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August 01, 2007

Going With The Flow?

Going With The Flow?...You probably saw that the 2Q GDP report came in relatively strong, as was absolutely no surprise at all. Inventories were rebuilt relative to the contraction in 1Q, which is academically additive to the GDP calculation. Government spending was also quite strong, especially defense spending. No surprise at all. Non-residential real estate construction also added to the strength in the headline number. But what stood out quite strongly is that personal consumption expenditures slowed dramatically, up a whopping 1.3% on an annualized basis. For those who have read our work over the years, you know that one of our primary macro themes is that the US economy is not running on a traditional business cycle, but rather on a credit cycle. These days that thought can in a sense be extended to the global economy in that the growth rate in monetary aggregates among the major industrialized countries across the planet has been running double digits.

If indeed we are anywhere near correct in this thematic view of life, data in the 1Q Fed Flow of Funds statement demands attention and monitoring as we move forward. Getting right to the point, the issue that stood out to us like a sore thumb in reviewing this material was what sure as heck appears to be change at the margin in terms of the character of household leverage. Who knows, maybe we're making a big deal out of nothing, but what we are seeing are the very first signs of change in the direction of household leverage acceleration that until now has been consistent and intact for many years, if not decades in a good number of cases.

A while back now, we penned a discussion questioning just what the baby boom generation was going to do for money/liquidity as they entered retirement years. Our observation at the time in reviewing household balance sheets was that households held plenty of real estate and qualified plan assets (profit sharing, IRA, 401(k)), but very little in the way of cash. We questioned for how much longer would households, and especially the baby boomers, be able to continue leveraging up as retirement years for the boomers were fast approaching. And lastly, we pointed to the fact that throughout a good portion of their adult lives, the boomers had learned to embrace asset inflation for their "savings" activity, evidenced by appreciation in stocks and real estate, and the lack of traditional savings as would be calculated by the savings rate.

So let's start with a very brief review of household asset inflation circumstances as perhaps being the genesis responsible for this change at the margin that we are seeing in recent quarterly numbers. As always, the charts tell a big story, so we'll try our best to keep the commentary short. First, the big overview of asset inflation. What we've done in the chart below is to calculate the percentage of real estate and equity price appreciation responsible for household net worth growth by decade over the last half century plus. As you can see, increasingly gains in real estate and stock prices have accounted for ever greater amounts of total household net worth growth since the 1970's. And importantly we need to remember that the baby boomers as a group really began to come of age in the late 1970's/early 1980's. In essence, what they've known in their adult life and have thoroughly enjoyed is household asset class inflation. Of course as a group they drove this very phenomenon in purchasing ever more residential real estate and common stocks (in IRA's, etc.). You get the picture.

But within the current decade itself, and especially over the last few years, this is starting to diminish directly due to residential real estate softening. Of course, directly from Hank Paulson's mouth in the Fortune article we cited to you earlier this year, he hopes "stock price appreciation has more than made up for the decline in residential real estate values". (We continue to suggest you not forget his exact words as we move forward.) Nonetheless, in 1Q of this year, increases in household real estate values and equity holdings accounted for the smallest amount of total household net worth expansion in eight years at least.

So the big question now becomes, how is this impacting household financial management choices? Let's get right to what we believe are the early anecdotes of what may ultimately become very important change. Change that if it becomes a trend will most definitely influence domestic economic outcomes ahead. Very simplistically, let's start with the character of household debt. The following chart could not be more basic in character. It's the year over year change in household debt outstanding. What we've done is mark the periods in red of official US recessionary occurrences.

The conceptual message seems pretty darn clear. When the rate of change in household debt growth decelerates meaningfully, the US has experienced recession. You don't need us to tell you that this makes all the sense in the world. We're a consumption based domestic economy that has been heavily debt financed. When the rate of change in debt slows, so does the economy. Simple enough? And what we see in the current period is a very sharp slowdown in household debt growth as of now. In our minds, this demands monitoring as we move forward.

Certainly the key area where household leverage growth has slowed is in mortgage debt assumption. For now, the following chart is showing us a relationship we've historically seen turn down maybe once a decade. It's household mortgage debt as a percentage of GDP. Now of course the ever growing financing of residential real estate is a phenomenon we've seen play out over sixty years at least. But you can see the long-term growth channel we've drawn in that has clearly been meaningfully breached to the upside this decade. As of now, we're still far above that long-term channel and just beginning to correct downwards. Is this the beginning of a meaningful change in trend? For now it's too early to call, but this is indeed change after almost a straight up decade of acceleration. Looking ahead, we'd suggest it's far from a stretch of the imagination to believe this trend could revisit the long term up channel. Personally, it's what we expect. And if so, total household leverage growth is set to decelerate meaningfully ahead. A key secular question at this point has to be, as the boomers push ever closer toward and into retirement years, just how much more debt will they be willing (or able) to shoulder?

Okay, here's where we believe the charts and trends start to get interesting and force us to wake up and take notice of potentially very meaningful change at the margin just beginning to develop. The following are all simply updates of charts we've used in the past, but the current period change will be self-evident. The first in this series is the very simple relationship between household cash and household liabilities. You may remember that our definition of household cash is as broad as can be. We include all household "banking products", per se, but also include all household holdings of bonds, inclusive of Treasuries, Agencies, corporates, muni's and mortgage backed paper. Implicitly, we are assuming bond holdings could be converted to cash at a moments notice. So what follows is simply total household cash less total household liabilities over the last six decades.

For now the change is minor in the current period in that this measure has stopped expanding ever further into negative territory, but what we believe is important is that this is the first trend break we've seen after sixteen years of literally consistent deterioration in this relationship. Again, for now the trend change is minor, but we need to watch in the periods ahead for corroboration of potential long-term trend change. And why is this important? A change in trend as we are now seeing suggests one of two things, or both - households are borrowing less and/or saving more. And if indeed that's the case, we have to believe there is less household liquidity then available for consumption moving forward.

A corollary to what you see above are these same numbers presented in a ratio format. Again, keeping it very simple, below we are looking at household cash (liquidity) as a percentage of liabilities. As you can see, this ratio has been in consistent and continual decline since 1989...until the current period. Prior periods of upward reconciliation in this ratio has been seen in or around official US recessions - 1970, 1974, early 1980's.

Like the chart of nominal dollar cash less liabilities, the uptick in the chart above as we are seeing tells us households are either saving more and/or paying down debt.

Next in the hit parade is this same household liability number now set against disposable personal income. In one sense, it's a measure of how much debt households have been able to support relative to their income at any point in time. And quite understandably, as interest rates in general have fallen since the early 1980's, households have been able to support ever larger total debt relative to their ongoing and growing income streams.

As you can see, we've marked in the chart with red dots each occurrence whereby this ratio contracted over the last sixty years. As we've noted, every single time in the last six decades where this ratio has declined, we've seen an official US recession. Again, this speaks volumes about a debt financed consumer based economy. Of course in the current period we are once again faced with a contracting ratio. For now, it's a one period occurrence. Too early to sound the alarm bells. But history is telling us to sit up and take notice.

Even we'll be the first to admit that the next chart here is a bit graphically dramatic, but again very simple in terms of design. What this chart documents for each period is the relationship between growth in household liabilities and growth in disposable personal income. Without sounding outlandish, this ratio has simply collapsed over the last few quarters after reaching what were unprecedented heights. As with prior charts, we've marked with red dots the periods where we've experienced official US recessions. Each one of these recessionary periods is characterized as having happened with a decline in this ratio. Of course absolutely nothing over the last half century even comes close to what has occurred over the last five+ years in terms of the magnitude of expansion and contraction.

As we promised, trying to keep it short, there you have it. Although we believe each individual chart tells its own story, our main point in this discussion is that collectively, these relationships represent multi-year or multi-decade trend breaks for now. They are now occurring in simultaneous fashion. Just a coincidence? We think not. Moreover, we suggest an important need for continual monitoring as these trends quite similarly hug trends in powerful demographic changes. Could it really be that as the boomers push near and into retirement, what has been their dramatic impact on asset inflation through continual expansion in household leverage is changing? We believe this is indeed the primary question and message to continue to monitor in these relationships. As we've suggested many a time, the credit cycle is the key. And this is a slice of the broader credit cycle as it applies to households. Households key to longer-term consumption trends important to both the US domestic and many a foreign exporting economy. You know we'll be checking back in on a quarterly basis to monitor whether these initial trend changes remain intact, or are simply blips on the ever-growing leverage expansion screen.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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