Raise the Economy's Speed Limit?
Storm clouds are turning ominously dark as global markets become more unsettled by the week. With fears mounting of a global energy crisis, crude prices surged to 10-year highs and natural gas to record highs. Currency markets were increasingly dislocated from underlying fundamentals, with the Euro and Australian dollar sinking to record lows, the British pound to a 14-year low, and "emerging" currencies from Asia to Latin America coming under selling pressure. And as the week came to an end, unusual trading hit the credit market, while heavy selling took a toll on the U.S. stock market. For the week, the Dow dropped almost 3% and the S&P500 declined 2%. The Morgan Stanley Consumer index declined 1%, the Transports 2%, and the Morgan Stanley Cyclical index 3%. The Utilities were the exception, adding 2%. Many stocks ignored the turbulence, as the small cap Russell 2000 and the S&P Mid-cap indices declined less than 1%. The technology sector came under heavy selling pressure, with the NASDAQ100 and Morgan Stanley Technology indices dropping 3.5%. The semiconductors were hit for 6%, while the NASDAQ Telecommunications index dropped 4%. The Internet and Biotech stocks held up well, with The Street.com Internet index and the AMEX Biotech index both declining less than 1%. Even the highflying financial stocks came under selling pressure late in the week, with the S&P Bank and AMEX Security Broker/Dealer indices declining 2%. The gold stocks had a disappointing week, dropping 6%.
It was a very unusual week in the credit market, especially the past two days. The long-bond saw its yield surge 16 basis points in two sessions and 19 basis points for the week. Two and five-year Treasury yields actually declined 2 to 3 basis points for the week, as the inversion between 5 and 30-year Treasury yields narrowed 22 basis points this week. In another noteworthy development, some key spreads narrowed dramatically. The 10-year dollar swap spread dropped 9 to 119. Mortgage spreads declined 13 basis points and agency spreads narrowed 9 basis points. Since we don't believe that the financial markets abruptly perceived less risk for the U.S. credit system, it is likely that these extraordinary moves were more a sign of an escalating market disturbance - players caught on the wrong side of losing trades. And considering that such dramatic price moves came concomitant with increasingly dislocated trading in the energy and currency markets, this supports our view of heightened financial market instability generally.
Broad money supply rose $12 billion last week, with both demand deposits and institutional money funds expanding $8 billion. Interestingly, bank credit jumped $29 billion, with holdings of non-Treasury securities increasing $15 billion. During the past four months, banks' holdings of non-Treasury securities have jumped $43 billion, an annualized rate of 27%. Also last week, bank "loans and leases" increased $16 billion, with "other" assets surging $28 billion. Interesting…
Today's headline, "US Nonfinancial Debt Grew at 5.6% Rate In 2nd Quarter," sure doesn't do another quarter of egregious credit excess justice. The latest data, in fact, once again makes for interesting reading. Total credit (non-financial and financial) growth expanded at an annual rate of $1.84 trillion, compared to $1.57 trillion during the first quarter. Corporate debt increased to an annual rate of $615.5 billion, or 13.9%, the strongest pace since the first quarter of 1999. Consumer debt increased at a rate of 9%, down slightly from the first quarter's 10%. Total mortgage debt expanded at an annual rate of $687 billion, or 11%, a new quarterly record. Total mortgage debt has increased an astonishing $1.5 trillion during the past 10 quarters, or 28%. The domestic financial sector increased borrowings at an annualized rate of $843 billion, or 10.9%, compared to a rate of $618 billion, or 8.1%, during the first quarter. The GSEs increased assets by $55 billion during the quarter, or at a rate of 13%, a significant increase from the first-quarter's 7%. Total GSE financial assets have increased $707 billion, or 64%, during the past 10 quarters. Finance companies continue to lend aggressively as assets increased at a 14% rate ($36 billion). "Funding Corps" expanded holdings of financial assets by $44 billion, a rate of 18%.
Remembering back to the first quarter, the securities firms had a record expansion as they increased holdings of financial assets by almost $150 billion. The credit baton, however, was handed off to the banking sector during the second quarter. For the quarter, banks' holdings of financial assets increased by a record $180 billion, a 12% annualized rate (compared to $55 billion during the first quarter and $66 billion during 1999's second quarter). Foreign banks increased holdings by $37 billion, or at a rate of 21%. To finance this significant increase in assets, U.S. banks increased "due from foreign affiliates" by $55 billion. "Fed funds and security repurchase agreements" jumped $50 billion. This is not the way we would suggest to financing ballooning bank credit. Total deposits increased $39 billion.
There is every indication that the great U.S. credit machine continues to fire on all cylinders so far this quarter. Broad money supply (M3) has expanded by $146 billion during the past 10 weeks, an annualized rate of 11%. Over the same period, bank credit has increased at a rate of 12%, with "loan and leases" growing at 13% annualized. August numbers are now in for Fannie Mae. For the month, Fannie expanded its mortgage portfolio at an annualized rate of 15%. After increasing its portfolio by $14.6 billion, or a rate of 8%, during the first four months of the year, Fannie has since expanded its mortgage holdings by $28 billion, or a rate of 16%, during the past four months. Fannie issued $20 billion of mortgage-backs during August, its strongest production in 12-months. One must also assume that the Wall Street's favorite consumer lenders continue to lend aggressively.
So, with credit excess running wild, we have a difficult time taking all the talk of a slowing economy very seriously. Either the economy is not slowing significantly, or inflation is increasing. There remains considerable evidence that key sectors of the economy continue to run red-hot. Yesterday, the Mortgage Bankers Association reported a 7% increase in its weekly mortgage application index, the strongest reading since July of last year. Mortgage purchase applications have increased strongly during the past three weeks, and are running about 16% above year ago levels. Applications to refinance surged 12% for the week, and are now at the strongest volume since early November. Applications to refinance have increased 40% since the trough in late June.
With mortgage lending running at a record pace, today's headline from the Minneapolis Star-Tribune should not be too surprising. "Strong demand for homes has brought Twin Cities-area realtors their first billion-dollar month. The value of sales closed in August reached $1.03 billion - 18% more than the $876 million of August 1999. There were more positive signs in August: Closed sales were up 5% and pending sales up 2.4% from August 1999…" The median prices of closed sales increased 11.4% versus a year ago. Volumes increasing about 5% and prices rising 11.4% don't appear cause for much concern. Yet, this equates to the 18% total transaction dollar volume increase. Further, it is total transaction volume that is most closely associated with new mortgage credit; credit that continues to fuel a consumer-spending binge in the "Twin Cities" and in communities throughout the country.
And while analysts were quick to play up the "weak" August retail sales report, it is worth noting that sales did post a 7% year-over-year increase. Moreover, sales were 19% above those from August of 1998. With sales to auto dealers increasing 3.3%, August durable goods sales ran just 4.5% above last year. This calculation, however, is deceptive, as it was a particularly difficult comparison. Last August's auto sales were the strongest in 13 years. Even compared to a very strong August of 1999 (retail sales 10% above August 1998!), sales of nondurable goods looked quite robust last month, running almost 9% above year-ago levels. By category, department store sales increased 8%, food stores 6.5%, and clothing stores 2.8%. Perhaps too much attention has been paid to unimpressive clothing sales, without appreciating that consumers may be bypassing clothing for electronics and other purchases. This week Best Buy reported revenues 18% ahead of last year.
The point is not to debate whether U.S. economic growth is slowing. It very well could be. However, the critical analysis is to recognize that demand remains exceptionally strong and, in fact, excessive for a sound financial and economic system. It is like a car traveling down the road reaching its maximum speed of 100 miles per hour. The good news is the automobile is no longer accelerating. More importantly, however, is appreciating that the car is still traveling dangerously and must be slowed before there is a perilous accident. Moreover, and continuing with the speeding car analogy, there has developed a perception that because the car has been traveling accident-free at 100 mph for sometime, that somewhere near 100 mph must be a "sound" speed to drive.
Indeed, just this week Robert McTeer, president of the Federal Reserve Bank of Dallas, stated on CNBC that the "economy's speed limit" had been raised - that the Fed and the bullish analytical community are quite comfortable with the speeding car, confident in the condition of the road, and are particularly comfortable with the skill of the driver. This complacency is not only dangerous, but based on flawed analysis. The way we see it, two critical risks have been ignored: the car's engine (the financial system) and the other drivers (the global economy). Granted, up to this point, the "engine" has sputtered a few times but has always recovered to provide the necessary horsepower, while the cars of the other drivers have been generally so slow that they were hardly a safety issue. Presently, however, there are strong indications that the environment has changed and risks have increased dramatically.
Wednesday, the Commerce Department reported that the U.S. posted a record current account deficit of $106 billion for the second quarter. This deficit has now increased 34% from last year, 73% from the 2nd quarter of 1998, and 254% since the 2nd quarter of 1997. Shipments abroad continue to accelerate, with exports increasing $9 billion (14% growth rate) during the quarter and $31 billion (13%) year-on-year. At the same time, our economy continues to absorb truly incredible quantities of foreign goods. Imports increased almost $20 billion during the quarter (18% growth rate), and $77 billion (21%) during the past year. Pulled from the text of the report: "U.S. liabilities to foreigners reported by U.S. banks, excluding U.S. securities, increased $48.7 billion in the second quarter, following a decrease of $8.8 billion in the first. Most of the second-quarter increase was attributable to a sharp rise in banks' own liabilities, mostly to (their) own foreign offices, as U.S. banks borrowed heavily from abroad to meet the higher demand for short-term funds in U.S. banking and securities markets."
Increasingly, the U.S. financial sector is forced to go to extreme measures to finance what are the truly massive imports required to satisfy clearly excessive domestic demand. As written above, the U.S. banking system borrowed aggressively overseas during the second quarter (strongest since the 3rd quarter of 1998), in a continuation of extreme financial sector leveraging over the past ten quarters. Add to this the strains of financing an historic real estate boom and unprecedented corporate borrowings, with a household savings rate that has turned negative. It should be patently clear the U.S. credit system "engine" has been pushed way beyond a reasonable, acceptable limit. Indeed, it is to the point now that the U.S. credit system is adding leverage upon leverage, with extreme and growing dependence on overseas financing. This situation could not be more unstable and the U.S. credit system more vulnerable. So far, global currency tumult has been to the advantage of the U.S. dollar. We not only don't see this dislocation and dollar strength as sustainable, we expect that unfolding turbulence in global energy, currency, and credit markets, will again test our acutely fragile financial structure.
This week provided further evidence of an unfolding global energy crisis; a situation made only more problematic for countries with sinking currencies. And while the convenient finger pointing is directed at OPEC, we hear few stating that exceptionally strong world demand is overwhelming the ability of producing and refining energy products. We also don't hear much analysis that makes the proper connection between years of egregious U.S. money and credit excess and the developing global energy crisis. The relationship should be clear. Total US imports for the second quarter were $446 billion, 21% ahead of a year ago. Not only has the production of U.S.-bound goods consumed considerable energy, booming exports to the U.S. has led the global economy to what is expected to be it strongest year of growth in a decade.
Earlier this week, Bloomberg news ran a story "Economic, Business Chiefs Say Asia Growth Brighter, See Risks." The article began, "The world economy is set to post 'blistering growth' this year as Asia's recovery from economic recession bolsters trade, speakers said at the World Economic Forum…From Singapore to Seoul, most Asian economies are notching growth on a par with the turbo-charged rates prior to July 1997…" Estimates have the Asia Pacific region growing at about 8% this year, with South Korea expected to post near double digit GDP, Hong Kong near 9%, Taiwan near 7%, and China 8%. Today, Singapore reported that July retail sales ran 28% above last year.
This week it was reported that Chinese industrial production grew at 12.8% during August, the same rate as July and a significant acceleration from the 10.7% growth during the first quarter. Industrial production has now expanded at an 11.6% rate for the first eight months of the year, a rapid increase from the 7.3% growth during last year's fourth quarter. From a research report from ABN-AMRO: "The acceleration in industrial production growth over the past several months was not just due to exports, it was more because of the pick-up in domestic demand, notably fixed asset investment. We expect the trend to continue." Retail sales continue to accelerate, growing 9.3% during August. ABN-AMRO expects that China's 3rd-quarter GDP could reach 9%. And while domestic demand is increasing, growth continues to be driven by surging exports. During August, exports ran 27.4% above year ago levels. Imports increased a stunning 54.6% year-on-year, the largest increase this year. Year-to-date, exports have jumped 37% to $159 billion, while imports have increased 39% to $142 billion. China's narrow money supply has surged 21.9% during the past twelve months, with broad money supply expanding by 13.3%.
Extraordinary growth is not limited to Asia. Even Russia reported that August industrial output expanded 10% from last year. South of the border Mexico is experiencing a major boom, with GDP growth of about 8%. Yesterday, it was reported that the growth of Mexican consumer spending during the second quarter accelerated to almost 10%, the most rapid pace since 1998's first quarter. Private investment grew at 11% during the quarter. Earlier in the week, it was reported that August sales of new automobiles climbed to a six-year high, with sales jumping 10% from July. Auto exports increased 12% from July and were 41% above year ago levels. Bus sales rose 17% and truck sales 18% from July, with year-to-date sales running ahead 55% and 35%. Year-2000 auto sales are running 33% above last year. Year-to-date total auto exports Mexican workers are demanding and receiving significant pay increases. Last month, Volkswagen gave its Mexican employees an 18% pay increase.
And this week from Market News International (MNI): "Globally, (demand for plastics is) expanding everywhere - every market around the world is now growing and that hasn't happened since around '95 and '96. We're seeing more than just a recovery of Asia, Latin America and Eastern Europe - it's into expansion. Whatever peaks we reached in most countries prior to the Asia crisis, we've now exceeded." Kevin Swift, chief economist for the American Chemistry Council on global demand for plastics.
In a separate article, yesterday Market New International focused on the US package delivery business. "UPS sees no evidence of economic slowing, although the biggest growth for the company appears to be in the international market - with the domestic market remaining 'steady.'" MNI quoted Bob Clarin, CFO from UPS: "From what we've seen in terms of our own growth rates and volumes, we've not seen a slowdown - just steady, healthy, long-term growth. General volumes in the U.S. have been steady. Any up tick is coming from companies doing more business on a global basis. I can tell you from what I've seen on our planning for the peak season, we have not seen a slowdown in terms of what our retailers are planning to move through the system."
Hopefully this sheds some light on the global energy situation and why it will not be easily resolved. We are in the midst of an historic domestic boom and an exceptionally strong global economy. The numbers should speak for themselves. After years of U.S. and global money and credit excess, the consequences are coming home to roost. And while the consensus fixates on the deceleration of U.S. domestic growth, little attention is paid to the real problem, the continuation of runaway money and credit excess, with its resulting financial and economic fragility. Importantly, what is unfolding is both a global energy crisis and a financial crisis. Neither will be easily dealt with. We continue to see the energy crisis exacerbating the unfolding currency crisis. Currency instability, at the same time, holds great potential to destabilize a highly overleveraged credit system and set off a fire in the swaps and interest rate derivative tinderbox. We should think in terms of one massive, integrated, and vulnerable derivatives market. As the week came to an end, the environment sure brings back memories of 1998. The a cadre of global money center banks, securities firms and the rest of the leveraged speculating community are all operating aggressively in the various markets throughout the world. When trouble strikes, the global financial system finds itself, unfortunately, highly integrated. And as was certainly the case in 1998, few appreciate the dimensions of what is unfolding. We just can't shake the notion that the huge overseas borrowings by the banking system and financial sector, likely associated with huge currency and interest rate derivative positions, isn't an accident in the making.
Raise the economy's speed limit? You've gotta be joking…