“In every battle there comes a time when both sides consider themselves beaten, then he who continues the attack wins.” –  Ulysses S. Grant

Watching with interest the lingering Brexit saga playing on in conjunction with the much commented trade war between China and the United States, when it came to selecting our title analogy, we decided to go for yet another poker card game reference (previous ones being “Poker tilt“, “Le Chiffre“, “Optimal bluffing“, the “Donk bet“, to name a few in no particular order). In the game of poker, the “Showdown” is a situation when, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner or winners. To win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not. Cards speak for themselves: the actual value of a player’s hand prevails in the event a player mis-states the value of his hand. Because exposing a losing hand gives information to an opponent, players may be reluctant to expose their hands until after their opponents have done so and will muck their losing hands without exposing them. Robert’s Rules of Poker state that the last player to take aggressive action by a bet or raise is the first to show the hand – unless everyone checks (or is all-in) on the last round of betting, then the first player to the left of the dealer button is the first to show the hand. 
If there is a side pot, players involved in the side pot should show their hands before anyone who is all-in for only the main pot. To speed up the game, a player holding a probable winner is encouraged to show the hand without delay (Brexit comes to our mind). Any player who has been dealt in may request to see any hand that is eligible to participate in the showdown, even if the hand has been mucked. This option is generally only used when a player suspects collusion or some other sort of cheating by other players. When the privilege is abused by a player (i.e. the player does not suspect cheating, but asks to see the cards just to get insight on another player’s style or betting patterns), he may be warned by the dealer, or even removed from the table. There has been a recent trend in public cardroom rules to limit the ability of players to request to see mucked losing hands at the showdown. One would probably think a similar rule should be applied to Brexit negotiations but we ramble again…
In this week’s conversation, we would like to look at US consumption and consumers, following the significant rally in the high beta segment of asset classes as we believe monitoring the state of the US Consumer in the coming months will be paramount. 

  • Macro and Credit – Secular stagnation or secular strangulation?
  • Final charts – Yes, Europe is turning Japanese
  • Macro and Credit – Secular stagnation or secular strangulation? 

With U.S. consumer prices increasing by the most in 14 months in March to 1.9% thanks to Energy prices climbing by 3.5% and accounting for about 60% of the increase, in conjunction with The University of Michigan’s preliminary consumer sentiment survey falling to 96.9 in April, from 98.4 the previous month, one might wonder what is the state of the US consumer.
On a side note, given the recent rise of the MMT crowd we read with interest Dr Lacy Hunt’s take in his latest 1st Quarter review. We highly recommend you read it, for those of you in the “Deflationista” camp. The Keynesian camp might be somewhat part of the “Inflationista” camp given their preference for 2% inflation and beliefs in the much antiquated “Phillips curve” (we have said enough on this subject on this very blog). It seems to us the MMT crowd, as rightly pointed out by Dr Lacy Hunt, could make us all fall into the “hyperinflationista” camp with their monetary prowess and “promises”.
As well we have seen many recent conversations surrounding the fact that in many instances in Developed Markets (DM) the “middle-class” has been hollowed out. This has been discussed at length by the OECD in their recent paper entitled “Under Pressure: The Squeezed Middle Class“.
Back in December 2014, in our conversation “The QE MacGuffin” we pointed out the following Societe General’s take from their FX outlook on central banks meddling:

“It’s broken, and they don’t know how to fix it. It is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.

Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms).”  -source Societe Generale

High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike.” source Macronomics, December 2014

The central banking “Showdown” is still going on we think. The “Global Savings Glut” (GSG), has been put forward by many defenders of Keynesian policies. 
We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation “The disappearance of MS München” on this subject:

“The “Savings Glut” view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled “The financial cycle and macroeconomics: What have we learnt?“:
“The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income.” – source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a “wicksellian” approach dear to Charles Gave from Gavekal Research.

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before.” – source Macronomics, February 2016

Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. But, returning to the wise note of Dr Lacy Hunt, he puts another nail in the coffin of this “Savings Glut” theory put forward by Dr Ben Bernanke:

“Secular stagnation is basically the rebirth of the over-saving theory. However, after WWII the U.S. balanced the budget, contrary to Keynes’s recommendation, and the economy boomed, permitting the U.S. to rebuild and open U.S. markets to the world’s exporters. What Keynes missed is that the national saving rate averaged over 10% during WWII, and the U.S. had a strong balance sheet. The private sector drew down their saving, and this propelled the economy higher. In 2018, the national saving rate was 3%, less than half the long-term average since 1929 and one-fifth the level of 1945. There is no excess saving to be drawn down (Chart 5).”

– source Hoisington, Dr Lacy Hunt
Given the worrying trend for the middle-class in DM countries, you probably understand by now our chosen title of “Secular strangulation”. For instance the “yellow jackets” (gilets jaunes) movement in France is an illustration of the fear of downgrade for many middle-class families which have been eviscerated by continuous fiscal pressure over the years. End of our parenthesis on the GSG.
Returning to the paramount subject of the state of the US consumer, with the volte-face made by the Fed, mortgages rates have fallen in sympathy giving some much needed respite to the US housing market. Existing-home sales climbed nearly 12% in February from the month before, reaching an annual rate of 5.5 million, according to the National Association of Realtors, which attributed the growth partly to interest rates. Of course lower interest rates for home mortgages buoy the housing market. In 19 weeks since November, the rate on a 30-year mortgage dropped from 4.94% to 4.06%, the most rapid decline since 2008. But, given “Shelter” comprises 40% of the Consumer Price Index, we might see some erratic readings in the coming months. 
As illustrated recently by Bloomberg, an excess of 7 million Americans were at least three months behind on their car payments at the end of 2018:

– graph source Bloomberg
Given the rapid deterioration in financial conjunctions in conjunction with housing headwinds thanks to rising mortgages rates in the final quarter in 2018, we think that this conjunction of factors on top of falling equity prices managed to spook enough the Fed to generate the aforementioned volte-face.
Obviously this welcome respite has managed to trigger an incredible rally for high beta thanks to global dovishness from central banks overall. Yet, we do think that the current housing bounce we are seeing is only temporary and providing some short term relief to the US consumer increasingly using revolving credit aka it’s credit card to maintain his consumption. On top of that, rising oil prices might be good news for US High Yield but, should gas prices continue to surge, it might start again to become a slight headwind for US consumers. This would point to overall weaker growth for the remainder of 2019 in the United States we think.
When it comes to the US Housing situation we read with interest Bank of America Merrill Lynch’s take from their Housing Watch note from the 12th of April entitled “A brief housing pop”:

Get ready for some good data…for now

All signs are pointing toward a short term boost to housing activity following a difficult end to last year. At the end of last year, mortgage rates were the highest since early 2011, the stock market was selling off and confidence in the economy was declining. Prospective homebuyers sat on the sidelines, uncertain about their future finances and concerned about affordability.

It has all changed since then. Mortgage rates have tumbled, returning to levels last seen in January 2018, the stock market has recovered and confidence has returned. If buyers were hesitant last year, this environment has lured them back into the housing market. Indeed, mortgage purchase applications have climbed, pending home sales have improved and existing home sales in February were very strong. Survey measures, including our own proprietary survey, show more favorable perceptions around housing with people noting that buying conditions have improved (Chart 2, Chart 3).

Similarly, homebuilders feel more confident with the NAHB housing index improving and realtor confidence surveys ticking higher. In our last housing watch in January, we argued that we would see a “brief period of stronger housing data.” We are doubling down on that view and now revising up forecasts for home sales in 2Q (Table 1).

Why are we looking for just a short-term boost to home sales rather than a more persistent recovery? Importantly, affordability challenges still remain. While the drop in mortgage rates provides a jolt to housing, housing is still overvalued given the strong rise in prices over the past several years (Chart 4). In addition, we see evidence that existing home sales have reached an equilibrium level based on the historical relationship between sales and the labor force. Of the people in the work-force, we are
at a historically “normal” rate of existing home sales (Chart 5).

There are greater opportunities for new home sales than for existing given that the recovery for new construction has been lackluster. Builders have been shifting away from the high-end of the market where inventory is higher toward the more affordable part where there is still incremental demand. This can be seen through the average size of a new single family home slipping lower and a drop in new homes sold over $300,000
(Chart 7, Chart 8).

Of course, housing dynamics are going to differ by region. A good way of understanding the relative strength or weakness in housing conditions is to track migration.

We find that people continue to leave Northeast, the Midwest and the California to move to Texas, Colorado as well as other areas in the West and South.” – source Bank of America Merrill Lynch

Given affordability is stretched, we agree with Bank of America Merrill Lynch, namely that the recent fall in mortgage rates is only providing some short term respite. When it comes to Main Street  it has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising in recent quarters. Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Housing activity is leading overall economic activity, housing being a sensitive cyclical sector.
The big question was that rising interest rates were starting to choke the US consumer hence the dovish tilt from the Fed following the horrific final quarter of 2018. 
On the state of the US consumer we read with interest Wells Fargo’s take from their note from the 2nd of April entitled “U.S. Recession? How Do We Count the Ways?”:

Are Consumer Finances in Good Shape?

Household leverage generally, and mortgage debt specifically, was at the epicenter of the last downturn. Although the severe repercussions of consumers getting over-extended a decade ago may still be fresh in the minds of borrowers, lenders and regulators, overall household leverage has fallen substantially over the past decade (Figure 1). As Mark Twain said, however, history does not repeat, but it often rhymes. Are there other areas in consumer balance sheets that pose a risk to the economy from an extensive build up in debt and deterioration in lending standards?

While mortgage debt has fallen over the past decade, Figure 1 also shows that leverage of other types of consumer debt, including autos, credit cards, and student loans, is at an all-time high.

 – Source: Federal Reserve Board and Wells Fargo Securities

Yet unlike housing debt in the 2000s, the increase has not been exponential. Leverage for consumer credit is also only a quarter of the size of housing-related leverage at the height of the housing bust. What’s more, debt service remains exceptionally low. Historically low interest rates and longer repayment terms have kept households’ monthly financial obligations ratios near levels last seen in the early 1980s (Figure 2).

– Source: Federal Reserve Board and Wells Fargo Securities

Notably, the most significant driver of the increase in consumer credit has been student loans. Given that educational debt is nearly impossible to discharge and primarily backed by the federal government, we view student loans as a sustained, long-term headwind to other types of spending rather than a mass credit event that could cause the financial system to seize up like the subprime mortgage crisis. In short, we do not think that consumer debt problems will trigger a recession in the foreseeable future.

Corporate Sector Debt: Keep an Eye on This Space

Where leverage may be more concerning is in the non-financial corporate (NFC) sector. As measured as a percent of GDP, debt in the NFC sector is at a record high. With corporate profit growth slowing, the ability to service debt likely will deteriorate somewhat over the next few quarters. At the same time, a shift in investor sentiment could weigh on asset values, which up until recently had been keeping pace with debt.

The financial health of the business sector has deteriorated since 2015, and significant further deterioration would be worrisome (Figure 3).

  – Source: Federal Reserve Board and Wells Fargo Securities

Firms that are stretched financially may be more reluctant to invest and hire. In addition, if companies start having trouble servicing their debt due to slower growth and/or higher interest costs, rising charge-offs and loan losses could disrupt credit growth. However, the current health of the non-financial corporate sector does not seem particularly dire at present when compared to the late 1980s or ahead of what we consider to have been the business-led recession of 2001.3 Interest rates have been rising from a historically low level and are unlikely to rise much further this cycle, while companies have locked in historically low interest rates by holding more long-term debt.

One segment of business sector debt that bears particularly close watch is the leveraged loan market.

  – Source: Federal Reserve Board and Wells Fargo Securities

Leveraged loans are made to companies with high debt-to-cash flow ratios that are typically rated less than investment grade. Loans outstanding in this sector have grown 35% since 2016, twice as fast as total NFC debt. Slower economic growth this year could make servicing that debt more difficult and lead to weaker demand from investors, which would weigh on credit growth to the business sector and therefore the broader economy. Yet leveraged loans are floating-rate instruments, and, with the Fed currently on hold, interest costs are not expected to shoot markedly higher. As a result, we do not see the leveraged loan market as an immediate threat to the economy.

Is There Overbuilding in Construction?

The bursting of the U.S. housing market bubble precipitated the Great Recession but it does not seem that lightning will strike twice, at least not in the current cycle. As noted above, households have de-levered over the past ten years. The value of mortgage debt outstanding among households is down 4% relative to its peak in early 2008. But disposable personal income is up 50% over the past ten years, giving households better ability to service that mortgage debt than they had at the height of the housing bubble. Furthermore, single-family housing starts are roughly 50% lower than they were at the height of the housing boom (Figure 5).

  – Source: Federal Reserve Board and Wells Fargo Securities

Although the level of multifamily starts is a bit higher today than it was a decade ago, apartment vacancy rates are low and rent growth remains solid.

Despite indications of robust activity in commercial construction, we do not think that commercial real estate (CRE) is an accident waiting to happen, at least not in the foreseeable future. As we wrote last autumn, the underlying fundamentals in the CRE market appear to be strong. Despite appearances of robust construction activity, the level of real non-residential construction spending is only 16% higher today than it was before the economy tumbled into recession in late 2007. At the end of the expansion in the 1980s, real non-residential construction spending was more than 60% higher than its previous peak. Commercial banks hold nearly $1.7 trillion worth of commercial mortgages, an all-time high. However, this amount represents less than 11% of their total financial assets, which is not out of line in a historical context (Figure 6).

  – Source: Federal Reserve Board and Wells Fargo Securities
Whereas it might be a little premature to call for a decisive turn of the credit cycle, to repeat ourselves, the next Fed Quarterly publication of the Senior Loan Officer Survey will be extremely important to monitor.

For now the US consumer is still holding on apparently. This is indicated by Bank of America Merrill Lynch in their BofA on USA report from the 11th of April entitled “The consumer spring into Spring”:

Strong consumer spending in March

The long-awaited rebound in consumer spending has arrived. According to BAC aggregated credit and debit card data, retail sales ex-autos jumped 1.5% month-over-month (mom) seasonally adjusted in March, partly reversing the decline over the prior three months. This recovery supports our view that the recent drop was largely due to temporary distortions rather than a fundamental weakening in consumer spending.

We see evidence that the timing of tax refunds pushed spending from February into March, specifically for lower income households. Those households receiving the Earned Income Tax Credit saw a significant delay in tax refunds, resulting in lower spending in February. Once tax refunds were received at the end of February, these households were able to spend, boosting activity in March. We see this notable swing in the data in the Chart of the Month.

It was the most apparent in the “discretionary” spending categories such as clothing, furniture and lodging. Interestingly, we did not see a big gyration in spending in restaurants which is typically sensitive to income changes. To be expected, spending at grocery stores was fairly steady over the prior two months (Chart 2).

We examine our tax refund data to see if the tax legislation, which capped state and local tax (SALT) deductions, altered refunds across the different states and income tiers. We focused on the top 10 states in terms of the SALT deduction and found that tax refunds were indeed down sharply for upper income households in these states – down 10% year-over-year (yoy) vs. an average of 1.7% increase over the three years prior (Chart 4).

In contrast, upper income households in the states with the most favorable tax laws saw little change in tax refunds relative to prior years. How does the decline in tax refunds among the upper income population in high SALT states impact spending? It isn’t obvious that it will have much of an impact since the upper income population tends to have more disposable income and are therefore less dependent on tax refunds to finance expenditures. Nonetheless, it could possibly weigh on confidence and curb purchases of bigger ticket items.

Bottom line: the consumer finally showed up in March, offsetting part of the decline at the turn of the year. We think we should see further improvement in spend going forward as consumers respond to higher wage growth amid solid job creation.

– source Bank of America Merrill Lynch 

While it’s difficult to validate yet a bounce as per Bank of America Merrill Lynch’s internal data, while University of Michigan Consumer Confidence remains high, it remains to be seen if there is indeed a change in the narrative:

– source IBT – University of Michigan
Something as well worth of interest when it comes to US Consumers given they make 70% of US GDP, has been the rise of Millenials and change of consumer habits as pointed out by another interesting report from Bank of America Merrill Lynch BofA on USA from the 17th of April entitled “Consumer, my how you have changed”:

Two numbers: age and income

The Millennials – who are currently aged 23 to 38 – make up 28% of retail sales ex-autos based on BAC internal card data, slightly outpacing the 26% from Baby Boomers. The wallet of Millennials is growing, with the average number of monthly transactions up 16% from 2012 vs. the 5% increase of Boomers. Millennials also live differently, with 51% of food consumption done at restaurants vs. Boomers at 34%.

There are also differences by income, as we find that 30% of spending is made by the >$125k income cohort while the <$20k group only constitute 10% of total retail ex-auto spending.” – source Bank of America Merrill Lynch

Overall, while it is too early to turn negative on US consumers, in the coming months ahead it will be essential to monitor closely the situation we think.

We have long posited that Europe was becoming more and more “Japanese” hence our frequent use of the word “Japanification”. Our final charts below goes more into the similarities.

  • Final charts – Yes, Europe is turning Japanese

Looking at the trajectory of policy rates and government bond yields in Japan, it looks to us more and more that Europe is becoming more Japanese and we are not even mentioning the slow pace of resolving the issue of nonperforming loans plaguing the European Banking system. Our final charts come from Deutsche Bank Thematic Research report from the 9th of April entitled “How Europe is looking like the next Japan”:

“In February this year, the Bank of Japan celebrated an ominous anniversary: 20 years since it first cut interest rates to zero. Despite a few abortive attempts to raise policy rates, they have never again exceeded 1% and remain stubbornly stuck around zero. Likewise, Europe has seen a few false dawns but again looks set for a long period of short-term rates being stuck at or below zero. More recently, long-term bond yields have fallen as well, with ten-year bund yields dipping into negative territory again over the last month. As such there are ever-growing similarities between the Europe of today and the Japan of the past two to three decades.

The consensus forecast is for the ECB to hike its policy rate from zero by the end of next year but this forecast has been repeatedly pushed back and markets are increasingly sceptical. Much like in Japan, there are now increasing concerns that ‘lift-off’ will never actually happen and Europe will be stuck in a world of ultra low growth and negative yields for years to come. Is this realistic? Well, as we know, it happened in Japan and it is therefore worthwhile examining in more detail the similarities and differences between the two economies with a suitable lag.” – source Deutsche Bank

Given in a “Showdown”, to win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not and that Cards speak for themselves, it is clear to us that any form of normalization by the ECB will be repeatedly pushed back à la Japan.

“In battle it is the cowards who run the most risk; bravery is a rampart of defense.” – Sallust

Stay tuned !

Source: https://macronomy.blogspot.com/2019/04/macro-and-credit-showdown.html