The Phoney Recession

World War II officially started when the Nazis invaded Poland in September 1939, forcing France and Britain to declare war on Germany. French and British troops manned the Maginot Line, Germans faced them from their own Siegfried Line and ... nothing much happened - until the cataclysmic attack on France in May 1940. This intervening period was dubbed the Phoney War.

The unfolding global economic crisis started back in early 2007 with a warning shot from US sub-prime mortgages. Viewed as an isolated event, this first crisis quickly quieted down - only to flare up again in the fall, engulfing the financial sector and sending money markets reeling. Still, the global economy was deemed healthy because BRICs were at full speed, US consumers kept spending and jobs were plentiful. In addition, rate cuts and liquidity injections provided by the Fed and ECB worked to reassure equity markets, soothing otherwise frayed nerves. The majority of economists and market analysts were sceptical, but not unduly alarmed. The truth is, however, that they have been lulled into complacency by a "phoney economy".

In the past two weeks the armies of the Global Recession have finally attacked the main front, the US economy. Holiday shopping was flat, housing and manufacturing weakened further, private employment dropped - Americans are reeling from high debt, rising fuel and food prices, low incomes, negative saving and dropping house prices. The blitzkrieg is in full blast now and the center of the defensive line is rapidly caving. In this election cycle no fiscal policy reinforcements can be expected, either (e.g. tax cuts). The Bush administration is politically bankrupt and may only manage a retreat. Given its past record of incompetency, from the Iraq war to New Orleans, chances are it will botch even this badly.

With the center gone, the wings made up of European and Asian auxiliaries are not going to be able to withstand by themselves the full force of the global recession. Decoupling is an illusion, another myth of the phoney economy that will prove as effective as the static Maginot Line was against Guderian's tanks and the Luftwaffe. The main reason is that at the core of decoupling stands, once again, the US consumer - a force that has now crumbled from within.

Oh, decoupling happened, all right: production moved abroad, but consumption - fuelled by easy vendor credit - stayed home. A simple statistic: minimum wage is $5.85 in the US and 55 cents in China. Even ignoring the fact that more Chinese make minimum wage and save more of it than Americans, it is obvious that China simply cannot consume more than a fraction of what it produces.

Let's look at those "wings" more closely. Europe is as much dependent on artificial growth boosts as the US: Club Med (Spain and Greece) fed on the familiar recipe of zooming household debt and real estate bubbles, newer EU members also borrowed with abandon (in yen and Swiss francs, no less), Russia is a hollowed-out economy entirely reliant on oil and gas and Britain, anchored as it is on the City's financial industry, is already reeling from the American disease. Germany, France and Italy are stalling at 1.6%-1.8% GDP growth; the strong euro is killing their exports. Inflation at 3.1% is far above the ECB's 2% target, and this only because the euro is somewhat cushioning the damage from imported oil and Chinese goods.

In Asia, Japan is similarly dependent on exports for whatever growth it can eke out. Its goods are almost entirely focused on affluent consumers (i.e. the US and Europe) and cannot be marketed to China and India; likewise for South Korea and Taiwan. The second (or third, depending on counting methodology) largest economy in the world is thus a basket case, growth-wise. China is growing on capital spending/investment steroids (around 50% of GDP), mostly because it is building factories and infrastructure to support exports going to America and Europe (readers may remember an older post titled China Kettle, Dryer and Scale, Inc.). The confluence of lower export demand and PBoC's tighter monetary policy are going to reduce growth much faster than people think, in my opinion.

India doesn't really "belong" to the BRIC bloc, except for a small percentage of its otherwise agrarian and backward economy, located in a couple of big cities and tech service enclaves. Australia, Canada, Brazil and the Gulf Arab economies are in a class by themselves. They are essentially pure commodity plays, one or two dominoes further removed from faltering US and EU consumers.

This is not to say that every country is solely dependent on the state of the American and European consumerist economies. But unlike recent decades, when the capitalist and free market system affected directly only a minority of the global population, globalization has today exposed the entire world to the vagaries of the business cycle. Dominoes falling in New York and London are once again affecting Moscow, Shanghai and Mumbai even more than they did during the glory days of laissez faire in the 19th century. Communism and interventionist statism certainly created a lot of dead weight, but it also provided inertia that attenuated the ups and downs of the global cycle.

I fear the phoney recession period is ending and the main attack of the Global Recession is about to commence.

Monster Jobs

I have been following the Monster Employment Index for several months now because it tracks online employment adverts, unlike the more traditional newspaper want-ad index which has been losing importance, with job postings moving increasingly to the Internet. Its latest reading for December 2007 was just released and it shows a very sizeable drop from 183 to to 169, only part of which can be attributed to seasonal factors (the index is not seasonally adjusted). Growth in job postings has been dropping steadily and is now down to 1.2% versus last December.

Add the rising number of claims for initial and continuing unemployment benefits, and the employment picture is darkening fast. With the "shopping-madness that wasn't" holiday period now behind us, I expect significant job reductions in the retail segment as stores adjust to lower growth. Retail jobs at 15.4 million account for 16.4% of all private service jobs, one of the largest groups in the employment universe.

Post Hoc New Year Predictions

Year-end brings to the financial community the obligatory round of New Year predictions. The prophet camp is usually split in two: "play it safe and give'em what they want to hear" types and those that "go for broke" and try to foretell multi-sigma events. Both can be fun to read, if rarely accurate, and they are forgotten faster than cheap bubbly goes flat. Before proceeding with 2008, however, let's first look at some otherwise timeless wisdom and how it could have been applied post hoc (after the fact) during 2007.

Delphic pronouncements like J.P. Morgan's "It will fluctuate" survive the test of time best. Seemingly useless, it should be dusted off occasionally, for example when VIX (volatility) was scraping the low 10's for months on end. I dedicate it to all correlation traders. Another favourite comes from the collective wisdom of the Street: "Don't confuse brains with a bull market"; I dedicate it to the financier who bragged earlier this year of being so successful he could raise tens of billions at the snap of his fingers. For him, and other hombres at Rancho Liquid Leverage, I will throw in a slight modification of my own: "Don't confuse credit with liquidity".

"Caveat emptor" (buyer beware) is thoughtfully offered to buyers of credit insurance, particularly CDS. For further elaboration please apply to Mr. Buffet and his brand-new credit insurance monoline. To sub-prime borrowers and lenders alike, a quote from Hamlet: "Neither a borrower nor a lender be; for loan oft loses both itself and friend".

For the embattled rating agencies, also from Hamlet: "To B, or not to B, that is the question". To the ex-heads of Citi and Merrill, from Benjamin Franklin: "Drive thy business or it will drive thee".

To the financial engineers who dreamt up all sorts of statistically-driven structured finance products like CDOs, CPDOs, CLOs, etc: "There are three kinds of lies: lies, damn lies and statistics", by Benjamin Disraeli. To their clients, from Bob Sarnoff: "Finance is the art of passing money from hand to hand until it finally disappears".

All right, then, how about 2008? As the Italians say, make me a prophet and I will make you rich. I am neither Italian nor Prophet, but this dictum comes from Cicero who is a sort of Italian and his sayings have lasted far longer than any portfolio prophet: "Endless money forms the sinews of war". Obviously, to Mr. Bernanke.

Finally, since this is, after all, a public version of a daily journal, to myself: "It is not advisable to venture unsolicited opinions. You should spare yourself the embarrassing discovery of their exact value to your listener" (Ayn Rand). Come to think of it, given the provenance, it is quite apropos for Mr. Greenspan as well.

A Happy New Year to all, filled with love from your family and friends.

Creative Destruction vs. Interest Rates

On the back of yesterday's post and spirited comments on the change of the recession cycle, some more ideas along the same lines.
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We are all familiar with Joseph Schumpeter's creative destruction principle, about the ups and downs of the economic cycle forcing businesses to adapt and evolve. I think of it as Darwinism for business (see book on the right).

Here's a question, then, that ties monetary policy with creative destruction: Did the massive interest rate cuts of the Greenspan Fed - and those in the works by Bernanke - prevent the creative transformation of the US economy?

During the last recession rates went to near zero, a level not seen since the 1960's. The response should have been a strong flow of investment in new industries (creation) to replace those damaged by the downturn (destruction). This clearly did not happen and low rates produced instead a capital misallocation of historic proportions. Massive debt pumped up a housing bubble, maintained consumer spending and financed portfolio transactions such as LBOs and share buy-backs.

Observing employment patterns, i.e. the number and type of jobs lost and created during the business cycle, provides excellent insight. Manufacturing jobs, in particular, are key because they add high value at many levels. Modern manufacturing is capital, knowledge and skills intensive.

In the chart below (click to enlarge) we observe that every time the Fed dropped rates in response to a recession (blue line), employment in manufacturing rebounded (red line) - except now. During the last cycle the economy shed 3.3 million manufacturing jobs - one in five - but did not get them back when the economy rebounded, despite record-low interest rates. Losing 20% of manufacturing jobs so fast certainly qualifies as "destruction". But what sort of "creation" occurred as the economy came back?

Fed Funds and Manufacturing Jobs Chart: St. Louis Fed

The rebound did create new jobs to replace industrial workers, but of a very different sort than before. Since the end of 2000, the US private sector created a net 4.5 million new jobs but nearly all (4.4 million) are in leisure, hospitality, health care and social services, i.e. low-skill, low value-added jobs located in the periphery of the service economy. And what replaced the 3.3 million factory jobs lost? Mostly construction, financial services and business services. The table below sets out the numbers.

Data: BLS

Even if we assume that these replacement jobs add as much value as manufacturing (a very big if), we see that on a net basis the latest expansion generated nothing but low-pay employment. This point is further corroborated by a study from the Ecomic Policy Institute which shows that despite the recovery real family median incomes are lower now than in 2000. As the NY Times puts it:

A new study by the Economic Policy Institute uses Census data to trace the dismal trajectory. Economic growth during the Clinton administration peaked in 2000, followed by a brief recession. Growth resumed at the end of 2001, the beginning of the Bush-era expansion, but real family income continued to fall through 2004. It has turned up since then, but as of the end of 2006, it was still about $1,000 below its peak in 2000. Even if that difference is made up this year (and it’s still too early to tell if that will happen) Americans would be merely breaking even. That would be a pathetic outcome after six years of strong labor productivity.

For the United States, therefore, the creative destruction process ran in reverse: it destroyed high-value manufacturing and replaced it with specifically low-value services. The loss of earned income implied by this shift should have been unacceptable to society, but as we know living standards were artificially maintained by increasing debt and by the illusory rise of purchasing power from cheap imports. Instead of going through the painful, but ultimately beneficial process of creative destruction, America took the easiest way out.

Data: FRB St. Louis

Simply put, Greenspan threw a monkey wrench into Schumpeter's creative destruction process and now Bernanke is repeating the mistake. What's worse, we have been led to believe that the Fed can keep the economy going indefinitely by mere adjustments of interest rates and injections of liquidity. However, wealth is not created by monetary policy but by constant innovation and judicious investment. We are clearly not investing as we should and innovation will soon depart, following industry abroad. No one has a lock on knowledge, after all.

We can make one more observation linking the cost of money with the creative destruction process. When capital costs are unusually low, businesses can be less choosy about their investments. For example, if a businessman can borrow at 4% he may be happy with starting a hair salon returning 8%. But if rates are at 10% he has to invest in something that adds more value and is potentially more profitable.

The conclusion is that for a developed economy, at least, unusually low cost of capital - debt and equity - ultimately works against the creative destruction process and leads to a loss of competitiveness. Let me put it another way: artificially low interest rates and high share prices over a prolonged period make America complacent and "dumb", particularly if it has to compete with a dynamic bloc like Asia.

The Slow Recession

Post-WWII recessions in the US occurred because of excess inventory accumulation by manufacturers. They came fast and went away pretty fast, too, as plants laid-off and re-hired industrial workers. However, the nature of the business cycle has changed: manufacturing now makes up a much smaller percentage of the economy and employment. Manufacturing jobs in absolute numbers are back to 1949 levels, when the country had half today's population. The process of de-industrialization accelerated sharply after 2000 as China became producer to the world and the US lost an astonishing 3.3 million manufacturing jobs. (see chart below).

Manufacturing Jobs (Chart:BLS)

It is instructive to examine the kinds of jobs lost and created during the full business cycle from 2000 to 2007 (see table below). Almost all net new jobs were in health care, social services, leisure and hospitality, i.e. at the fringes of the service sector. The jobs that replaced manufacturing came in construction, financial and business services.

Data: BLS

The nature of this employment restructuring suggests an increase of economic inertia at the cost of less value-added. I think that such peripheral jobs are slower to be lost during the initial phases of a slowdown, but once gone they will be slow in coming back, too. They don't cost as much to maintain, but they also don't produce as much immediate profit when the cycle turns up.

Therefore, the business cycle may now become more grinding and drawn-out, instead of painful and short. This explains why the current slowdown is like watching paint dry, with limited job losses so far (noting, however, the effects of the controversial BLS birth/death model on job creation since 2003) and mediocre retail sales, ex-fuel and food.

Opera Buffa: From AAA to CCC

The Wall Street Journal has an excellent graphic on how mezzanine CDOs like Norma, originally rated AAA-A when issued in March 2007, went from 100 to nearly worthless within months. When the WSJ page appears click (launch content) and the graphic will start.

For opera lovers, Norma by Vincenzo Bellini is probably the most demanding role for any soprano. It was the signature role of the incomparable Maria Callas who performed it 89 times in a career spanning 300+ appearances.

You can imagine what she would have thought of naming a slapstick CDO after it...opera buffa, perhaps?

P.S. In the opera, Norma almost murders her children and eventually commits suicide by throwing herself on the funeral fire consuming her lover. Hmmm... I think there must be a few opera lovers in the financial engineering field. Perhaps the CDO name was a warning? Notice the dagger...

Maria Callas as Norma (Teatro alla Scala, 1955)

Holiday Sales and The Aftermath

Retail sales muddled through during the holidays, apparently rising at the slowest level in four or five years (3.6%). After inflation, the rise is essentially zero and has come at the expense of profit margins, at least for large department stores where the weakness was pronounced. Shoppers moved their spending downscale towards WalMart and Costco, leaving stores like Macy's scrambling and doing things like staying open round the clock to squeeze every available consumer penny. Not a healthy picture, and one that will likely have repercussions going forward, as exhausted consumers pause to regroup. Let me put it this way: if it took aggressive promotions to achieve decidedly lackluster results at Christmastime, the next couple of quarters look tough, indeed. The saving rate had already dipped into negative territory once again in November, signaling another reason for a pullback after the obligatory gift-giving season.

Poor retail performance is blamed on stretched budgets from a combination of (a) rising costs for fuel and food, (b) vanishing home equity piggy banks and (c) limited wage increases.

Let's examine gasoline first. Looking at price alone provides limited information, because a variety of factors have changed over the years: inflation, incomes, fuel efficiency, number of cars per person. To account for these I produced a chart tracking the number of hours a person needs to work to buy a year's supply of gasoline for the car(s) he owns, currently around 540 gallons per car. Though fuel efficiency has improved significantly from 700 gallons/car in 1967, the number of cars owned per person has grown quite dramatically, going from 0.50 in 1967 to 0.78 currently. All of these factors are combined in the chart below (click to enlarge).

Data: EIA, DOT, FRB St. Louis

For those on minimum wage (currently ~$12.000/yr) driving has has quite clearly become a luxury. But even for average wage earners (currently ~$37.000/yr) real gasoline costs are back to the bad old days of the early 1980s. At current prices of $3.10/gal, they have to work for nearly a month just to pay for gas. No wonder, then, that even middle-class people are scaling down and looking for bargains.

Food expenses haven't become as burdensome, yet. The hour-cost of purchasing one unit of the Consumer Price Index for Food, as published by the Bureau of Labor Statistics, has risen for low-income workers but remained flat for average earners (chart below).

Data: BLS, FRB St. Louis

However, this situation may change quite rapidly if fuel costs remain elevated. Energy is a very important cost factor in food production because of the heavy mechanization and high usage of fertilizer and pesticides in US farming. During the past 12 months crude foodstuff and feed prices are up 20%, a jump that is only gradually now being passed through to consumers, as the crop cycle hits food processors. The chart below shows that there is a potentially large "pent-up" move in retail food prices relative to fuel.

Data: BLS, EIA

"Extracting" home wealth had up to recently boosted spending at the cost of increased monthly financial obligation payments. Such payments are now almost one-fifth of disposable income - a record high despite low interest rates. Of course, home loans don't actually "extract" anything; for this to happen homeowners must sell or refinance at a lower rate and save the monthly difference. According to studies done by the Fed only a minority of homeowners did this - the rest just spent the money.

Financial Obligations Ratio Chart: FRB St. Louis

According to a recent (2007) paper co-authored by Alan Greenspan and published by the Fed, net home equity extraction (i.e. after fees, taxes and points) had been running as high as 10% of disposable income in 2004 and again in 2005 but then declined to 4.5% in the third quarter of 2006 (click chart to enlarge). Given developments in the real estate and mortgage markets since then, it is certain that the extraction has dropped further, perhaps towards 2% of disposable income.

Chart: FRB, Sudden Debt

The difference between 4.5% and 2% translates to $230 billion less per year, or 5% of current annual spending at retail and restaurant establishments.

A Christmas Tale

One Christmas morning Americans woke up to find their swords beaten into ploughshares. The mighty nuclear carriers and submarines had been transformed into power stations, bombers and fighters into windmills and the vast armada of tanks and troop carriers into hydrogen-fueled trucks and buses. The huge Army barracks stood as sparkling universities and the Pentagon shone as a state-of-the-art solar array. The dumps of shells, bullets and grenades had become fertilizer. The menacing silos of intercontinental missiles were gone, replaced with plants producing ethanol from the grasslands of the Plains.

The people were frightened at first. How could they protect themselves from all they dreaded? What stood between their homes and the enemies that menaced their land? A cry went up to quickly convert everything back into weapons and munitions, and many an opportunist asserted they would do it, if only the pay was right. "Security requires sacrifice", they proclaimed. "Why, look at all our wealth! - if we do not protect it, surely it will be plundered by those evil and greedy, waiting just outside our shores. Nay! - they may already be inside, working to weaken and destroy our mighty fighting spirit. To arms, to arms!!"

Yet, even as these ugly words arose, the people looked around carefully and found the land more prosperous than ever; and though they searched diligently, they could not discover foes within or without. Everyone was busy learning how to put the new machines to better use, how to transform their lives to better fit the new era. Foreigners did come, but instead of menacing with arms they proffered goods to trade in exchange, for all this technology was new to them and valuable.

And the people soon realized that the only enemies were those few of their own who called them to fear and battle. So they did what all sensible people do with such ilk: they scorned and laughed at them, and made them perform their ludicrous tirades at every school and theater in town. Oh, how the children giggled! The ridicule was so great that soon no one thought of swords again without guffaws and hoots.

And the land became happy.

Spreads, Credit Fears and Principal Conservation

The following chart tracks the yield of 3-month US Treasury bills; recessions are marked in gray (click to enlarge). With the exception of 1984-86 when inflation came down rapidly due to plunging oil prices, every time T-bill yields dropped significantly the US economy entered a recession, or was already in one. The reason is that investors facing recessions get out of riskier assets such as stocks and corporate bonds and park their cash in T-bills, instead.

Three Month T-Bill Yield Chart:FRB St. Louis

The same thing is happening today, but with an important twist. The current credit crisis is targeting specifically the short end of the yield curve. The failure of the SIV - ABCP and other structured finance markets has increased demand for the safest possible short-term instruments, i.e. T-bills. While 3-month bills are now at 2.85%, bank certificates of deposit (CDs) with the same maturity are at 5.00%, 3-month LIBOR (the rate at which banks lend to one another) at 4.86% and commercial paper issued by financial institutions at 4.90%.

The spread between T-bills and such rates is the main credit fear indicator for money markets. The next chart shows the spread between 3-month bank CDs and T-bills (click to enlarge). It is at 2.15%, the highest in over 20 years.

Data: FRB St. Louis

However, even this big spread understates the magnitude of the current crisis because it is in absolute terms, not relative to current interest rates. It is one thing for spreads to be at 2.15% when market rates are at 10% and very much another when they are at 3%. For proper perspective, the next chart tracks the spread as a percentage of T-bill rates (click to enlarge).

Data: FRB St. Louis

The ratio is now at the highest point in at least 43 years (75%), meaning that investors are so concerned about getting their money back after three months that they are willing to forgo a record 75% more income available through CDs than from T-Bills (2.15%/2.85%). This is not mere credit fear, but full-out principal conservation mode.

Effectively, the money market has ceased functioning normally. Banks rely instead on borrowing unprecedented amounts from central banks and this explains the ECB's decision last week to provide "unlimited" liquidity and the Fed's announcement that it will continue its TAF operations for as long as it takes. The central banks have drawn a line in the sand, betting that they can ultimately win the battle against fear.

This is a very fragile state of affairs. Despite the rhetoric, even central banks do not posses enough resources to fund the entire system and one more wave of major credit-related news could easily wipe out the line.

Yes, Virginia

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The next few days are devoted to the Holidays. May I wish you all the warmest and most joyful of times. Sudden Debt will likely return, as Mae West used to say, "in between the holidays".
But in the meantime...
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The following epistolary communication was recently intercepted by our homemade Echelon system. The first letter was addressed to a Mr. Jack Bonus, Managing Director of Bonus Bonus and Bail, a reputable investment bank. His response follows, beautifully calligraphed upon heavy cream stock and engraved in copperplate with the firm's "BBB" logo.

Dear Mr. Director, I am 26 years old and some of my friends say there is no invisible hand. My boss says, "If you see it in your paycheck, it's so". Please tell me the truth, is there an invisible hand?

Virginia Smith

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Dear Virginia,

Your little friends are wrong. They are affected by what they earn, instead of what they ought to yearn. Skeptics, liberals, socialists, Keynesians and terrorists, all. They want their little selves to be more than mere insects in the great marketplace of ours - to be given by it, instead of giving to it. They do not grasp the ultimate truth contained in such a boundless enterprise: wealth is created by the invisible hand.

Yes, Virginia, there is an invisible hand. It exists as certainly as malls and car dealerships and restaurants do, even if you may rarely afford to visit them. How dreary life would be for the rest of us if such commerce did not exist! It would be as dreary as not having Armani and Hermes and Bentley, no trinkets to make our lives more tolerable. We should have no enjoyment except for polyester and frozen fries, then! And imagine what yours and your friends' lives would be like if you could not dream of such gifts, too. How could you tolerate meatloaf and plonk if you could not peek through our windows to see us quaffing Cristal and munching venison? Why, the very thought would extinguish the light that fires your eternal hopes.

Not believe in the invisible hand! You might as well not believe in the stock market. You may lose your entire pension in some misbegotten investment made in your name by a fund manager in Florida, but what would that prove? Nobody sees the invisible hand, but that does not mean it does not exist. The most tangible things available to us are created by it, but did you ever see capital gains dancing in the Street? Of course not, because they dance in our accounts, unseen and unseeable by you and yours.

You try to take away a bone from a mongrel and see what today's economy is like for most, but there is a veil covering the workings of the invisible hand that not the strongest analyst could tear apart. Only greed of a higher order than known to most permits entrance past the veil, to grasp that which the hand has wrought.

No invisible hand! Thank Mammon! it lives and lives forever. A thousand points from now, Virginia, nay 10 times 10.000 points from now, it will continue to bulge the purse of those that steer it.

Very truly yours,

Jack Bonus
Managing Director and Head
Secret Handshake Dept.