The Next Reflation: Where It Will and Will Not Be

“Only when the tide goes out do you discover who's been swimming naked.”~Warren Buffett

The tide has clearly gone out in the financial markets with the reining in of debt expansion in the mortgage markets, particularly to the subprime market. The securitization of these mortgages has come to a standstill as prices on ABS secured by subprime mortgages and home-equity loans have collapsed. The collapse in pricing of these securities has exposed those who've been caught swimming naked, the over leveraged hedge funds and banks with exposure to U.S. subprime debt, which has led to the current credit crisis.

Mark Zandi, Chief Economist and co-founder of Moody's Economy.com, updated his U.S. Macro Outlook this week. The outlook in August entitled, "Fragile, Handle with Care," has been altered lower to September's more distressing title, "Very Near Recession." The rising risks to the economy are mounting as Mark Zandi points out in the excerpts from September's outlook provided below.

The subprime financial shock has dealt a substantial blow to the economy. The risk of recession during the next 6-12 months has surged to almost 40%, up from less than 15% before the shock. These are the highest odds of a contraction since the 2001 downturn (see chart).

Figure 1

Source: Moody's Economy.com, DismalScientist

Homeowners with adjustable rate mortgages facing their first payment reset will crest this fall, but remain elevated well into next year (see chart). According to the Mortgage Bankers Association, the percentage of homeowners entering foreclosure has never been higher since they began keeping records (emphasis added).

Figure 2

Source: Moody's Economy.com, DismalScientist

With fewer home sales and increased foreclosures adding to the already record amount of unsold housing inventory, housing construction and house prices are set to fall sharply. Housing starts will have to fall more than 50% from their peaks and house prices by no less than 10% for enough inventory to clear to allow the market to stabilize. To date, starts are down approximately one-third, and house prices by only 4%.

This calculation assumes, however, that businesses continue to add to payrolls; an assumption that is much less compelling after the reported loss of jobs in August.

Consumer Retrenchment Opens Door for Fed Rate Cut

With housing continuing to weigh on the economy and the August employment report showing the first monthly payroll decline since August of 2003, and with June and July's employment numbers revised downward by 81,000 jobs, the door has been swung open for the next round of reflation.

The next round of reflation in the debt supercycle is predicated by a consumer retrenchment that is well underway. The current economic expansion has played out according to the historical script of cycles past. Housing is a leading indicator that peaks first, followed by the general economy as measured by retail sales and employment. What has been perplexing in this cycle is that retail sales plunged starting last year while employment growth decelerated at a much slower rate. The source of the discrepancy has been the birth, death model used by the Bureau of Labor Statistics, where fictitious jobs have accounted for 70% of job creation over the last seven months. (For an explanation of this topic, see commentary from a previous WrapUp: Figures 7-9, 07.11.07).

Figure 3

Source: Moody's Economy.com

The next script to play out in an economic cycle is for revolving consumer credit (aka: credit card debt) to peak. The typical cycle sees retail sales peaking despite credit card debt growth rates expanding. Expanding credit card debt near the end of an economic expansion no longer finds its way into the economy via retail sales but instead is channeled towards paying off consumer debts (mortgages, car payments) and discretionary items.

Figure 4

Source: Moody's Economy.com

The consumer retrenchment underway is likely to accelerate with ARM resets increasing over the coming quarters. This is going to put a considerable strain on the banking industry whose exposure to the residential real estate market has never been higher. This has resulted from housing becoming the principal target of the last reflation campaign to pull us out of the tech bubble bursting of 2000 and the 2001 recession. The conduit of this reflationary campaign was the commercial banks who took advantage of the decade lows in interest rates.

Commercial bank home equity loans exploded northward in 2001 as housing was the reflationary target earlier this decade. Not only did banks increase their leverage through an expansion of home loans, but they also increased their exposure to mortgage backed securities and derivatives to record levels.

Figure 5

Source: Moody's Economy.com

Figure 6

Source: Moody's Economy.com

Figure 7

Source: Moody's Economy.com

Without even peak ARM resets occurring, we are already seeing delinquent loan nominal values surpass the levels of the last two recessions. The year-over-year (YOY) rate of change in non-current loans shows no sign of slowing, nor prime and subprime ARM delinquency rates. This is occurring at a time commercial bank loss allowance as a percent of total loans and leases is near record lows, hinting that any surge in defaulting loans will put a sizable dent in banking profits. Not surprisingly, the percentage of unprofitable banking institutions is rising rapidly, surpassing 2001 recession levels.

Figure 8

Source: Moody's Economy.com

Figure 9

Source: Moody's Economy.com

Figure 10

Source: Moody's Economy.com

Figure 11

Source: Moody's Economy.com

The current credit crunch and resulting strain on the banking industry from exposure to the housing downturn along with declining employment is putting pressure on the Fed to "do something." A Fed rate cut next week is all but certain, though the same can not be said as to the likely source of the next reflation campaign.

A History of Debt Expansion

Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark: "I wasn't worth a cent two years ago, and now I owe two millions of dollars."

The Gilded Age: A Tale of Today
Mark Twain & Charles Dudley Warner

That line can aptly be applied to maids and bartenders who falsified their incomes and received home loans worth hundreds of thousands of dollars during the euphoric peak of subprime lending in 2005, who are now caught swimming naked as the tide of cheap money has gone out and their payments reset to higher rates.

The reflation campaign that propelled housing prices to unjustifiable levels was the most recent chapter in nearly a half century of debt expansion that really took flight when the constraints of the gold standard was removed on August 15, 1971, a day of financial infamy ('A Day of Infamy: August 15th, 1971' by Tony Allison). Since then the printing presses of the Federal Reserve have been running full steam with the expansion in dollars created out of thin air finding their way to all sectors of the economy, from households to businesses.

Figure 12

Source: Moody's Economy.com

What should not be lost when looking at the reflationary campaigns of our central bank is that each reflation requires greater levels of money printing to keep things afloat resulting from diminishing economic returns from each dollar of newly created debt. This has substantially increased the level of credit market debt as a percent of GDP to levels surpassing the Great Depression.

Figure 13

Source: Moody's Economy.com

Figure 14

The history of the past 50 years or so has been one of a steady buildup in debt, punctuated by crises that threatened to topple the whole financial edifice. Each time, the authorities have found a way to stave off disaster, and in the process, set the scene for even greater excesses down the road. Long-time BCA readers will know that we have described this process as the Debt Supercycle, and the key question always seems to be: how long can this keep going on?

BCA Special Report: An Inflection Point in the Debt Supercycle
Martin H. Barnes, Managing Editor

As highlighted in the quote from BCA, economic downturns and financial shocks have been the catalyst for new waves of reflation over the years (Figure 15). The typical cycle sees the Federal Reserve increase interest rates to slow down an overheated economy which ultimately leads to a financial crisis due to the misallocation of credit from speculation. Each crisis then provides support for the Fed to start the reflation cycle again by lowering interest rates and printing money. As seen in Figures 16 & 17, money supply growth rates turn up sharply in response to recessions (shaded regions).

Figure 15

Source: Jim Puplava, "The Next Rogue Wave"

Figure 16

Source: Moody's Economy.com

Figure 17

Source: Moody's Economy.com

The Next Reflation: Follow the Money

The preeminent investment question is, to where will the newly created money flow and which area of the economy is next to increase their debt exposure? Knowing this answer will allow an investor to position oneself to profit the most from the coming reflation. Major returns were made in the last reflation in anything tied to housing, mortgage lenders, homebuilders, home improvement stores, and REITS. The three key sectors of the economy, household, corporate, and federal, all take part in reflation cycles to different degrees.

For example, to pull us out of the 1990 recession (Figure 18, red shaded bar) the federal government increased fiscal spending substantially, with defense spending increasing significantly, while total household debt to GDP remained relatively flat and corporate debt levels actually falling in response to the recession. In the 2001 recession (Figure 18, green shaded bar), household debt growth accelerated as did federal debt (defense spending again), while the corporate sector retrenched debt levels.

Figure 18

Source: Moody's Economy.com

Since Volker put out the inflationary flame in 1981 by raising the federal funds target rate to 20%, the greatest source for debt expansion has been the household sector bar none. Total household debt as a percent of GDP rose from roughly 40% to 50% over the twenty year period from 1960 to 1980. The next twenty years saw that figure jump another 20% to roughly 70% in 2000. In just seven years that figure has ballooned to 96%.

Figure 19

Source: Moody's Economy.com

The rate of indebtedness on the part of the U.S. consumer over the last quarter century has been explosive to say the least, with the rate of debt growth to GDP accelerating. The twenty year period between 1960 to 1980 saw household debt as a percent of GDP increase 10%, the next twenty years saw that level increase 20%, and the past seven years alone have seen a rise of 26%. The U.S. consumer has clearly leveraged up over the last quarter century, but how much more room does the consumer have to leverage? Will the consumer be the next sector to take part in the next reflation? Don't bet on it.

When the U.S. consumer decided to go on a debt accumulation binge that started in the early 80s, it was doing so with a savings rate near 12% and a financial obligation ratio near 13%. Since then the consumer has unleashed spending fueled by a growth in debt and a reduction in the savings rate to negative levels never seen before. What's more, homeowners are facing a record financial obligation ratio at a time when income levels are falling, as is employment. The household sector is likely to keep debt levels relative to GDP stable for the foreseeable future as the housing recession unfolds.

Figure 20

Source: Moody's Economy.com

With the household sector not likely to expand debt significantly going forward, the question then becomes how likely is it for the corporate sector to leverage their balance sheets. Not likely, according to historical precedent. As seen in every recession over the last half century, corporate debt as a percent of GDP contracts during and after a recession as business reins in spending on capital expenditures as seen in the figure below.

Figure 21

Source: Moody's Economy.com

One may then question the likelihood of a recession if corporate debt growth appears to still be rising relative to GDP levels in the figure above. As mentioned in a previous WrapUp (Who's Carrying the Economic Baton?), the corporate sector has not funneled the increased debt into business expansion, but rather into retiring corporate debt. Moreover, the demand for consumer and industrial (C&I) loans is falling and is likely to fall further as there is a 15 month lag between C&I loan demand and the federal funds rate.

Figure 22

Source: Moody's Economy.com

The deceleration in corporate debt growth is supported by the National Federation of Independent Business (NFIB) optimism indices. The overall optimism index is below 2001 recession levels and is continuing to decline as is the percentage of businesses planning capital expenditures in the next several months.

Figure 23

Source: Moody's Economy.com

If neither the household or corporate sectors of the economy are likely to expand debt levels relative to GDP figures, the only other candidate that remains is the federal government. The federal government has taken a back seat to the consumer and corporate sector over the last decade and a half in debt growth relative to GDP levels. Federal debt levels peaked at 49% in 1993 and fell with a strong economy until bottoming in 2001 at 33%. As in previous recessions, the federal government stepped up spending to help pull the economy around with another round of defense spending kicking in as a result of the terrorist attacks in 2001. With current levels at 36.6%, the federal government has the most latitude to expand its debt levels going forward in the next reflation.

Figure 24

Source: Moody's Economy.com

If the federal government is set to expand on increased fiscal spending, there are two likely targets. The first comes as no surprise while the second has come into light in recent months. One area likely to benefit from increased fiscal spending is the aerospace and defense areas as a result of the ongoing conflict in the middle east. Defense spending is most certain to balloon if the conflict spreads to Iran where tensions between Tehran and the White House remain high due to Iran's interest in nuclear energy, which it vehemently professes is for peaceful uses.

The other area likely to benefit from increased fiscal spending is infrastructure, which is what Jim Puplava highlighted as "The Next Big Thing" in his Big Picture Segment in the March 10, 2007 Financial Sense Newshour (Click here for transcript). In the segment Jim spends over thirty minutes discussing with John Loeffler the infrastructure crisis facing this nation. This foresight came before the eight-lane interstate bridge collapsed during the Minneapolis evening rush hour on August 1st of this year. As is typically the case, it takes a disaster before the government reacts, and that terrible bridge tragedy will likely spark an infrastructure spending program in the near future that will be comprehensive, ranging from roads and bridges, energy, rail systems, and roads.

The financial market turmoil that has gripped the markets over the last few months is likely to continue. The Fed is likely to cut as much as 50 basis points at its September 18th meeting which will likely give the market an initial boost. However, with housing and the subprime mess still ongoing in the market will likely take several more months to digest, along with a continued slowing economy as seen by decelerating retail sales and employment.

Expect a tug-of-ware between the bulls and the bears in the markets for the remainder of the year. As the reflation campaign picks up steam over the coming year, look to profit from a likely infrastructure spending program as the federal government is the most likely candidate to increase its debt levels going forward. Maybe a tip off to federal spending in this area will come in President Bush's next State of The Union address this coming January. Besides infrastructure plays, precious metals should do well as it appears gold already smells whiffs of reflation as it is back above $700/oz. The commodity boom will likely continue as China and India remain economic growth juggernauts, leading to higher commodity prices in the years to come making commodity plays a worthwhile investment.

Today's Market

The markets traded lower initially after the release of the petroleum inventory report that showed crude oil stocks falling 7.1 million barrels, the largest weekly drawdown since last December. The news pushed the spot price of West Texas Intermediate Crude (WTIC) up to records levels at $79.91 a barrel, on the verge of breaking the $80 a barrel mark.

Negative third quarter updates by Texas Instruments and Nucor also weighed on the markets, but the buying of large-cap stocks helped support the markets due to their larger weight in the broad indices. The best performing sector was energy (+0.79%) due to the bullish petroleum report while the negative report by Texas Instruments led to a sell off in technology stocks as tech was the worst performing sector of the day, falling 0.61%.

The Dow Jones Industrial Average fell 16.74 points to close at 13291.65 (-0.13%), the S&P 500 was flat, rising 0.07 points to close at 1471.56 (0.00%), and the NASDAQ gave up 5.40 points to close at 2592.07 (-0.21%).

Treasuries fell with the yield on the 10-year note rising 4.4 basis points to close at 4.408%. The dollar index was down for the sixth consecutive day, falling 0.32 points to close at 79.38. Declining issues represented 55% and 56% for the NYSE and NASDAQ respectively, reflecting a mixed market.