied policy rates by the relation: rate = 8.5 + 1.4*(inflation - unemployment). Making a similar inflation substitute as in the above Taylor rule model, our adjusted Mankiw rule model implies that, unlike in the above Taylor rule model, policy was too tight going into the early 2000s recession, but too loose coming out of it. More interestingly, this model also implies a positive nominal rate, just recently breaking back above zero. The divergence between this Mankiw rule model and the model Taylor rule above likely is due to the unemployment input replacing the TCU-derived output gap input. Both unemployment and the output gap are meant to represent proxies for underutilized resources, and so we derive a new Mankiw rule, using an average of total capacity non-utilization (100-TCU) and unemployment as the new "underutilization" input. After a bit of trendline fitting, coefficients are modified for this new adjusted Mankiw rule, and the result gives a similar signal as the Taylor rule model above, including the lower implied policy rates in the early 2000s recession and the recent return to positive implied nominal rates. The chart below presents the federal funds rate, the Mankiw rule, our model Mankiw rule, and our TCU-adjusted model Mankiw rule.

Source: FRED

Finally, we present a compilation of all of the discussed rates, rules, and models in the chart below. As is evident, policy rate models are now all implying positive nominal rates.

Source: FRED

The debate about what constitutes optimal monetary policy is well beyond the scope of this article, and we acknowledge the crudeness and imprecision of our approach. However, three key insights present themselves:
  1. The assumption of extrapolated output growth trends may have caused monetary policy rules to systematically underestimate the fragility in growth in the early naughts, by overestimating overheating inflationary pressures.
  2. The substitution of owners' equivalent rent for primary residences, for house prices, in CPI and PCE inflation metrics may have caused policy to be excessively tight on the margin, due to underestimating inflationary pressures during the housing boom and overestimating inflationary pressures during the housing crash.
  3. There is a consensus among the various policy rate models tested and constructed that implied policy rates are now back into positive territory again for the first time since the zero bound was hit.
This presents interesting evidence that the US has escaped its liquidity trap for the time being and that credit demand will become more price elastic going forward as transmission mechanisms thaw. Certainly household and shadow banking balance sheets have a long way to go before being fully and sustainably rebalanced. But it is no coincidence that aggregate household liabilities (not their leverage ratio versus income) are finally approaching the zero break-even level, as well (see chart below).

Source: FRED

It is also no coincidence that the housing market -- the primary culprit behind the inability for private markets to clear and the asset whose corresponding liabilities' deleveraging have driven the household paradox of thrift -- is showing its first signs of life. The proportion of households with negative equity continues to decline, each new positive equity mortgage thawing the monetary transmission at the margin, and housing starts and homebuilder confidence are rising impressively. The chart below shows the relationship between housing starts and mortgage debt growth.

Source: FRED

Whether these housing "green shoots" are sufficient for a self-sustained recovery remains to be seen, but if these incremental upticks are the beginning of a new fixed residential investment cycle (as Conor Sen has been anticipating), they would reignite the virtuous process from higher private fixed investment to softened deleveraging to marginal employment growth to higher tax revenues to public fixed investment (a pathway described by Conor).

The Fed Senior Loan Office Survey's data supports this idea that the US is breaking free of its liquidity trap. The latter half of 2011 marked the beginning of a strong jump in the percentage of banks reporting greater demand for prime mortgage loans, while the same is true of auto, credit card, and consumer loan demand (see chart below). Liquidity traps are demand-facing credit constraints and the unlocking of this latent credit demand is a very supportive signal to the US economy's prospects for igniting a virtuous cycle within its private sector.

Source: FRED

One of the best characterizations of the impaired market clearing processes in the housing and labor markets is the charge-off rate on all commercial bank loans. The majority of the household's deleveraging (contraction in liabilities/disposable income) has been from defaults/discharges, more so than higher income growth, diminished net new origination, and forbearance. As such, a normalization in charge-off rates likely will represent the completion of the "involuntary" phase of household deleveraging, where capital structure impediments like negative equity prevent households from accessing credit. Charge-off rates have declined by about 2/3, suggesting they are about 80% through in the process of normalizing creditworthiness standards (see chart below).

Source: FRED

However, households are not the only sectors that are hoarding cash. Corporates have near-record margins, profits, and cash flows, but are using their cash to engage in capital structure arbitrage and other return streams resulting from Fed-induced borrowing cost manipulations (and their consequent impact on earnings yields). Substantial investment in labor and capital expenditures are still a far cry in this economy, but corporate propensity to deploy cash seems to be picking up on the margin, especially when the near-term negative prospective impact of the fiscal cliff is accounted for.

The Fed's financial repression has removed a substantially greater amount of net interest income from households than net interest expense, while massive federal deficits lower corporate interest burdens and repair corporate balance sheets. This acts as a subsidy from households (in need of net surpluses through which to deleverage) to corporates (successfully normalized to sustainable leverage and in possession of excess net surpluses). Corporations also take advantage of the cheap long-term financing by locking in favorable terms and repurchasing equity with some of the proceeds. However, going forward, corporations will have to actually deploy capital, whether for labor, LBOs, or M&As, as profit margins decline from record peaks, and organic sales and market share growth are required for continual earnings expansion. This is already starting to begin in every S&P 500 sector besides IT and financials, as the chart below shows:

Source: Ed Yardeni

This leads right to a question Matt Busigin investigated this week: is it time for wage growth to return? Busigin presents a wage growth model whose inputs are nominal US Treasury interest rates of different tenors. The calculation, (5yr-10yr) + (1yr-2yr) appears counterintuitive and arbitrary on the surface, but may better be represented as the inverted 2yr fwd 5s10s curve, a measure of expected curve steepness, accounting for inflation expectations. With wage growth tied to the hip to core CPI, it appears that interest rate markets are pricing in wage growth in the US by next year. Busigin's model and actual wage growth are presented below (keep in mind, the visual relationship appears even stronger when scaled for different times and y-axes).

Source: FRED, Matt Busigin/Macrofugue

The following concurrent developments compel us to consider the prospect of the US escaping its liquidity trap:
  1. House price stabilization
  2. Federal funds rate models implying positive nominal rates
  3. Increased household loan demand
  4. Household liability growth approaching and breaking the zero YoY level
  5. Open-ended Fed credit easing (targeting MBS as opposed to USTs arguably qualifies this as credit easing) that overwhelms net supply issuance
As various others have noted, there are many signs pointing to the US beginning a transition from an underutilized, low-velocity economy plagued by the fallacy of composition, to a neutral, normalized-velocity environment in which labor and housing markets begin clearing in earnest and Adam Smith's invisible hand retakes control over aggregate income allocation. The most interesting point to us is that the Fed announced its open-ended MBS purchases against a backdrop of range high inflation expectations, rising housing prices, and slowing household deleveraging. This further reinforces the Fed's strategy of emphasizing the expectation channel, as the Fed is already beginning to follow through on its promise to remain reactive to employment as opposed to proactive to inflation.

Whether a suitably and sufficiently determined monetary sovereign central bank can generate inflation remains to be seen, but for the first time, there are significant tailwinds behind the Fed's back. Because of the household balance sheet issues at the heart of the broken monetary circuitry presently, the rise in housing prices directly increases the Fed's policy efficacy, as opposed to the quantity of the Fed's policy initiatives influencing lending decisions and house price appreciation (loans create deposits, not vice versa). The added kicker is that the Fed is engaging in these policies at the early stages of household liability stabilization. Where housing prices go from here will be vital to determining whether the US economy has exited the muddle-through or will be at persistent risk of slipping back into a liquidity trap.

But it is important to maintain perspective about the magnitude of the economic impediments plaguing the US. Specifically, the prospect of a fiscal cliff looms ominously, and corporate uncertainty about the fiscal cliff is feeding into conservative investment and project origination, at least through year end. Perhaps it will be the conclusion of the 2010-present Congressional economic deadlock that determines the difference between two binary outcomes:
  1. 2004/05 moment: Corporates focus on top-line growth, particularly domestically, invest in labor, M&A, LBOs, & cap ex, drive up wages, causing household incomes to accelerate, consumption to pick up, balance sheets to continue rebalancing, and credit accessibility increasing. Housing markets continue to clear more effectively and shadow supply continues to dwindle, while former negative equity mortgageholders successfully refinance as their assets rise in value. Employment growth picks up steam, alleviating state & local and federal deficit burdens and "crowding in" public investment (including for public sector labor demand, which has been one of the biggest headwinds to the recover).
  2. 1937/38 moment: Corporates brace for a demand drop off, while households garner incrementally smaller net surpluses and income, slowing and prolonging their deleveragings. Housing dips back down, unwinding any thawing of monetary transmissions, and US economic sensitivity to global output dynamics spikes. Labor markets face headwinds from the fall in aggregate demand, and the high base from which unemployment is starting would lead to excessive labor market inefficiencies and skills gaps. The trend since the recession of unsatisfied labor force members dropping out of the labor force to (re)enter school on student loans is likely to continue in this scenario. And with more than one fifth of student loans outstanding delinquent, such a high base of nonperforming loans from which to accelerate a boom in student loan demand could cause student loans to flip from net borrowing (mitigating the household mortgage deleveraging and shadow banking collaterealized lending deleveraging) to debt stock reduction (exacerbating the household deleveraging).
Either way, the association between economic performance and financial market returns will remain very nuanced and complex: after all, if money velocity picks up and corporates start investing in labour and M&A, employment growth will benefit, corporate margins will decline, labour share of income will rise, and equities will only benefit if there exists sufficient revenue growth to offset the margin contraction. US stocks and bonds both returned dramatic performances since 2009, while real GDP has hovered around 2% and unemployment around 8%. Could we be in for a stage in this economic cycle where real GDP accelerates to 3-3.5%, unemployment drops to a low 7-handle, and yet asset prices tread water? After all, earnings reports are starting to come in weak just as the median US households/employees/consumers appear to be bouncing back strongly.

I don't know the answer to these questions, but one thing I do hold conviction in is: if the US is exiting a liquidity trap and money velocity is about to pick up (albeit slowly -- these are not binary on/off things), then fighting the Fed will be a dangerous move, so long as the flow of newly-created reserve credits overwhelm net fixed income product issuance and crowds out private sector demand for risk-free securities, pushing investors in aggregate into more risk seeking. 

Saturday, July 28, 2012

Still no signs of recession, but consumption will have to pick up to offset political & external drags

The advance Q2 2012 estimate was released today, printing at +1.5% vs +1.4% consensus vs an upwardly revised +2.0% prior. Consumption decelerated, bringing down the total growth with it, which will be a key area to watch going forward. However, investment picked back up and a big upward revision to the Q4 2011 investment print drove a significant revision to the total output growth as well. Government continued to be a moderate drag on growth, while net exports fell on the back of persistent USD strength (driven by both the deteriorating European backdrop and a slowing EM bringing down emerging market FX). Despite the external factor risks to NX and the ongoing government sector drag on output growth, the fight between decelerating consumption and strong investment growth will be the deciding factor on whether this is a mid cycle slowdown or a tip into a new recession. In the meantime, the continued downturn in the GDP and PCE deflators remains an interesting indicator to watch, especially if and as the recent surge in food prices feeds into the broader inflation gauges.

Household consumption decelerated to +1.5% annualized growth this quarter, with recent quarters' durable goods demand growth collapsing into negative territory. The deceleration in autos & auto parts was especially marked, coupled with a similar slowdown in home furnishing demand. Auto inventories are seasonally high due to atypical lack of a summer retooling period, which is influencing the seasonally adjusted jobless claims data, as well as providing a boost to inventories (more on this later). Auto (and housing) demand are two oft-cited leading indicators of business cycle turns, and whether this inventory is channel stuffing or will be filled with demand in coming quarters will likely be the biggest determinant of the nature of this slowdown. In this context, the negative contribution from motor vehicles & parts demand to overall output growth is a worrisome signal to keep an eye on, but a single datum does not make a trend. Nondurables were driven by a big jump in gasoline & energy goods demand, which represents large unit volume demand, given the sharp decline in oil prices in Q2 (though admittedly, natural gas prices staged a sharp rally and the hot summer may have increased natty's impact on the overall energy demand print). Services realized another strong and accelerating print, with housing & utilities services demand leading the way. This was likely due to a combination of an unseasonable hot & dry summer and the ongoing, slow yet steady housing recovery. With meager real income growth (though finally accelerating again), consumption is likely to remain weak in the near term, particularly against the capital structure constraints of the overindebted household sector, and is a key risk to the continued expansion of the US economy. The big retail sales miss from a couple weeks ago could be an important harbinger of things to come.

Investment growth was again meager this quarter, showing no acceleration, driven by a decline in demand in both nonresidential and residential structures, offset by an increase in the inventories delta. Equipment & software demand accelerated, with large jumps in software and industrial equipment growth, which is a good sign for the US's resilience to external slowdowns in China, Europe, and emerging economies. And the slowdown this quarter in structures demand may be a temporary blip, as telecommunications and power structures led the way down in nonresidential, and the all-important single-family homes showed their fourth consecutive positive quarter. Residential fixed investment is typically a strong leading indicator of the business cycle so keep an eye on this. Still, inventories contributed about 21% of overall output growth this quarter, and the aforementioned auto inventory accumulation could be an unstable pillar for growth going forward unless there is demand to meet it in coming quarters. Without a slowdown in auto/housing, there will be no recession, save for a massive fiscal cliff or greatly accelerated slowdowns in Europe/Asia. The former is a risk, but not a base case scenario, and the latter is more of a persistent and recurring risk rather than an immediate and acute one, especially considering the new easing cycle in China and the resilience the US has shown to outright depression in the European periphery (now feeding into the core).

Government expenditures were a drag on GDP growth for an eighth consecutive quarter, with state & local spending staying very depressed and little help from the federal sector. Equipment & software spending was stronger this quarter, decelerating the negative drag from government on output growth, but with prospects of a fiscal cliff looming, government spending should only become a bigger impediment to real GDP growth in the next 3-6 quarters. The US will likely hit its debt ceiling around September or October, and with the prospect of a Red/Blue Dog Congress with no fiscal mandate and a heavily-campaigned Presidential election in November, the likelihood of partisan politics meddling in near-term US fiscal policy is high and destabilizing. The best-case outcome seems to be small to moderate compromises mitigating the potential drag from the status quo fiscal trajectory, but the worst-case would go beyond even that and exacerbate it. This space is unlikely to be helping US growth anytime soon, especially as defense cuts come in, unwinding the temporary uptick we saw in this quarter's print.

Net exports took a small hit in Q2, as a combination of a strong USD and stronger import demand fed into real net exports declining. Petroleum imports jump out, as they went from a large negative contribution last quarter to a small positive one this quarter. Real export growth did accelerate, so the real net exports contraction was due to a proportionally larger increase in real import growth (mainly in goods), which could represent more of the US/ROW decoupling. Still, the 10 big figure selloff in EURUSD this quarter alone has yet to fully feed into net exports, and the FX effects of this strong USD will likely hamper real net exports in coming quarters and as long as the Asian and European slowdowns persist.

Source: BEA

Friday, April 27, 2012

The public-to-private sector handoff attempt continues

The advance Q1 2012 GDP estimate was released today, coming in at +2.2% vs +2.5% consensus vs +3.0% prior. Two emerging trends of recent quarters, strong PCE growth and worsening government expenditure contraction, continued in Q1 to be the engines for the overall output growth.

Household consumption, coming in at a +2.9% clip, was very strong, particularly in durable goods demand, where motor vehicles & parts consumption growth highlighted the ongoing auto recovery story. The big question going forward is whether, given meager income growth, household consumption can be sustained or if the recent attempt at household releveraging will be stopped in its tracks and take consumption growth down with it.

Investment was rather meager, contributing about a third as much to GDP growth as in Q4. A reduced impact from inventories and the first decline in nonresidential investment since Q4 2010 weighed on GPDI. The contraction in structures investment accelerated, but even more alarming is the continued deceleration in equipment & software investment, which had its worst print since Q2 2009. Residential investment was a major bright spot, with the SAAR accelerating to 19.1% in Q1.

Government expenditure continues to be the major drag on output in the US, with its sixth consecutive quarterly contraction in Q1. Both federal and state & local spending contracted, highlighting a pattern that is likely here to stay for the foreseeable future. The federal deficit reduction contingency in Washington has the ball in its court and with a breach of the debt ceiling potentially due by the end of the year (in an election year no less), the prospect of a fiscal drag is very real.

Net exports contributed virtually nothing net net to output in Q1, as an increase in services exports offset an increase in services imports. The difficulty with decoupling from externally weakening growth prospects is that it can translate into a larger current account deficit, so this will be an important component to watch going forward if the US/ROW growth divergence persists.

Source: BEA