We are all well aware by now of the more than doubling of the Fed’s balance sheet in the past couple months, surpassing the $2 trillion mark for the first time. The question then becomes, if the Fed is drastically expanding its balance sheet then why are we not seeing a noticeable change in the economy? The answer lies in the fact that banks are scared and hoarding capital as well as raising lending standards across all loan types, and so the cheap money being offered by the Fed is not finding its way into the economy.
Figure 1
Source: Federal Reserve
Figure 2
Source: Federal Reserve
Because banks are hoarding their reserves, loans are not being made and economic growth is slowing which then leads to a drop in the money velocity (GDP divided by the money supply), or a drop in the supply of money finding its way into the economy as money in the economy does not change hands as much. This is typically the hallmark of recessions, and economic turnarounds are often seen when the money velocity picks back up as the money in supply changes hands more frequently in the economy.
Figure 3
Source: Federal Reserve/BLS/BEA
The reason why there is a lag between when the Fed begins to reflate and when the economy turns around is that commercial banks' first objective is to restore their balance sheets before they begin to lend again. This process is made possible as the Fed engineers a positively sloped yield curve as the Fed slashes short-term rates faster than long-term interest rates fall. As banks borrow from the short end (lower interest rates) of the yield curve and lend out at higher long-term interest rates, they are able to capture the positive interest rate spread which improves their profitability. This can be seen in the figure below that shows how US Treasury and agency securities take a much larger share of commercial bank assets as the yield curve steepens, which occurs just prior to or coincident with recessions (grey bars below).
Figure 4
Source: Federal Reserve
As the yield curve steepens and banks invest in more US Treasury’s their profitability improves. Currently, though banks now have an improved yield curve to work with, they are still writing off billions in bad loans with the number of profitable FDIC banks still dwindling. Once we see an improvement in the number of institutions with earnings gains it is likely that banks will loosen the reigns in lending standards and begin to make new loans to the consumer and other sectors.
Figure 5
Source: FDIC/Federal Reserve
Figure 6
Source: FDIC/Federal Reserve
While banks may be on the road to recovery as their profitability improves from a positively sloped yield curve and with the write-down of nearly a trillion dollars in debts behind them, the question then is what type of road lies ahead of them? The answer could be summed up in one word - DELEVERAGING. Bank credit relative to GDP absolutely skyrocketed after the 1995 mid-cycle economic slowdown. Bank credit to GDP ballooned to nearly 67% of GDP, nearly four standard deviations above its long-term average of 44% as we truly were in a credit bubble. The primary culprit of the expansion in bank credit relative to GDP was real estate loans. Real estate loans made up 29% of bank loans in 1998 and reached 40% of loans by 2007.
One of the most powerful concepts in finance is a reversion to the mean in which a data series that moves too far away from its long-term average (mean) has a tendency to revert back to its average and quite often overshoots the average in its reversion process. When looking at the figure below we can see that the average of 44% will act like a strong magnet as GDP expands relative to bank credit in the years ahead, likely taking several years to revert back to the mean.
Figure 7
Source: Federal Reserve/BEA
The sharp economic downturn in the 1973-1975 recession saw bank credit contract from a high of 46% in 1974 to a low of 40% in 1981, a seven-year deleveraging cycle by the banks which is likely what we will witness out to 2015. Interestingly enough, the 2015 time frame coincides perfectly with the analysis done in a previous WrapUp entitled “Secular Sign Posts: The View from 30,000 Feet" with an excerpt provided below:
While there is a positive relationship between productivity and relative population demographics, there is a negative relationship between productivity and inflation. As such, we can connect the dots and then infer that there is a negative relationship between inflation trends and relative demographic trends with productivity trends providing the associating link. The inverse relationship between relative demographics and inflation rates can be seen below as peaks in the smoothed CPI inflation rate roughly coincide with relative demographic troughs and vice versa.
Figure 8
Source: U.S. Bureau of Labor Statistics/U.S. Census Bureau
With the above relationships established we can begin to look at what the future may hold with relative population demographics holding the key. As seen in Figure 5 (8) above, the relative demographic ratio peaked in 2000 and was coincident with the real S&P 500 peak, and does not bottom until 2015. Because the ratio continues to decline for another seven years we can expect productivity gains to be on a declining trend until 2015, and subsequently, infer that inflation trends will also be with us until 2015.
The conclusion is that the secular bear market we entered back in 2000 will not likely end until roughly 2015, and the secular inflationary trend that began in 2003 will be in place until 2015 as well. This time frame makes sense when looking at the historical script of secular inflationary events that typically last roughly 17 years when excluding the protracted 1879-1920 event. The actual bottom in the year-over-year (YOY) rate of change in the CPI came in 1998 at 1.55%, with the smoothed rate bottoming in 2003 at 2.45%. Taking the average secular inflationary length of 17 years and using 1998 as the disinflationary bottom and you get 2015, also the bottom in the relative demographic ratio which should correspondingly mark the peak in inflation and bottom in productivity gains.
Figure 9
Source: U.S. Census Bureau
Facilitating the reduction in bank credit relative to GDP will be a significant consumer retrenchment as the U.S. consumer pulls in the reigns of their spending and begins to slowly increase their savings rate. We are already seeing a major breakdown in consumption as the trendline in personal consumption expenditures (PCE) as a percentage of disposable personal income (DPI) that has been in place since the early 1980s has been broken, signaling that the long overdue consumer retrenchment is well underway.
Figure 10
Source: BEA
As highlighted in Figure 11 below, the prime consumption demographic (35-49) is projected to be in decline until 2015, leading to a major drag on aggregate consumption (see 10/15/08 Observation for a detailed explanation) when it will begin to rise again. A seven-year decline in aggregate consumption will allow the commercial banks to deliver relative to GDP back down to the long-term average of 44%. Right about the time, the banks will have deleveraged to their long-term average relative to GDP, the will be met with a pent-up demand from consumers as well as a favorable demographic change that will allow bank credit to expand again relative to the economy.
Figure 11
Source: U.S. Census Bureau/BEA
A retrenchment in U.S. consumption will mean tough times ahead for U.S. corporations who have benefited from the debt boom over the last 30 years that fueled higher consumption and corporate profits. As the trendline in PCE as a percentage of DPI has been broken, it won’t be long before the trend in corporate profits takes a serious hit. Corporate profits relative to GDP reached an extreme of two standard deviations (red lines below) from its mean (black line below) in 2006 and is already underway towards mean reversion. It is possible the ratio will fall below its mean as consumers increase their savings rate. The last secular turning point was the early 1980s when the savings rate peaked and corporate profits relative to GDP bottomed, with the current peak in relative corporate earnings likely marking a significant top.
Figure 12
Source: BEA
Figure 13
Source: BEA
While banks reign in credit someone will have to take the place of the consumer (and thus indirectly domestically exposed U.S. companies), and the 800-pound gorilla in the corner is the U.S. government. We are already witnessing massive deficit spending by the U.S. government to help stimulate the economy while the financial economy deleverages. This is exactly what happened when banks went through their seven-years deleveraging process from 1974 to 1981, where U.S. government debt relative to GDP expanded from 23% to 30%, more than making up for the 7% reduction (46% to 40%) in bank credit relative to GDP.
Figure 14
Source: Federal Reserve/BEA
Hopefully, the increased deficit spending by the government will go towards productive means. Over the last thirty years, we have been getting less bang for every buck borrowed. The growth in total U.S. debt has grown faster than GDP with each decade getting fewer dollars in GDP for each dollar of debt accumulated, with large drops seen in the 1980s and 1990s (Figure 16).
Figure 15
Source: Federal Reserve/BEA
Figure 16
Source: Federal Reserve/BEA
The large drop in productivity as measured by how much GDP rises per dollar of debt borrowed in the 1980s and 2000s corresponds with increased debt accumulation by the consumer on “things” as well as increased defense spending out of necessity (Cold War, 9/11 attacks). Unfortunately, cars, tv’s and missiles have a short shelf life and do not add significantly to economic growth and productivity gains.
Figure 17
Source: Federal Reserve/BEA
Hopefully, the wars in Afghanistan and Iraq will come to a close and allow the government to shift its spending towards areas that will have long-lasting gains in productivity such as infrastructure as well as energy independence. Not only will spending on infrastructure and energy independency produce more jobs here at home, it is an outright necessity. If we do not increase infrastructure spending then we can expect to see more electrical blackouts, more levees breaking, spikes in energy due to inadequate supply, more bridge collapses, more gridlock on the freeways, and so on and so on. Hopefully, President-elect Barack Obama and his advisors understand this so that we can come out of our nation’s crisis more productive than when we entered it. If he does then infrastructure companies may be the next big thing in the years to come.
