The Dow Jones Industrial Average closed last week at its highest level since December 2007. The S&P 500 trades only 10% below its 2007 high. The S&P 400 Mid-Cap index is just 4% below its all-time high (April 2011). The Morgan Stanley Retail Index is up 14% so far in 2012 and rests only 3.7% below its record high (March 2012). The small cap Russell 2000 is 5.2% below its all-time high (April 2011). While still some distance from 2000 Bubble peaks, the Nasdaq100 sports a 2012 y-t-d gain of 22% and the Morgan Stanley High Tech is up better than 17%. Near record debt issuance has corporate Credit poised for its strongest growth since 2007 (Q1 7.2% growth rate). At almost $30bn, junk bond issuance so far this month is already an August record and compares to the 5-year average for the month of $8.4bn.
My thesis has been one of a historic global Credit Bubble and financial mania. For the past 18 months, Europe has been the focal point of my and others’ macro analysis. I’ve viewed the Greek debt crisis eruption as the first crack in the “global government finance Bubble.” Not unexpectedly, aggressive policy responses have done little to resolve the steady downward debt spiral in Europe. As the crisis that began at Europe’s periphery methodically engulfed the core, confidence in the sustainability of euro monetary integration began to falter. Structural flaws and deep political fissures have been exposed. Confidence in the European banking system has waned. The resulting severe tightening of financial conditions and weakening economies are having an increasing global impact, especially on the overheated “developing” economies. Europe has been at the precipice of unleashing a historic global financial and economic crisis.
At the same time, the U.S. these days remains firmly immersed in its Credit Bubble, fueled predominately by Washington-based debt, federal guarantees and monetary distortions. Somewhat ironically, the European crisis has worked to exacerbate U.S. Bubble excess, as Treasury bond and market yields have sunk to record lows. While risk aversion and the tightening in global financial conditions have repeatedly threatened U.S. shores, the bottom line is that Credit conditions here have remained extraordinarily loose. With Europe in somewhat of a late-summer crisis respite, I’ll take the opportunity to focus on U.S. Bubble dynamics.
When Europe is unraveling, global de-risking/de-leveraging market dynamics are in command, and U.S. confidence is waning - the feeble U.S. recovery becomes immediately susceptible to recessionary forces. Not irrationally, market attention quickly returns to the Fed’s itchy QE trigger finger. Yet, a few weeks of potent “risk on” have an impact: things start to look different and not particularly deflationary. Crude oil is back above $96, the housing recovery appears on track, spending looks resilient and the U.S. stock market is posting boom-time gains. Suddenly, the case for additional quantitative easing seems really weak. The bond market gets fidgety.
The Standard and Poor’s 500 Homebuilding index sports a y-t-d gain of 71% and a 52-wk rise of 123%. July Building Permits were reported at a four-year high, although they remain at less than half of boom-time levels. Yet housing fundamentals have clearly improved. An increasing number of locations are again enjoying strong price appreciation, with froth returning to scattered markets. Given sufficient time, incredibly low mortgage rates will work their magic.
The consensus view holds that the worst of the housing crisis is fading into history. Friday, from the Treasury Department’s Michael Stegman: "With today's announcement, we are taking the next step toward responsibly winding down Fannie Mae and Freddie Mac, while continuing to support the necessary process of repair and recovery in the housing market.” The plan is to push forward with the shrinking of Fannie and Freddie’s balance sheets. This implies real reform, with reduced reliance on these troubled institutions and less exposure burdening the U.S. taxpayer (federal bailout $190bn and counting).
Truth be told, Fannie, Freddie, and the American taxpayer and economy will remain highly exposed to mortgage Credit risks for many years to come. While GSE mortgage holdings (and balance sheets) have been somewhat reduced, exposure to mortgages they’ve insured remains at near-record levels. Fannie’s “Total Book of Business” (mortgages held in the portfolio and MBS insured) ended June at $3.183 TN, little changed for 2012 and down only about 2% from the March 2010 high. Across town at Freddie Mac, total mortgage exposure remains above $2.0 TN, down only 10% from record highs. It is also worth noting that FHA guarantees have increased dramatically since the 2008 crisis to exceed $1.0 TN. I’ve argued that there will be “no exit” from Federal Reserve “easy money,” and there will similarly be “no exit” from federal control over mortgage Credit.
The virtual nationalization of U.S. mortgage Credit in concert with incredible monetary stimulus has ensured the ongoing availability of inexpensive mortgage Credit. Fannie, Freddie and the FHA – key players in the Mortgage Finance Bubble – are today important participants in the Government Finance Bubble. There will be huge future costs, but for now housing and the economy enjoy the stimulus. And while mortgage Credit in aggregate remains stagnant, there are indications of typical problematic excesses spurred by mispriced finance.
I have posited that today’s Bubble is the latest in a series of Fed-accommodated bouts of Credit and speculative excess. And as each successive Bubble grows larger and more systemic, the effects actually become less conspicuous. The technology Bubble was rather obvious, although the greatest associated excesses were more generally contained (i.e. Internet/technology stocks, telecom debt, California incomes and real estate). The mortgage finance Bubble was much less conspicuous until the arrival of the more egregious late-cycle price and construction excesses. Few appreciated how Trillions of new mortgage debt were inflating incomes, spending, and corporate profits, while covertly distorting the economic structure. Today, it seems that virtually no one recognizes how Government Finance Bubble excesses inflate incomes, spending, profits, state & local government receipts, and equities and bond prices.
In the five years 2003 through 2007, total mortgage debt increased about $6.2 TN, or almost 75%. This historic Credit expansion saw National Income inflate $3.0 TN, or 32%, to $12.4 TN, with Total Compensation increasing 29% to $7.9 TN. Corporate profits (before tax) surged 128% to $1.74 TN. The 2009 recession saw a one-year 3.7% decline in National Income, a 3.2% fall in Total Compensation, and a 22% drop in profits. But unprecedented Washington stimulus was immediately forthcoming.
In the 15 quarters June 30, 2008 to March 31, 2012, Treasury debt increased almost $5.6 TN, or 106%, to $10.828 TN. This massive inflation of government Credit, in concert with Federal Reserve rate cuts and monetization, reflated system price levels that in 2009 had commenced a problematic downward spiral. Indeed, National Income jumped 4.5% in 2011 to a record $13.421 TN, after increasing 5.7% in 2010. After gaining 4.0% in 2010 and 3.3% in 2011, Total Compensation has also grown to record levels. Corporate profits have inflated to record levels after increasing 25% in 2010 and another 4% in 2011. As bullish analysts extrapolate corporate profit growth, U.S. stock prices appear “cheap” after doubling from 2009 lows.
The key has been that overall system Credit resumed its historic expansion. While down from 2007’s 8.4% growth rate, U.S. Non-Financial Credit still increased 5.9% in 2008, 3.1% in 2009, 4.1% in 2010 and 3.6% in 2011. It didn’t really matter that the vast majority of 2009-2011 growth originated from Treasury debt. Massive Washington stimulus was able to sustain inflated price levels throughout much of the economy – perhaps not home prices, but definitely system incomes, spending, GDP, and profits, while state & local receipts bounced back to, and in many case surpassed, pre-crisis levels.
There was a school of thought coming out of the bursting of the technology Bubble that a jump in mortgage Credit growth was necessary to help ward off dangerous deflationary forces. And, predictably, once the mortgage finance Bubble gained momentum no one was willing to take away the punchbowl. Today, our policymakers are using government finance to inflate system Credit and price levels, and are again willing to tolerate excesses that will only become more unwieldy over the life of this latest Bubble. Somehow, the Fed’s biggest concern is the timing of its next spike to the punchbowl.
From Bloomberg: (Sarika Gangar, August 16): “Sales of junk bonds in the U.S. have already set a record for August… Charter Communications Inc., the cable-TV provider that emerged from bankruptcy in 2009, and Energy Future Holdings Corp., the Texas power producer struggling with $36.6 billion of long-term debt, are among companies that have sold $29.6 billion of speculative-grade securities this month. That compares with an average $8.4 billion in August sales for the past five years… Companies are tapping into an unprecedented $44.9 billion of cash that has poured into funds that buy junk bonds in 2012 as the fourth year of near-zero short-term interest rates prompts investors to put their money into higher-yielding assets. Issuance accelerated even as the pace of earnings at speculative-grade companies slowed in the second quarter… ‘It has become such a feeding frenzy,’ Bonnie Baha, who helps oversee $40 billion as head of global developed credit at DoubleLine Capital… said… ‘It’s almost like credit fundamentals don’t even matter in markets like this. You’ve got too many dollars chasing too few bonds.”
Today from the Financial Times, “The Danger of Getting Hooked on Junk Bonds” and “Debt Dealers Await Move From Greed to Fear.” This week from Bloomberg: “Morgan Stanley Leading Long-Bond Sales to Record.” From the Wall Street Journal: “As Corporate-Bond Yields Sink, Risks for Investors Rise.” And from the New York Times: “Muni Bonds Not as Safe as Thought,” and “Risk Builds as Junk Bonds Boom.” Current excesses certainly go well beyond junk. With record issuance and market prices that make little sense, Bubble excess is increasingly conspicuous throughout the entire fixed income complex. To be sure, the Fed-induced yield chase has created historic price distortions from Treasury bonds to corporates to municipal debt.
From Bloomberg: (Brian Chappatta and Tim Jones, August 16): “Illinois has set aside only 45% of what it needs to meet public-worker pension obligations, the worst of any U.S. state. Standard & Poor’s may cut its bond rating if lawmakers don’t come up with a fix tomorrow. Investors are unfazed. The fifth-most populous state’s unfunded pension liability is growing by an estimated $12.6 million a day… Yet the penalty on general-obligation bonds from issuers in Illinois, relative to top-grade debt, fell to 1.51 percentage points last month, the lowest since February 2011…”
Over the years, I’ve noted how the Credit Bubble saw annual non-financial debt growth increase from about $650bn in the mid-nineties to surpass $2.0 TN by 2004. This enormous Credit expansion inflated price levels throughout the entire economy, with non-financial Credit growth peaking at 2007’s $2.5 TN. Non-financial Credit growth dropped to $1.1 TN in 2009, before bouncing back somewhat in 2010 and 2011. Importantly, however, growth appears to have more recently jumped back to the $1.8 TN range. Such Credit growth implies that an inflationary bias is quietly regaining a foothold in the U.S. economy.
“Risk on” has seen 10-year Treasury yields jump 40 bps off July 24 lows to 1.81%. The way things are unfolding, the placid Treasury market might turn into rather treacherous waters. I expect Draghi’s Plan to be yet another European disappointment. “Risk off” waits patiently. But it’s also apparent that over-liquefied U.S. securities markets have turned highly speculative. An enduring “risk on” backdrop could easily see things get out of hand. Amazingly, as the signs of excess become increasingly apparent, the Fed apparently remains ready with additional monetary stimulus. It’s going to be an interesting fall.