North Atlantic Tides

By: Doug Noland | Fri, Jul 11, 2003
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The rally continues, as stocks were led higher by (surprise) the highflying Biotech, Semiconductor and Technology sectors. For the week, the Dow gained 0.5% and the S&P added 1.3%. Altria and Coke were hit hard but it was otherwise a good week for the Dow components. The Transports were very strong on the week, rising 5.4% while the Utilities were pared back 3.3%. The Morgan Stanley Cyclicals added 2.6% with the Morgan Stanley Consumer index flat. The broader market showed continued strength. The Small-cap Russell gained almost 4% and the S&P 400 Midcap added about 2%. The Nasdaq100 rose a full 4% this past week, increasing year-to-date gains to above 30%. High Tech showed no signs of abating, as the Morgan Stanley High Tech index rose by 3.7% (up 36% y-t-d). The Semiconductors posted a 6% surge on the week, upping 2003 gains to 35%. The Street.com Internet index gained 3.2% percent (up 51% y-t-d) and the Nasdaq Telecom index returned 4.7% (45% y-t-d). The speculative Biotechs added 5.7% this past week, increasing 2003 y-t-d gains to 38%. Financial stocks were strong as well. The Broker/Dealers added 3.6% and the Banks gained 3%. With bullion sinking $6.20, the HUI gold index declined 1.7%.

The Credit market took the global stock market rally in stride. Two-year Treasury yields declined 3 basis points to 1.28% and five-year yields fell 4 basis points to 2.45%. Ten-year Treasury yields closed the week at 3.63%, down 2 basis points, while the long bond saw yield was about unchanged at 4.68%. The spread on Freddie's 4 ½% 2013 note widened six to 38, and the spread on Fannie's 4 3/8% 2013 note widened 5 to 39. The benchmark 10-year dollar swap spread increased almost 2 to 37. Corporate spreads generally narrowed, with junk performing well. The dollar rally continues, with the dollar index gaining better than 1%. The CRB index was about unchanged, with crude oil trading to the highest prices since March.

Although issuance has now lagged somewhat for two weeks, nearly $10 billion of corporate debt was sold this week. Goldman Sachs issued $2 billion of bonds, SLM Corp $1 billion, Ohio Power $450 million, Buckeye Partners $300 million, Hartford Financial $320 million, Wells Fargo $200 million, John Deere $200 million, Fairfax Financial $150 million, and Entergy Gulf States $200 million. The junk area was quieter, although energy operator Calpine's $2.55 billion offering was the largest in the junk market since 1999. Strong demand caused the company to double the original size of the deal. Other junk issuers included Western Wireless selling $600 million, Rockwood Specialties Group $375 million, CMS Energy $300 million. The convert market remains on record pace. Medimmune issued $500 million of converts, TXU Energy $475 million, CMS Energy $150 million, Jetblue Airways $150 million, and Protein Design Labs $250 million.

Broad money supply surged an eye-opening $63.1 billion (to $8.83 Trillion), the strongest weekly gain since the Fed's post 9/11 liquidity operations. M3 has now expanded $255.4 billion over the past 11 weeks, a 14% annualized growth rate, with y-o-y growth at 7.9%. M3 is up $3.6 Trillion, or 70%, in six years. For the week, Demand and Checkable Deposits gained $12.0 billion. Savings deposits rose $8.4 billion (up $63.8 billion in five weeks). Small Denominated Deposits declined $3.8 billion, while Retail Money Fund deposits gained $5.5 billion. Curiously, Institutional Money Fund jumped $52.6 billion, with three-week gains of $67.6 billion. Large Denominated Deposits declined $8.5 billion. Repurchase Agreements dipped $1.2 billion and Eurodollars declined $1.5 billion. Fed "custody" holdings increased $2.3 billion.

Total Bank Assets added $7.4 billion, while Bank Credit surged $48.1 billion. Securities holdings rose $8.5 billion, with "Other" non-Treasury positions up $14.3 billion. Loans and Leases surged $39.7 billion. Real Estate loans jumped $27.5 billion, while Commercial and Industrial loans expanded $5.1 billion. "Other Loans" jumped $29.9 billion. Elsewhere, Commercial Paper increased $15.1 billion last week, with two-week gains of $36.2 billion. CP has now increased to the highest level since September. Financial sector CP jumped $13.9 billion to $1.367 Trillion, its highest level since June 2001. Financial CP is now up $80 billion from March lows, while expanding at a 10% rate thus far during 2003. Conversely, Non-financial CP has dropped $19 billion y-t-d to $136 billion, declining at a 19% rate.

Consumer debt increased by a stronger-than-expected $7.3 billion (5.0% annualized) during May. It remains puzzling that revolving and other non-mortgage consumer debt continues to expand despite record mortgage refinancings. But, once again, the most interesting aspect of this release was the "Terms of Credit - New Car Loans" data. The average Amount Financed increased another $380 during the month to $27,920 (up from March's $25,152). This compares to third-quarter 2002's average $25,959. The average loan maturity increased 0.6 months to 60.7 months, up from the third-quarter's 58.9. Average Loan-to-value was unchanged for the month at 97%, up from the third quarter's 96%. The average Interest Rate declined 11 basis points during May to 2.40%, down from the third-quarter's 2.68%. It strikes me as notably non-deflationary that the average auto loan is approaching $28,000 and the average new home these days is going for about $243,000.

According to Moody's Credit Card Index report, the charge-off rate rose another 5 basis points during May to 7.05%, up from the year earlier 6.46%. Yet the market is supposedly discounting a much improved environment going forward. From JPMorgan research: "Our market-weighted index of monoline credit card issuers rose 45.8% in the second quarter of 2003, significantly outperforming the S&P500's 14.9% gain by 30.9%... Since bottoming on March 11, our monoline issuer index has appreciated 79%, outperforming a 22% return in the S&P500 by 57%."

Holiday-week distortions led to a significant decline in weekly mortgage applications. However, examining year-over-year comparisons, Refi applications were up 196% and Purchase applications were up almost 17%. In dollar terms, Purchase applications were up about 24%. Freddie Mac's reported 30-year mortgage rate jumped 12 basis points to 5.52%, up 18 basis points in two weeks to the highest level since early May. One-year adjustable rates rose 6 basis points to 3.55%, with a two-week increase of 10 basis points.

It was another amazing month for Countrywide: "Average daily applications reached an all-time record of $3.2 billion, up 203 percent over last year. Loan fundings reached an all-time high of $48 billion in June, an increase of 23 percent over last month. Total loan fundings for the second quarter reached a new milestone of $130 billion, up 27 percent over the prior quarter's record of $102 billion, and up 209 percent over the second quarter of 2002. Monthly purchase fundings hit a record high of $13 billion, advancing 29 percent over last month's record. For the second quarter, purchase fundings were $33 billion, up 38 percent from the first quarter of 2003… The mortgage loan pipeline closed at a record high of $82 billion, up 11 percent over last month's." This compares to a loan pipeline of $23.4 billion to end June 2002. Year-over-year, June purchase fundings were up 77% y-o-y. Non-purchase (refi) fundings were up 408%. Home equity fundings were up 52% y-o-y, and Subprime funds were up 132%. From company COO Stanford Kurland: "Fundings for the first half of 2003 reached $233 billion, fast approaching the $252 billion originated for the full year of 2002. In just six months, purchase fundings totaled $57 billion, 8 percent more than the purchase volume for the entire 2001 calendar year." It is also worth noting that "Total assets at Countrywide Bank…rose 11 percent over last month to $13.1 billion." Pretty good month…

The May Trade Deficit, up 19% y-o-y to $41.8 billion, remained at a near record level. Year-over-year Exports were up 1% to $57.6 billion, while Imports increased 7% to $104.4 billion. Imports were 81% greater than Exports during May, compared to 72% one year ago. Year-to-date by largest trading partner, Imports from Canada were up 7.3%, Mexico 3.3%, China 27.9%, Japan 0.0%, and Germany 14.1%. Others of note include Saudi Arabia up 71.1%, Brazil 22.8%, India 15.1%, and Russia 56.8%.

June Import Prices jumped a stronger-than-expected 0.8%, the biggest gain since the prewar February price surge and noteworthy for its broadness. Import Prices were up 2.0% y-o-y, although the detail is more interesting. Food & Beverage prices were up 5.8% y-o-y. Industrial Supplies were up 8.8%, with Fuels & Lubricants up 15.5%. Paper & Stocks prices were up 8.5% y-o-y. On the downside, Capital Goods prices declined 1.6% y-o-y. Autos were up 0.7%, while Consumer Goods ex-auto was unchanged y-o-y.

June Producer Prices were reported this morning up a stronger-than-expected 0.5%, the strongest rise since March. For perspective, there was only one month during 2001 when PPI was up more than 0.5%. Year-over-year, PPI was up 2.9%. Consumer Goods prices were up 3.9% y-o-y (residential gas up 35.5%!), and Capital Equipment was unchanged. Intermediate Material prices were up 4.5% y-o-y, with Manufacturing up 2.9%, Processed Fuels up 15.7%, Construction up 1.1%, and Supplies up 1.9%. Crude Material prices were up 29.4% y-o-y, with Food & Feedstuffs up 13.6%, and Crude Fuel up 80.7%.

Insightful analysis from our most-capable summer intern, Indiana Hoosier Ryan Bend: "General Electric announced their second quarter earnings today, and most market watchers usually find their results to be adecent barometer of economic trends. GE reported quarterly earnings of $0.38, a decline of $0.06 or 14% over 2Q 2002. CEO Jeff Immelt painted the picture of a slow growth economy where industrial manufacturers have little pricing power and are faced with rising raw material costs. Excess capacity remains an issue as capacity utilizationis stagnantat about 74%. Consumer spending is chugging along, as we have seen in the recent retail numbers. SARS worries are lifting and advertising spending is trending upward. On the surface it appears that the economy is picking up steam and slowly working its way out of the doldrums. But we caution investors to jump to this conclusion. This is not a typical recovery. Yes the Dow, S&P and Nasdaq have all had nice runs this first half. Unfortunately, economic data paints a different portrait. Job growth has been non-existent. There is little evidence of pricing power. And reports like the one from GE today help confirm what is happening in today's Fed-fueled economy. A significantly greater proportion of GE'searningscame from financial services and insurance than last year. Managing credit card receivables appears to bea better business these days than manufacturing gas turbines, aircraft engines, or plastics. As inflation manifests itself in housing, health care, and financial services, industrial producers face continued problems. Raw materials costs are increasing and sales are slow because companies do not want to invest. The GE's and Ford's of the world turn to their suppliers and say prices have to go down. And someone gets squeezed." (I'm trying not to "brainwash" Ryan!)

Admittedly, most eyes will instinctively glaze over the minutia of various economic and earnings releases. Yet, it is especially important these days to carefully analyze trade, pricing and profit data. A key tenet of Credit Bubble analysis is that our contemporary, mutant financial system is hopelessly incapable of disseminating liquidity evenly or effectively throughout an increasingly maladjusted (domestic and global) real economy. I believe we receive decisive support for this hypothesis weekly. Even today's gap between June PPI and "core" Producer Prices (up 0.5% vs. down 0.1%) is further confirmation of unusual Inflationary Manifestations and atypical, especially uneven pricing pressures. And this morning's huge Trade Deficit indicates clearly that rampant domestic Credit Inflation persistently manifests into ballooning foreign liabilities with minimal benefit to domestic goods-producing industries. We also know that today's wild mortgage finance excesses are stimulating consumption and housing inflation; yet these financial flows (Monetary Processes) are abnormally unbalanced and unsustainable.

We have learned that the Fed still holds sway over the liquidity spigot; but we are as well witnessing that, these days, when they crank it wide open some quite unusual things develop. For the equity market, to this point it has clearly been a case of a rising (powerful North Atlantic) Tide lifting all ships. There's been a major short-squeeze that has hoisted countless rickety old boats. Moreover, the newfound wide-open Credit market has given new hope to many an ugly balance sheet (and the energy and telecom industries!). And then there's the issue of the proliferation of derivatives, where investors, fund managers, and speculators can easily take positions in indexes from the S&P100 to the small cap Russell 2000. Placing a bet on a single index can nowadays provide buying power for up to a couple thousand stocks. As such, we are of the view that market dynamics have been much more responsible for the impressive stock market breadth over the past months than underlying fundamentals. And while there is no way we will dismiss this most powerful liquidity backstop, the bulls should be unusually cautious when it comes to the veracity of today's marketplace as a discounting mechanism.

Importantly, today's extraordinary divergences in relative prices, along with the confluence of unmistakable domestic cost pressures and a savage global goods pricing environment, does not lay the groundwork for a traditional cyclical earnings recovery. In fact, we expect something at significant variance to what the bulls confidently believe is being forecasted by the stock market: we are increasingly of the view that the same (unbalanced inflationary) dynamics that are wreaking havoc with California and state budget deficits (rising costs and sticky revenues) and holding back job growth for most industries will also play the role of Inevitable Profits Spoiler.

Sure, ultra-low interest rates -- along with the recent liquidity and market surge and relatively strong, Credit-induced spending -- could prove constructive for a few decent quarters of earnings gains. But today's dysfunctional Credit system and maladjusted economy absolutely do not create a positive long-term earnings story.

It is worth noting that Asia equity markets nicely outperformed this week. Despite today's decline, the Nikkei advanced another 1% this week. The Hong Kong Hang Seng was up 3%, China Shanghai A shares 2%, Taiwan 2%, the Korea Composite index 2%, India's Mumbai index 1.5%, Indonesia's Jakarta 4%, Singapore 4%, and the Philippines Composite 1%. Major U.S. indices lagged. We note this as potential early confirmation that market players globally and here at home are beginning to appreciate that the unfolding (especially unbalanced) environment will favor some economies, industries and companies over others. Some ships will for now sail smoothly over rough seas, while many other unsound boats will struggle in what will prove a less than hospitable environment.

Watching "Kudlie and Cramie" the other night, Mr. Cramer posed the (rhetorical) question, "Is the current rally like 1991 or 1998." Of course, Messrs. Kudlow and Cramer, along with the bullish contingent, are increasingly confident that the feisty bear has been put to rest and a new nineties-style bull market has been launched. They will be disappointed.

We've all read and discussed the concept that recession and bear markets are the requisite adjustment periods to cleanse the system of unsound boom-time excesses. On a basic level this is little more than common sense. But the real analytical "meat" is not so readily discernable. When examining the complexities of contemporary economies and financial systems, there is much that remains nebulous and difficult to conceptualize.

Delving into Mr. Cramer's question provides us an additional opportunity to refine our analysis. It is rather straightforward that recessions are traditionally a period where bloated inventories are thinned, while excessive consumer and corporate debt loads are reduced to more manageable levels. Uneconomic enterprises are liquidated, improving profitability for the survivors. Unsustainable macro imbalances, such as outsized trade deficits, are brought back into balance. The concomitant financial bear market is an opportunity for an impaired system to rid itself of the individuals, institutions, and mechanisms that were misallocating resources (financial and real), inciting unsound excesses (economic and financial), and fostering economic vulnerability and financial fragility. We experienced somewhat of a healthy purging process during the early nineties recession, with the downfall of Michael Milken, Drexel Burnham, the S&Ls, the Bank of New England, and such.

Curiously, the economic consensus (focused only on the conspicuous) effectively developed the view that -- with inventories having become such a small factor in the contemporary U.S. economy -- the business cycle had basically become an archaic concept. And after its great early-nineties "success," the Greenspan Fed apparently convinced itself that boom-time financial imbalances were no longer especially problematic. After all, banking system (boom-turned-bust) losses could be easily rectified by the magic of artificially low short-term rates and a steep yield curve. Central bankers now enjoyed the power to recapitalize troubled institutions or an entire system simply by bestowing the capacity to borrow cheap short-term and lend dear long-term. Along the way, the entire notion of the value/necessity of purging the system of excesses (both real and financial) was deemed antiquated and rather senseless.

Basically, it has been the ambition of the Greenspan Fed to abrogate the requisite adjustment process: A Not So Grand Experiment. This has, most importantly, created a profoundly different environment today when compared to 1991 (or any post-adjustment period). Previously overheated and distorted systems (financial and real economy) emerged from the early-nineties adjustment with a "clean slate." Sectors that had demonstrated strong inflationary biases and unsustainable booms were severely restrained, breaking (speculative) inflation psychology and arresting outsized (profligate, uneconomic and destabilizing) liquidity flows.

Dysfunctional Monetary Processes (fraudulent S&Ls and junk bond operators, over-zealous real estate finance, and destabilizing financial speculation) were broken. This provided the backdrop for balanced financial flows to stimulate a measured and broad-based economic recovery. And with speculative impulses having been harshly punished during a wrenching bear market, emerging heightened liquidity flows were much more driven by true economic profits than they were induced by speculative "profits".

Today is not 1991. Yesterday's Financial Times featured an interesting piece, "Hustling for the Hedge Funds' Dollar: Why Booming Prime Brokerage May Become the Next Target for Regulators." A couple of charts get right to a heart of the matter. Estimated Global Hedge Fund Assets ended 1991 in the range of $55 billion, with the number of funds around 600. Estimated assets (a fraction of total positions) ended 2002 north of $600 billion, with the number of funds above 5,000. Greenspan's Not So Grand Experiment -- while thus far mollifying economic adjustment -- has acted significantly to exacerbate financial and speculative excess. And while it is almost reasonable to trumpet the wonders of contemporary finance and central banking, the reality of the situation is anything but wondrous.

Today is a lot like 1998. After the Russia/LTCM collapse - and the "seizing up" of the Credit market - the Fed aggressively cut rates and reliquefied the system. The GSEs led the charge. The Fed and GSE's maneuver more than nullified what would have been a fortuitous purging of speculative impulses throughout the leveraged speculating community. Rather, Fed operations only emboldened the speculators with lavishly easy gains. The speculative (inflationary) bias throughout the Credit system was intensified, with the resulting liquidity deluge swamping the stock market and telecom debt arenas (poised for blow-off excess). This speculation-induced liquidity torrent hit a real economy with a strong expansionary bias, especially throughout the booming technology sector. The consequences were a devastating stock market Bubble, with historic excess running rampant throughout NASDAQ, the Internet, and technology generally. The corporate debt Bubble went to near catastrophic excess, while the real economy suffered extreme maladjustments. And with the Credit system and monetary environment out of control, acute structural imbalances were imparted throughout. The inflationary seeds for today's California budget fiasco were planted by the Fed back in the fall of 1998.

The key difference between 1991 and 1998 can be found with the latter's strong inflationary biases. The Fed commanded great power in October 1998 to incite speculation, foster liquidity creation and fuel economic expansion. But underlying inflationary biases throughout the increasingly distorted financial system (Dysfunctional Monetary Processes) and maladjusted real economy guaranteed only the exacerbation of unfolding Bubbles.

Conversely, with excesses purged and dangerous inflationary biases having been wrung out of the system back in 1991, the Fed-induced expansion demonstrated patently divergent dynamics. For one, there was little in way of a "leveraged speculating community" aggressively reacting to Fed largess. Hence, speculative financial profits played no significant role in commanding liquidity creation or its dissemination. There was certainly no destabilizing speculation-induced "liquidity deluge." Importantly, financial flows were dictated much more by economic profits than financial "profits". This crucial attribute was engendered by the character of both the financial system and the real economy. The Credit and financial systems were devoid of powerful speculative impulses, with players guilty of previous misdeeds and financial excesses confined financially and/or otherwise. At the same time, the real economy was bereft of sectors exhibiting strong inflationary biases that would attract disproportionate (and destabilizing) liquidity flows. And, importantly, large numbers of uneconomic enterprises throughout the economy had disappeared. While not appreciated at the time, the prospect for strong, balanced, and sustainable earnings growth had been created through the (real and financial) purging process. A difficult adjustment process was, throughout 1991, setting the stage for a new bull market.

There are today strong (1998-style) inflationary biases that forestall the commencement of a sustainable economic expansion, an enduring broad-based profits recovery, and an attendant new bull market. Moreover, these problematic inflationary biases are deeply ingrained in both the financial sphere and real U.S. and global economies, eradicated only through a quite formidable adjustment process. The powerful GSEs and Wall Street firms remain the masters of liquidity management, as if their operations were not largely responsible for previous booms-turned-bust. A mortgage finance Bubble larger and much more dangerous than the equity market/technology Bubble runs completely out of control. And with a massive and enterprising leveraged speculating community - with Fed policies acting generally through the manipulation of financial profits - the pursuit of speculative gains today overwhelmingly dictates financial flows ("Financial Arbitrage Capitalism"). Within the real economy, strong inflationary biases throughout the expansive real estate, healthcare, and financial services sectors ensure that little of the massive liquidity creation flows to sound business and capital investment. This has none of the characteristics of 1991.

Real economic profits nowadays play an abysmally insignificant role toward dictating financial flows, investment, or economic expansion. And while deep structural maladjustments ironically foster only greater financial and speculative excess, the resulting liquidity cataclysm is destined to foster only more spectacular booms and unavoidable busts. Any expansion (financial or economic) fueled by speculative gains as opposed to economic profits is unsustainable and destined to end in tears. Today, a broad-based and sustainable profits recovery is more a chimerical impossibility than even a remote possibility. But we will be the first to admit that things are going to look seductively encouraging as long as liquidity remains so cheap and over-abundant. In this most speculative of environments, liquidity begets speculation that begets only more destabilizing inflationary liquidity excess. Yet we do have the sense that we are approaching a period where the market will begin to be a bit more discriminating. This has "1998 boom and bust" written all over it.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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