Thursday, November 25, 2010

Economic Condition Review, 3Q 2010

So far, the consumer is missing-in-action in the US economy, placing all the pressure on both commercial and government balance sheets. Commercial balance sheets are doing everything possible to restore financial health, including cutting expenses, mainly by laying off workers and paying off debt. Banks, the primary source of credit for consumers and commercial borrowers, are lending only to prime customers, letting growth of credit remain below trend. Most businesses do not have pricing power, so prices are holding the line. Exceptions are businesses with pricing power such as health care, food and energy. Interesting to include that food inflation is widely recognized in China too. Online newspaper Caixin reports that: A rise in food prices, driven by too much bank credit, quantitative easing measures in the United States, speculation in commodities and natural disasters, was mainly responsible for the worse-than-expected inflation, according to the National Bureau of Statistics.

The government is using it's balance sheet (Federal Reserve as proxy) with the QE2 strategy, with the goals of increasing inflation in assets and stimulating job recovery, by creating new money with serial quantitative easing. John Hussman describes, in his Nov 15, 2010 letter, the financial recovery seen in 2010 as "an "economic recovery" that requires a tripling in the Fed's balance sheet, continues to average 450,000 new unemployment claims weekly, and relies on fiscal stimulus to counter utterly stagnant personal income, is ipso facto (by the fact itself) not a "standard" economic recovery. We have swept an enormous volume of bad debt under rugs, behind dams, and in back of curtains (not to mention in off-balance sheet vehicles such as Maiden Lane that were created by the Federal Reserve). But it is all effectively still there, festering. Meanwhile, our policy makers are trying to reignite financial bubbles in order to create an illusory "wealth effect" to propagate spending patterns that were inappropriate in the first place." These are conditions that are almost identical to a year ago, not overlooking isolated and significant price inflation over the year.

Axel Merk adds this observation about the lack of control facing the Fed's reflation attempt. "However, such efforts will likely require a lot more money than policy makers anticipate. It appears Bernanke has already come to this realization – purchasing $1.3 trillion in mortgage-backed securities (MBS) didn’t have the desired effect, hence QE2. The real Achilles heel for policy makers is a lack of control over where the money printed actually flows. Both fiscal and monetary stimuli may not flow to where the money is needed, but to where the greatest monetary sensitivity is. Intuitively, commodities, precious metals and currencies with a high correlation to commodities, such as the Australian or Canadian dollar may benefit the most."

Economic Observations:

Net seasonally adjusted money supply has increased. This is usually good for equity markets indicating a pool of cash that could be used for investment. Currently, it might not be so supportive of equities because it might be more of an indication of consumer savings increasing. I'll look at that further on. The graph below is the current ten year chart for M2. M2 includes M1, plus time deposits, savings accounts and non-institutional money market deposits. Money supply is cash both for business and consumers to use, as well as money for banks to lend. If business and consumers prefer to borrow, like in the past twenty years, money supply growth would probably tend to be slow so that disposable income can support growth of debt service requirements. That appears to only be happening recently.

Click on graph for a larger image.

In synche with lower growth of money supply, the total of outstanding credit is contracting too, as indicated on the following graph. It might be that money supply is being tapped to reduce loan balances, including charge-offs at financial institutions. Creating credit is the fundamental bank service, and it is shrinking.

Click on graph for a larger image.

There is something else importantly wrong illustrated with the following graph, showing total non-performing loans as a percentage of total loans. Because problem loans are steadily increasing, banks must set aside capital for future losses and that won't help lending grow. This is an alarming trend for lenders. They would be much more comfortable with the level remaining below 2.0%, which still is historically elevated. Instead we see the 'declared' problem exceeds 5% of all loans! What's happening almost weekly since 2008 is that the FDIC is closing banks with high problem loan ratio's and it is assuming the problem loans. That will keep the percentage from growing more on the graph below.

Click on graph for a larger image.

Next, here is the current level of the federal budget deficit, a reflection of all of the financial commitments we have made. This is a concern because it impacts the value of the dollar, interest rates and covertly, the amount of daily political freedom we stand to lose to our government. The declining trend is illustrating a growing deficit, take a look. The chart is updated to 9/30/2010.

 Click on graph for a larger image.

At almost $1.4 trillion dollars, compare the budget deficit to the total annual measured output of our economy, GDP. GDP is the monetary value of all the finished goods and services produced in the U.S.. In other words, how much revenue do we have for all of the financial commitments we have. Looks as though the growth of revenue is struggling to maintain. To me, this is currently a no growth picture. Personal consumption spending makes up slightly less than 70% of the GDP number, seen below. The national debt service is now more than 10% of our annual GDP.

Click on graph for a larger image.

With our financial system technically collapsing and the structural debt problem there must signs of a storm on the horizon. The bond market is good barometer of financial conditions. Now consider the spread between the five year US Treasury Note and the five year Inflation Protected Note. This yield spread is a way to spot bond market concern. If bond investors like the inflation protected feature more, we should see the spread widen, since the five year note is generally less popular than the 10 Yr Bond and requires a lower price, higher yield. A typical five year spread has been 2.20%. The current five year note is yielding 1.57% and the inflation protected note is yielding -0.18%. The spread is currently1.75%. This indicates to me investors are less concerned about inflation in the future at this moment. The yield is also saying there is not very much concern about the dividend paying capacity (credit worthiness) of the issuer, the US Treasury. Yields are low and have been falling.

 Click on graph for a larger image.

Obviously, yields can continue falling. For example, look at the yields in Yen bonds, from Bloomberg, for a wider perspective. The 5 year yield is currently at 0.41%. That is 1.16% below the US 5 year note! Yields probably can go lower in the US.

Here is a look at corporate bond yields and the spread between Aaa and Baa bonds.

Next, with yields low and potentially going lower, are US savers saving? If they are, it would be an indication of less consumer income available for personal consumption expenditures. That matters because the consumer is the machine that runs US GDP. The thirty year chart below indicates that personal savings is rebounding to 5.7% as of September 2010. This is good for the economic health of the nation but not good for the stock market. The stock market relies on growth of revenues produced from the consumption of goods and services. An increasing savings rate is a sign of the "slowdown". It might get real slow as more consumers catch on to the seriousness of the crisis we are in, the lack of any real solution or political will to call for austerity here, the risk of full blown deflation is on the horizon.

Oil is an embedded cost in GDP. It influences the cost of goods produced and transportation costs of everything. Not quite as obvious, as the price of oil changes, so does the contribution to reducing the federal deficit. Higher oil costs reduce the the amount of GDP we can apply against the deficit, as well as everything else. The 11/22/2010 price for West Texas Intermediate (WTI) crude oil on the spot market was $81.24.

Finally, look at the slowest indicator of economic change, unemployment. The blogger, Calculated Risk, has done a thorough job of covering the relationship between the level of unemployment and when we'll enjoy a sustainable recovery in the housing market. It is his premise that "real house prices decline until the unemployment rate peaks - and maybe even decline slightly for a few more years". The following chart illustrates the year over year percent change in civilian employment.

Nobody describes the condition of our economy in a more pragmatic manner than Michael Shedlock (Mish). He pulls no punches and is not trying to disguise reality. Here is a link to his article titled Following the Path of Japan and the Madness of Bernanke Fighting Just That. Mish describes the US economic reality this way. "Somehow, some way, if you listen to Treasury Secretary Geithner and economist Paul Krugman, all of these problems are supposed to go away if only China would float the Yuan.

Well none of this will go away as long as the US looks for scapegoats instead of admitting reality. That reality is we are on the road to bankruptcy and neither Keynesian nor Monetarist stimulus will help.

Our problems are structural in nature and everyone needs to admit there will be no quick solutions and we cannot spend our way out of this mess. The only thing that can put the US back on track is fiscal prudence and sound monetary policy. Unfortunately, no one wants to hear the truth.

For now, Bernanke's efforts have caused rising commodity prices, which is hurting small businesses that cannot pass on those price increases because consumers are tapped out. The net effect of the policies of this Fed and this administration is small businesses are getting crucified in a price squeeze."

With that stated, here is a look at the S&P 500 Index, right scale, as well as the US$ Index, left scale, in the black price line. Indicators in the upper clip are the 20 day moving average for the S&P, and two horizontal lines. At 1200 on the right side scale this line is illustrating current resistance. The second line at 79 on the left side scale is illustrating former resistance for the dollar index. Is it going to reassert its force? In the lower clips, RSI is illustrating a recent lack of momentum with what may become sequential crossovers, or not. The low clip is MACD illustrating a weakening of advancing momentum.

In conclusion, I want to allocate strategically for a stagflationary economy. Stagflation because that is what we get from underlying deflation and a government bound and determined to reflate the economy. Neither one is going to back down. Deflation wins because it is the embedded or natural condition in our economy. My asset allocation is to be long equities (20%) involved in commodities and metals (gold mining, oil and natural gas, alt energy) for their high beta and long-term appeal, offset with an inverse equity position of equal percentage (20%) to counter the high beta in the long positions, and the balance of the portfolio allocated between high quality, short duration corporate bonds (25%), intermediate duration high quality corporate bonds (15%), foreign government bonds (15%) owned in local currencies, and gold bullion or coins (5%). Individual allocations will vary, based on the risk profile of the investor. Scanner