The Press Meets The Wrench

Sometimes, two sentences are enough.

The NY Times today has an excellent article that starts: "Ben Bernanke, meet Gary Crittenden. While you're easing credit, he is tightening it." In two brief sentences the writer (Floyd Norris) speaks volumes: Gary Crittenden is Citigroup's CFO, who just told analysts the largest bank in the US is reducing consumer lending and raising interest rates. Asked whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.” Mortgage lending is also being cut.

That's what a credit crunch looks like, in the ground: lenders working to repair damaged balance sheets end up throwing monkey wrenches into the Fed's "printing press". And that's also how economies slide to the bottom of a liquidity trap, staring in frustration at a useless ZIRP .

These developments are not unique to Citi, caused as they are by well-publicized write-offs and "beggars-can't-be-choosers" entreaties for Asian moneybags. The entire US banking industry is tightening, as the following charts show (click to enlarge). They come from the Fed's October 2007 senior loan officer opinion survey. The January 2008 survey will be released in February and will likely show further credit tightening.

• Residential mortgage standards tightened sharply, particularly for prime mortgages.
  

Net Percentage Tightening Standards for Residential Mortgages

• Commercial real estate lending terms tightened even more (also look at Markit's CMBX indices).
  

Net Percentage Tightening Standards for Commercial RE Loans

• Credit cards were not impacted as much, back in October, but matters are changing fast now. With Citi tightening, other lenders won't be far behind. Notice that "other" consumer loans were already tightening.
  

Net Percentage Tightening Standards for Consumer Loans

• Spreads over banks' own cost of funds are rising sharply.
  

Net Percentage Increasing Spreads of Loan Rates

Money, in other words, is getting dearer and more difficult to get. Printing press, meet the mon(k)ey wrench...

Oh, and China just raised bank reserve requirements again, by 0.50% to 15%. That's the highest in at least 20 years. Hank Paulson, meet your lenders. They just got tighter, too.

Stocks, Bonds, LBO's and PPT's

Why was the stock market -until recently- so apathetic to the various negative signals coming out of the economy and credit markets? Many point fingers to the so-called Plunge Protection Team (PPT), which has supposedly moved from rare interventions during crisis events to full-blown daily manipulation.

It is a matter of definition as to what or who exactly is the PPT but, as I have said before, the market is now easier than ever to "steer", strictly from a means and methods standpoint. These are the reasons:

1. Individual investors and speculators have mostly departed the scene, leaving the game to the professionals (pls. refer to post from May 18, 2007). This is important because it is impossible to consistently predict and control the actions of millions of individuals holding thousands of different shares. The best example is what happened during the 2000-01 day-trader craze.
2. The market has become derivativized to an unprecedented extent. On any given day the top most active issues are the various trackers (QQQ, Russell, super-shorts, etc.). This is a market where the derivative tail wags the cash-market dog, at least for the index-heavy issues.
3. The emergence of highly capitalized hedge, private and sovereign funds has concentrated the market into the hands of fewer players, in combination with the few global prime brokers, who also actively trade for their own account.
   

It follows that the market's facade (i.e. the popular indices) has become theoretically easier to manipulate on a daily basis. Nevertheless, effective manipulation requires more than the ability and the means to do so; there must also exist an underlying current, a fundamental backstop upon which daily operations can be based. In other words, there must be ultimate buyers or sellers of cash stocks, depending on what kind of manipulation is being undertaken (bullish or bearish).

Since we are currently talking - theoretically, always - about bullish manipulation by the "PPT", we must look for ultimate buyers.

In this regard, one of the most revealing charts I have seen in months is the net amount of equity withdrawn from US markets through buy-backs, buy-outs and LBO's (black bars, chart below - click to enlarge). The amount reached a record $210 billion in the 3Q2007, from near zero in early 2004.

Chart: FRB

The US has never before experienced such a sustained equity withdrawal in the history of its public markets. In just four years between 2004-07 total net equity withdrawn came to over $1.6 trillion, an enormous sum when compared to US market capitalization (end-2003: $14.3 trillion, end-2007: $19.9 trillion). The effect was to provide a constantly growing underlying "bid" for cash shares, one that leveraged the performance of indices: while total capitalization rose only 39% in the above period, the S&P 500 index gained 67%, i.e. 70% faster. (Does this make it a Potemkin village market?)

Where did the money for the buy-backs and LBO's come from? Some came from corporate earnings, which reached a record ratio of GDP; but most of it came from debt. Record low credit spreads and volatilities encouraged CFOs and private equity funds to buy shares with borrowed money. Investment bankers, always fee-hungry, piped in with their advice: "There is too little debt and too much equity on corporate balance sheets". (The same bankers are today eating their words as they go hat-in-hand to raise emergency capital for themselves, but that's a story for another day.)

The chart below shows net issuance of bonds (i.e. new debt) by US corporations. The total amount during 2004-07 came to $3.2 trillion, another record. Given the furious M&A and LBO activity in 2005-07, obviously a big chunk of that money went to finance share purchases.

Chart: FRB

To sum it up: the market was riding a sea of buy-backs, M&A's and LBO's that were financed by cheap and easy credit. The "PPT" helped things along, taking advantage of the means, methods and conditions mentioned above, to support their own books. By my definition, therefore, the "real" PPT is a loose association of major market players that trade their own book taking advantage of dominant position and back-stopped with customer orders from LBO's, etc. It's the oldest game in Appletown: taking advantage of customer flows, with some new bells and whistles added.

As to the future: the credit crunch slashes LBO and M&A activity, while lower corporate profits reduce share buy-backs. The sovereign wealth funds will be more prominent, but they don't have the same equity and risk appetite as the other players. In addition, they are subject to significant internal political and power-play pressures. If their investments show mark-to-market losses, their managers will quickly go into CYA (cover your ass) mode. Add all these together and the conclusion is that customer flow is ebbing quickly.

The consequences for ongoing "PPT" operations are, in my view, quite obvious.

The "Virtual Reality" Recovery - And Beyond

We are told that lost manufacturing jobs are made up in the service sector. OK then, let's look at how many service jobs were created during the last expansion versus the past. Surprise, surprise: such job creation peaked at the lowest level since at least 1940, when BLS started keeping data (chart below, click to enlarge).

Service-Providing Jobs - 12 month percent change (BLS)

The service job situation is not isolated, but part of an overall decline in job-creation trends. Total non-farm job creation has been weak in the last expansion, too - again, the lowest peak since 1940 (chart below).

Total Non-Farm Jobs - 12 month percent change (BLS)

The recovery following the 1990-91 recession was called the "jobless recovery" because of the low rate at which it created new jobs (peaked at +3.5% y-o-y) . What, then, should we call the recovery from the 2001-02 recession, which created jobs at a peak rate of only +2.1% (currently at +1.0%) ? And this was only made possible through the rapid expansion of household debt vs. income and the pumping of asset bubbles.

I think, therefore, that for the US the 2003-07 period should be called the "virtual reality recovery". Unfortunately, the looming recession is already shaping up to be very real.

The US is not alone in this condition: several European countries followed the same path, made possible by record-low Euro interest rates. ECB slashed rates as low as 2% in 2003 and a building boom created jobs and consumer demand that kept Europe growing, albeit very slowly. Club Med and the UK are particularly pointed examples, but so are some of the newer EU members and peripheral economies (e.g. Turkey). Households there borrowed heavily in foreign exchange (e.g. euro, yen and swiss francs) to "take advantage" of low interest rates vs. their own currencies.

In the US, the Fed is bending over backwards to accommodate Bush fils by sharply cutting rates, even in the face of rising inflation (Nov.2007 was 4.3% annualized). Perhaps Bernanke does not want to be accused of damaging the economy - as Greenspan was by Bush pere for keeping rates too high prior to the 1990-91 recession, which cost George Bush a second term ("It's the economy, stupid"... "I've fallen and I can't get up").

But the ECB is not playing along, seeing that average consumer inflation in the eurozone is at 3.1% vs. 2% target. Indeed, several eurozone countries are already experiencing higher rates: Spain 4.1%, Greece 3.9%, Ireland 3.5%. Many non-eurozone EU countries have much higher inflation (e.g. Latvia 13.7%, Bulgaria 11.4%, Estonia 9.3%, Romania 6.8%), but the key point is that every single EU country (except Holland at 1.8%) is now above the 2% ceiling and even inflation-phobic Germany is at 3.3% (all figures annualized November 2007 rates). Unless inflation somehow drops sharply in the next few months, do not expect the ECB to cut rates significantly.

In Asia, China is raising interest rates and bank reserve ratios quickly, imposing price controls for food and fuel and allowing the yuan to appreciate somewhat faster. With 37% of its GDP made up of exports, a concurrent slowdown in the US and EU won't leave its economy unscathed, despite hopes of decoupling. A slowdown from 11% growth to even as much as 5% won't be a "recession" per se, but I think it will definitely feel like one in China. And if the US-EU slowdowns happen faster and last longer than current projections, the Chinese economy itself will enter a bona-fide recession, as unthinkable as this may seem right now.

In conclusion, I believe the "virtual reality" recovery that sustained the Western economies and boosted Asia into an export boom is coming to an end.

Fifty Cents On The Dollar: The Empire State Building Story

Vulture investors are putting together syndicates to purchase US real estate, crowing that they are getting it for fifty cents on the dollar, focusing particularly in "carrion-infested" states like Florida. And Bank of America is buying the whole of Countrywide Financial at a deep discount after its initial $2 billion investment went very sour, very quickly.

A little history may serve as a warning to overzealous buzzards.

The Empire State Building was completed in record time (one year!) in 1931, costing a total of $41 million ($25 million for the building plus $17 million for the land). Construction costs were half the original estimates because the Great Depression quickly and dramatically cut prices and wages. The owners were John Raskob and a group of wealthy investors from the du Pont, Kaufman and Earl families - hardly unwashed hoi polloi. I imagine they, too, thought they were getting a bargain at fifty cents on the dollar.

Things did not work out as expected. The building could not find tenants and was called the Empty State Building for years; it was eventually sold by the Raskob estate in 1951 for a total of $34 million. Not only did the original investors suffer a loss in absolute terms, but in the meantime inflation had cut the value of the dollar down to 67 cents. In real terms their loss was 45% and they had to wait twenty years to get even that.

But... this time is different - right?




________________________________________

P.S. Yesterday's post created a not-unexpected storm of comments, both pro and con, particularly about the "targeted jobs program". Let me clarify a few points:

1. I'm not calling for the government itself to go out and employ millions of people, but to create the conditions where private industry will do so. Just look at what Germany is doing with mandatory renewable energy legislation.

2. Building a new energy infrastructure is completely different from building a "bridges to nowhere", as happened in Japan. We are actually in dire need of such infrastructure, for economic, environmental and national security reasons.

3. Funding/incentives will necessarily have to come from a variety of sources: carbon taxes, cutting defence spending (less needed to guard oil), a more graduated income tax scale, etc. The amount needed is proportional to the energy balance between fossil fuels and cleaner sources, i.e. the ratio of EROEI's will provide a rough idea of the money needed.

4. Government action is absolutely essential because entrenched fossil fuel interests are not going to do it by themselves. Their combined profits are in the trillions annually.

5. The most serious challenge is not technological choice but geopolitical economic balance. If, as I expect, the new energy regime is distributed vs. central (think Internet vs. mainframe) the thorniest question is how we transit from Dollar Hegemony to Sustainable Growth. The current global socio-economic model is Perma-Growth fueled by oil and gas. The US is center stage because the dollars it issues at will contain oil-purchase value (i.e. oil producers accept them in exchange for oil). The mind boggles at the challenge of changing this structure, but it MUST be done.

For those not quite sure how oil, money, growth and the environment are connected please look at the following books at the Amazon sidebar:

• The Prize
• Resource Wars
• Blood and Oil
• Something New Under The Sun
  

The Bernanke Paradox And How To Overcome It

Following on the heels of the Greenspan Conundrum, we may get a Bernanke Paradox. Rapid cuts of US interest rates may not revive the debt-ridden and asset-dependent US economy, but instead drive it closer to what Mr. Bernanke fears most: the hole of a liquidity trap. Given the nature of the developing recession (deflationary asset and credit contraction), the odds of this happening are increasing.

Central to this line of thought is the observation that the current slowdown is not the common variety, caused by excess inventory accumulation. Rather, it is most similar to the popping of the Japanese bubble: a stubborn contraction preceded and caused by excessive credit expansion and unsustainable asset appreciation.

The term "excessive credit expansion" is best explained by the following chart, showing the annual growth in household debt (red line) and hourly earnings (blue line). Borrowing rose much faster than earned income for too long (1998-2006) and is now imploding because households cannot properly service their existing debt out of current income. It follows that Americans won't jump into more debt and won't rush out to buy new assets until their balance sheets are lighter and debt service can be more comfortably met by earned income - a process that will take many years (The Slow Recession).

Annual Growth Rates for Household Debt and Hourly Earnings

The characteristics of this potential liquidity trap is different from the classical definition (lenders unwilling to lend). This trap may be aggravated by borrowers unwilling or unable to borrow, even if benchmark interest rates near 0%. Thus, the Bernanke Paradox.

I am aware that American consumers (72% of GDP) have historically pulled the economy out of previous slumps and that betting against their propensity to "shop till they drop" has been a losing proposition. But, in my opinion, right now they are "dropped, so they can't shop". It's not for lack of want, but lack of means that the mighty US consumer is pulling back.

Under such a scenario, cutting interest rates in a panicky mode can only exacerbate matters. It officially signals that the Fed and the government expect worse to come for the economy and causes consumers to respond by shutting down spending even faster. Let's not forget that the "wealth effect" caused by the prior real estate run-up is now rapidly becoming a "poverty effect", further depressing their propensity to consume.

In the last few days several economists are finally saying that monetary policy alone won't do the job, a position that I have long held and expressed in this blog. They want fiscal policy to help out but I fear they are looking in the wrong direction, since they focus exclusively on tax cuts. It is quite obvious that Bush's favorites (permanent tax cuts for the rich) won't do a thing, but even cuts and one-time rebates targeted to the poor and middle classes won't achieve more than a temporary boost. And this, assuming most of the money isn't saved instead, a possibility that can't be ignored.

To be effective, economic policy must rapidly raise real earned incomes for the "bottom" 95% of Americans that have not substantially benefited from the 2003-07 expansion and who are feeling unsure of their future. In other words, what we need is a targeted jobs program. This is a difficult proposition that does not lend itself to quick fixes, announced as TV sound-bites by politicians ("$1,000 for every family"). Instead, serious problems demand serious fixes, not one-liners.

My proposal may smack of "state planning" - and you know what? That's exactly what it is. The US needs official policies that will create high value-added jobs in energy and environmental mitigation, to name my two favorite fields that are also the most pressing problems facing our world. Hoping that the invisible hand of the free market will cause solutions to miraculously materialize is tantamount to believing in the tooth fairy.

We need government-sponsored action on a scale several times bigger than the Manhattan or Apollo projects. Expecting private enterprise to undertake them is unrealistic: such projects are simply not profitable enough in the short time horizon that business operates in. Every infrastructure development that radically altered the American economy was undertaken and financed by the government: going as far back as the Erie Canal (1817-1825), the Panama Canal, TVA, the great dams, the interstate highways, ports and airports.. even the Internet was originally a government scheme.

This is the kind and scale of economic - fiscal policy we urgently need. If anyone has a better idea, please let me know because I, for one, do not believe in tooth fairies.

More Kettles and Such

Yesterday I visited the same electrical/electronics store as last October, when I posted the original China Kettle, Dryer and Scale, Inc. piece. This time I did a little more research on small appliances, casually strolling down the aisles...

The same conclusions apply as in the first post, with the added observation that MP3s are in a bubble all of their own. I noticed that the two most expensive models were iPods, whatever that means for competitive conditions in a sector so crucial for Apple.

The price spread from low-to-high in each appliance category is roughly 1-to-10, excluding a few very top-end models that are not really comparable with the rest. Corollary: tapped-out consumers can trade down in their selections as never before; for example, why pay ten times more for the simple task of boiling water? Again, whatever this means for retail sales and profits...

Speaking of appliances, stainless steel demand is dropping, even in Asia. The region's largest steelmaker (by market value) announced lower sales and a 20% drop in profit, blaming less demand from appliance makers and builders. Other steelmakers in Asia are reporting similar trends. Decoupling, where art thou?

A Gross CDS Warning

PIMCO's Bill Gross is easily the most influential fixed income money manager so what he says counts, even when talks his book (as he should). His latest monthly Investment Outlook focuses on the shadow pyramid banking system that has arisen during the last few years and on the effect of potential Credit Default Swaps (CDS) losses, which he calculates at $250 billion net of recoveries. He lays out his case in a clear and straightforward manner that is both easy and enjoyable to read. Highly recommended.

Confirming his view, the current action of the CDX indices for investment grade and junk corporate CDS is very poor: spreads have jumped to 96 and 564 basis points, respectively. These are record highs for the indices and mirror the weakening stock market environment - a correlation that I have constantly emphasized in this blog.

Furthermore, I believe that Mr.Gross's underestimates the potential losses. It does not account for the possibility that thinly capitalized speculative CDS sellers (e.g. hedge funds) may be unable to fulfil their insurance obligations, thus rendering opposing hedges worthless. The troubles at credit insurance monolines (and Mr. Buffet's decision to start his own) make this quite clear.
_______________
P.S. Three totally unrelated stories which I found interesting:

• China is banning plastic shopping bags. There is something to be said about quick action from authoritarian regimes, eh?
• ATT is disconnecting large numbers of residential phone and internet customers (20% of sales) for failure to pay their bills - a direct consequence of the housing and credit bust. The ripples in the pond are widening.
• German retail sales are dropping fast. Real sales in November were down 3.2% from the previous year, excluding autos and fuel. The statistics office expects that for 2007 as a whole real sales dropped 1.5-1.8%. Germany dominates Europe's economy. More ripples.
  

About Decoupling

In the previous post I argued that the BRIC "wings" of the global economy cannot make up for the looming consumer driven recession in the US and possibly Europe. Others argue that China, and perhaps India, will simply substitute domestic consumption for exports and keep chugging along, i.e. decoupling. Is this supported by the data? No.

GDP per capita at purchasing power parity is as follows (2006 data, CIA Factbook).

The figures speak for themselves, but some further elaboration is perhaps needed:

• People in poor countries like China and India spend a greater portion of their income for basic necessities like food and fuel, leaving less for discretionary spending. For example, food in China accounts for 30-35% of the CPI index, indicating that the average family spends an equivalent portion of their income for food. By contrast, expense for food at home is only 8% of US CPI.
  
• A large part of GDP in China and India comes from FDI (i.e. capital spending by foreigners), geared towards creating manufacturing capacity for exports. This ties in to the previous point: most of the value added to export goods does not come from cheap labor, but from foreign capital in the form of new plant and equipment. Simply put, Chinese cannot afford to purchase the value they add to their export goods.

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.