Economic Cracks

February 17, 2019

by Steve Stofka

As the recovery enters its tenth year, there are signs of strain. As debtors struggle to pay their loans in a weakening economy, the percentage of non-performing loans increases.  The current rate of one percent indicates a healthy economy (Note #1). When the annual change in the rate of delinquency increases, that has been a reliable indicator that the economy is growing stagnant. Here’s a chart of the percent change in non-performing loans. A change above zero has preceded the last three recessions.

Non-PerfLoansChange

Let’s add one more series to the graph to help us understand the cycle of consumer credit. In the graph below, the red series is the percentage of banks tightening lending standards. Notice how the banks respond to a rise in delinquencies by being more selective in their credit criteria. Eventually, this tightening of credit leads to a recession. The cycle is as natural as the ocean currents that distribute heat around the planet.

NonPerfBankTighten

The financial news agency Bloomberg reports that delinquent auto loans are the highest since 2012 (Note #2). Bankrate reports that credit card debt has risen since last year. Less than half of people surveyed have emergency funds (Note #3).

December’s retail sales report, released only this week because of the government shutdown, showed a surprising decline of 1% from November. Have some consumers reached their limit? Retail sales, adjusted for inflation and population growth, does not show the strain so far. Look at the period from late 2015 through late 2016 when sales growth consistently slowed below 1%. That was a key factor that cost Hillary Clinton the election. Trump turned voter dissatisfaction into an electoral victory in the Midwest.

RetailRealAdjPop

Politicians ride to power on the anger of voters. In 1994, Republicans overcame forty years of Democratic rule in the House by promising less regulation and lower taxes in a “Contract with America.” When the Supreme Court decided the 2000 election in favor of a Republican president, they enacted tax cuts to reverse the tax increases passed by Democrats in 1993. In 2006, voters were angry with the incompetent Bush administration and reinstalled Democrats in the House.

In the depths of the Financial Crisis in 2008, Democrats rode a wave of anger, despair and hope to take the White House and command a filibuster proof majority in the Senate for the first time since the post-Watergate Congress thirty years earlier. Such a rare majority indicated that voters strongly wanted a solution to the crisis (Note #3). The Obama administration and Democratic Congress protected the financial and insurance industries while ordinary people lost their homes and their savings. The one piece of legislation that emerged from that majority was Obamacare, the bastard child of back alley compromises between mainstream Democrats and the health care industry. Few who voted for it knew what was in the bill.

In 2010, Republicans rode the anger wave of the Tea Party caucus to retake the House. With an equal number of Senate seats up for re-election, Republicans took six seats from Democrats and ended their filibuster proof majority (Note #4). In 2014, voters handed the Senate back to Republicans, then gave the reins entirely to the Republicans with the election of Donald Trump to the presidency in 2016.

In 2018, Democrats rode a wave of anger to take back control of the House. Social media campaigns whip up indignation to fan the flames of voter anger in the hopes that Democrats can at least take back the presidency in 2020. Voters may not be in enough economic distress to give Democrats control of the Senate in 2020, but it is the Republicans who have the most seats up for re-election this coming Senate cycle (Note #4).

Credit expands and contracts in a seasonal multi-year cycle. Banks are tightening in response to higher delinquencies. Will the timing of the credit cycle coincide with the 2020 election?

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Notes:
1. In 2016, China, Japan and Germany had rates below 2%; the U.K. and Canada had less than 1%. On the high side, Greece had 36%; Italy had 17%, and Spain had 7%.
2. Why are so many people delinquent on auto loans? Bloomberg
3. In 1964, the Supreme Court forced the states to redistrict their state legislatures based on population changes. For fifty years, Democrats were sometimes able to forge filibuster proof Senate majorities because racist Southern states were effectively one party Democratic states. Reynolds v. Sims . Since the ratification of the 17th Amendment in 1914, Republicans have never had a filibuster proof majority
4. A third of Senators are up for election every two years so party advantage shifts with every election cycle.

Consumer Credit

It is very iniquitous to make me pay my debts; you have no idea of the pain it gives one. – Lord Byron

October 7, 2018

by Steve Stofka

The total of all consumer loans, excluding mortgages, is almost $4 trillion. The Federal government owns $1.5 trillion of that total, most of which is student loans, which have tripled in the past decade. According to the Dept. of Education, 11% of student loans are in default, three times the credit card default rate and more than ten times the auto loan default rate (Note #1).

Over a five-decade period, the stock market has risen when consumer credit rose. Below is a chart of consumer debt outstanding as a percent of GDP (Note #2).

ConsCreditPctGDP

This a decade long indicator, not a timing tool. Notice that the ratio of credit to GDP (blue line) rises during recessions (shaded gray) when GDP, the bottom number in the fraction, falls. When the recession is over, credit falls as people fall behind in their payments, loans are written off, etc. Now GDP starts rising again while the top number, credit, is falling.

Auto loans make up 28% of outstanding consumer credit and currently have less than a 1% default rate. If we adjust the total of consumer credit by the extraordinary growth in student loans, auto loans make up 39% of total consumer credit (Note #3). We saw a similar percentage in the mid to late 1980s when savings and loans aggressively extended auto loans and mortgages. In the late 1980s and early 1990s, a third of all S&Ls failed.

Typically, people do not count vehicle depreciation in their budget, but they should, just as businesses do. Example: the average yearly take-home pay is $52K. Let’s say the average car, new and used, is $24K and depreciates $2400 a year (Note #4). Let’s say that the average person saves about $2400 a year to make the math easy. The $2400 that goes in the savings bank is simply offsetting the $2400 in depreciation. There is no savings.

In addition to depreciation, many of us don’t include the cost of inflation in our budget. Six years from now, a replacement car, new or old, could cost an additional 15%. Without adjusting for these “hidden” costs, we may think we are getting by. Over time, however, we add these hidden costs to our credit balances. We put less down on the next car and get longer auto loans. The average loan length is now 5-1/2 years. As soon as we are done paying off one car, it is time to get another (Note #5).

The economy is strong, and it needs to stay strong so that households can pay back their loans. The ultra-low interest rates of the past decade have reduced the monthly debt payments for many. For the past two years they have leveled at 5.6% of disposable personal income, the mid-point of the past forty years. For every $20 that a person takes home, they are paying $1 to service their consumer debt. The average yearly debt service payment would be about $3000 on a $52K take-home pay.

In response to the strong economy, the Federal Reserve has been raising interest rates to a more normal range. The 30-year mortgage rate just hit 5% this past week. Rising interest rates raise the monthly payments and reduce the loan amounts that borrowers can qualify for.  Many younger workers are unfamiliar with a world of normal interest rates.  They will have to learn a new math.

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Notes:

1. Student default rates . Default rates reported by the credit agency Experian .
2. More detail on consumer credit here at the Federal Reserve ()
3. I made the adjustment by subtracting $1 trillion in Federal student loans from the current total of credit. This pretends that Federal loans grew 15% in the past decade, not 300%.
4. The average amount financed on a used car is $17,500 (FRED series DTCTLVEUANQ). New car loans average $29,800 (FRED series DTCTLVENANM).
5. A buyer of a new car holds it for 71 months according to Auto Trader.

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Misc

Amy Finkelstein is a MacArthur genius award recipient who studies trends in health care. Proponents of Medicaid expansion projected that lower income families would better control and plan their medical care under Medicaid. Instead they have used the ER even more.  She found that people visit the ER more, not less. Although families report better health and more confidence in their financial security because of Medicaid expansion, measureable health outcomes have shown no change. WSJ article (paywall) is here. Her citations on Google Scholar.

 

Washington’s Role

“The rich are much better placed to feed at the public trough. The poor get crumbs.” – Steve Hanke, American Economist, 1942 –

August 5, 2018

by Steve Stofka

In the past fifty years, the increasing role of the Federal government in the economy has been the chief contributor to inequality. In the last years of the Bush administration, America became a socialist economy. Credit growth under the Trump administration has not changed from the levels during the Obama administration. On this score, Trump is Obama II.

Since the Great Recession, the federal government has far surpassed the role of banks in net input into the economic engine. In the post WW2 period, the annual growth in credit outstanding (see Notes #1) to households, corporations, state and local government surpassed the net input of the federal government, its spending less the taxes it drained out of the engine. The blue line in the graph below is the growth in bank credit.

CreditGrowthvsFedInput1953-1970

The Great Society and the escalation of the Vietnam War in the 1960s marked a changing role for the Federal government. Bernie Sanders marked the early 1970s as the beginning of the increase in inequality. Bernie suggested that the Federal government should have a greater role in the economy to correct the problem. Bernie has it backwards, as I will show. It is the greater role of the Federal government in the economy that has contributed to inequality. The hand that feeds the poor becomes the hand that feeds the rich.

Under subsequent presidents after 1968, both Republican and Democratic, the Federal input into the economy dominated the net – loans minus payments – input of bank credit. When the Federal government spends more than it taxes, it becomes a proxy debtor for individuals, state and local governments who cannot borrow enough to meet their needs. As the net credit input into the economy sank in the last two years of the Bush administration, 2007-2008, the role of the Federal government approached the levels of western European socialist governments.

CreditGrowthVsFedInput

The Obama Administration and super-majority Democratic Congress of 2009-2010 simply held that input level established earlier by the Bush Administration and a Democratic House. When Republicans took control of the House in 2011, they fought with the Obama Administration to reduce the input level. From 2012 through 2015, the growth in credit eclipsed the net input of the Federal government. Since early 2016, the growth in Federal input has once again dominated the role of the banks in the private economy. After the tax cuts passed last year, the Federal government will drain less taxes out of the economy and further cement its dominant role as an input into the engine.

For the past 65 years, quarterly credit growth has averaged 1.9%. In the last ten years, it has averaged .4%. From April 2017, two months after Trump took office, through March 2018, quarterly net credit growth averaged the same .4% as it did during the Obama years. Banks may express confidence in the Trump presidency, but their credit policies indicate that they have as little confidence in Trump’s Washington as they had in Obama’s Washington. Unless Trump can turn that sentiment, his administration will suffer the same lackluster growth as the Obama administration. If the Federal government continues to dominate economic input, Trump’s pledge to drain the swamp will be broken. Federal economic power only feeds the K-Street crocodiles lurking in the swamp waters.

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Notes

  1. The growth of credit outstanding (net input) is a function of new credit issued (input), debtors’ payments on existing loans (drain) and the write-off of non-performing loans (drain).

K-Street in Washington is the location of many of the nation’s most powerful lobbying firms.

 

Engine Flow

July 29, 2018

by Steve Stofka

“Banking was conceived in inequity and born in sin” – Josiah Stamp

In the past two weeks, I’ve looked at the inputs and drains to the economic engine. This week I’ll look at the flow between bank credit, the largest input, and loan payments, the largest drain. Because bankers want to make a profit on the money they pump into the economy, they do a better job of managing the economy than government officials.  Banks manage access to the credit system better than governments and achieve less economic inequality. Whenever governments wrest control of credit creation away from the banks to promote greater equality, the country’s economy suffers.

Let’s begin with the first point; banks must protect their loan portfolios. To do that, they monitor the health of the economy. The Conference Board uses ten data series to construct its index of leading economic indicators to estimate the probability of recession. ECRI uses 50 data series to chart its weekly leading index. These indicators are sensitive and may give a false signal, indicating a coming recession which doesn’t occur. Watching these data series are the banks who form an emergent Artificial Intelligence machine that varies the amount of credit they input into the economic engine.

Let’s piggy back on the efforts and watchfulness of the banks. We can look for a change in the ratio of household credit, an input to the engine, to the unemployment rate, or the ability to drain the input. One quarter’s decline of 2% or greater in this ratio, or two quarters of a smaller decline has been a reliable indicator that a recession is approaching. Below is a graph of the Household Debt-Unemployment ratio during the past thirty years but this signal has been reliable since World War 2.

HouseholdDebtUnemploymentRate

Bank behavior has accurately predicted the start of every recession since WW2. Is this the holy grail for mid to long-term trading decisions? Not quite. The Federal Reserve does not release the total amount of household debt for each quarter until the end of the following quarter (see #1 at end). However, every month, the BLS releases the unemployment rate, the divisor in the Debt-Unemployment ratio. If the rate is lower than a year ago, no worries. If the year-over-year change in the rate is higher in two consecutive months, worry.

Unemploy

Here’s the same chart with the stock market’s reaction when the year-over-year change has been above zero for two months in a row. Insiders and market movers have lightened their exposure to equities.

UnemployStkMkt

Loans add money to the engine. Loan payments drain money from the engine. As unemployment rises, people reduce their loan payments. In managing their risk, the banks react to signs of economic weakness by reducing the amount of credit they issue. Because they are more responsive to evolving conditions than central banks and elected officials, banks manage the economy better than the government.

Access to credit is the key to understanding the disparity in fortunes among Americans. Let’s look at the flow of credit creation in a system where a bank can loan out ten times its deposits. Let’s say I borrow $10,000 from Bank A for a bath remodel. The contractor might have a gross profit of $2500 which he deposits in Bank B, who leverages that into a $25,000 loan to another customer, who remodels her basement. Her contractor’s gross profit of $5000 is deposited in Bank C, which leverages that into a $50,000 loan to another customer for a complete kitchen remodel. Only those people with good credit – the haves – can access this money machine. The machine is closed to the have-nots.

Governments have attempted to fix this inequality. The government borrows from the banks, acting as a substitute for the people who cannot borrow. The government then inputs the money into the economy, but this does not make the engine run because there is not enough being drained out in loan payments and taxes. The engine runs on flow – inputs and drains. One without the other damages the engine and makes the country vulnerable to a triggering event which causes collapse and the economic engine blows up. Yugoslavia (1994), Argentina (2000), Zimbabwe (2008) and Venezuela (2017) are the most recent examples.

Quoting an unnamed source, Winston Churchill said, “Democracy is the worst form of Government except for all those other forms that have been tried from time to time.”  Private bank management of credit creation is a terrible system, but far better than the other systems that have been tried.

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Notes:
1. With a month delay, the Fed releases a monthly estimate of household debt that excludes mortgages and HELOCs.

Ten years after the recession, the amount of household debt per employee is still above trend. A ratio of debt to disposable income is below trend.

According to the credit reporting agency Experian “Transactors” are 29% of card holders and pay off their balance each month. 43% carry a balance. The rest are dormant accounts. Experian ranks states by the average credit rating of its residents.

Fannie Mae reports that, as of the end of 2017, 37% of the mortgages modified during the housing crisis had defaulted again.

Bank of America clients with High Net Worth reported that their allocations were 55% stocks, 21% bonds, 15% cash, 10% other.

In May, consumer credit increased at a seasonally adjusted annual rate of 7-1/2 percent. Revolving credit increased at an annual rate of 11-1/2 percent, while nonrevolving credit increased at an annual rate of 6-1/4 percent (Federal Reserve)

 

The Hunt, Part 2

July 22, 2018

by Steve Stofka

Last week, I showed the inputs to the credit constrained economy as a percent of GDP. I’ll put that up again here.

CreditGrowthFedSpendPctGDP

This week I’ll add in the drains but first let me review one of the inputs, bank loans. Focus your attention on that period just after 9/11, the left gray recession bar,  and the end of 2006, just to the left of the red box outlining the Great Recession on the right.  For those five years after 9/11, the banks doubled their loans to state and local governments, a surge of $1.4 trillion. The banks increased their household and mortgage lending by $5.3 trillion, or 67%. Why did banks act so foolishly? Former Fed chairman Alan Greenspan couldn’t answer that. We have a partial clue.

For 4-1/2 years after 9/11 and the dot-com bust, there was no growth in credit to businesses, a phenomenon unseen before in the data history since WW2. The banks reached out to households, as well as state and local governments because they needed the $1 trillion in loan business missing on the corporate side (#1 below).

There are four drains in the economic engine – Federal taxes, payments on loans, bad debts and the change in bank capital. State and local government taxes are not a drain because those government entities can not create credit. The change in bank capital reflects the changes in the banks’ loan leverage and their confidence in the economy. During the 1990s and 2010s the sum of the inputs and the drains remained within a tight range of about 1/7th of GDP.

InputLessDrains

The results of bad policy during the 2000s are shown clearly in the graph. In addition to the surge in bank loans, the Federal government went on a spending spree after 9/11. There was too much input and not enough drain. The reduction in taxes in 2001 and 2003 exacerbated the problem. There was less being drained out. Asset prices absorb policy mistakes until they don’t – a life lesson for all investors.

Let’s add in a second line to the graph – inflation. The rise and fall of inflation approximates the flows of this economic engine model with a lag time of several months. I’ve shown the peaks and troughs in each series.

InputLessDrainsVsPCE

Look at that critical period from 2006 through 2007. The Fed kept raising rates in response to rising inflation (the red line), driven primarily by increases in the price of oil.  The Fed Funds rate peaked out at 5-1/4% in the summer of 2006 and stayed at that level for a year. The Fed misread the longer term inflation trend and contributed to the onset of the recession in late 2007. The net flows in the engine model (blue line) indicated that the long term trend of inflation was down, not up.

Where will inflation go next? Using last week’s theme, follow the hounds! Who are the hounds? The banks. The inflow of credit from the banks is the primary driver of inflation. Why has inflation in the past decade been low? Because credit growth has been low. Where will inflation go next? A gentle increase – see the slight incline of the blue line at the right of the graph. Contributing to that increase were last year’s tax cuts. Less money is being drained out of the engine.

Too much flow into the economic engine or an improper setting of interest rates – these mistakes are absorbed by assets, which are the reservoirs of the engine. Stocks, bonds and homes are the most commonly held assets and most likely to be mispriced. During the early to mid 2000s, the mistakes in input were so drastic that the financial crisis seems inevitable when we look in the rear view mirror. During the past eight years, the inputs and drains have remained steady, but interest rates have been set at an inappropriate level. Again, we can anticipate that asset prices have been absorbing the mistakes in policy.

 

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1. In the last quarter of 2001, loans to non-financial corporate business totaled $2.9 trillion and had averaged 6%+ growth for the past decade. Anticipating that same growth would have implied a credit balance of $3.9 trillion by the end of 2006. The actual balance was $3.1 trillion.

The Big Picture

May 19, 2018

by Steve Stofka

Here is a simple and elegant animation model of the economy in a thirty-minute video from Bridgewater Associates, the world’s largest hedge fund. The video illustrates the spending – income – credit cycle in easy to understand terms. The video includes an insight first noted eighty years ago by the economist John Maynard Keynes, who pointed out that one person’s spending is another person’s income. Sounds obvious, doesn’t it?  I spend money on a pizza which increases the income of the pizza store.

When Keynes explored this simple idea, he revealed a glitch in the traditional model of savings and investment. In a simplified version, money not spent is saved in a bank. The bank loans out those savings to a business.  A business invests that loan into production for future spending. When economists model the whole economy, Savings = Investment. It is an accounting identity like a mathematical definition. The financial industry transforms one into the other.

During the Depression, something was obviously broken, and economists debated various aspects of their models. Keynes asked a question: what happens to the merchant where the money was not spent? Let’s say the Jones family decides not to buy a new TV and puts the money in a savings account at the Acme Bank.  The local Bigg TV store sells one less TV and has a corresponding decline in its income. Because Bigg had less income, they must withdraw money from their Acme Bank savings account to meet payroll. The money that the family saves is withdrawn by the business. The money Saved never makes it to the Investment side of the equation.  There is no increase in investment.

Most of the time, those who are saving and those who are spending funds from saving balances out. But there were times, Keynes proposed, when everyone is saving. Keynes attributed the phenomenon to “animal spirits.” As incomes fall, people start using up their savings to make up for the lost income.

During a crisis like this, Keynes proposed that government increase its spending, even if it needed to borrow, to boost incomes and break the vicious cycle. When the crisis was over, the government could raise taxes to pay back the money it borrowed. In Keynes’ model, government spending acted as a balancing force to the animal spirits of the capitalist economy. In the real world, politicians win votes by spending money but find that raising taxes does not win them favor with voters. Without legislative debt controls, government borrowing to counterbalance declines in income only produces greater government debt.

Turning from government debt to personal debt, the average credit card rate has risen to 15.3%, an eighteen year record. As an economy continues to expand and credit is extended to those with marginal creditworthiness, the default rate grows. The percent of credit card balances that have been charged off in default has risen from 1.5% several years ago to 3.6% in the 4th quarter of 2017.

Mortgage rates have risen to about 4.9% on thirty-year loans, and about a half percent less on fifteen-year loans. That half percent difference is close to the average for the past twenty-five years and adds up to an extra $1.60 in interest paid during the life of the loan on every $100 of mortgage principal. The graph below shows the difference between the two rates.

MortRatesDiff

Because shorter-term mortgages require higher monthly payments, they are more feasible for those with stable financial situations and above average incomes. When the difference in rates is less than average, there is a smaller advantage to getting a short-term mortgage.  At such times, the mortgage industry is reaching out to expand home ownership to lower income homeowners. When the difference is more than average, as it has been since the recession, the finance industry is cautious and not actively reaching out to lower income families.

Mortgages are secured by a physical asset, the house. U.S. Treasury bonds are secured by an intangible asset, the full faith and credit of the country. Just like us, the Treasury usually pays a higher interest rate for a longer-term loan.

A benchmark is the difference between a 10-year Treasury bond and a 2-year bond. As this difference declines toward zero, economists call it a “flattening of the yield curve.” At zero, there is no reward for loaning the government money for a longer term. Knowing only that, a casual investor would sense that something is wrong, and they are right. Periods when this difference falls below zero usually occur about a year before a recession starts. In the graph below, I’ve shaded in pink those negative periods. In gray are the ensuing recessions.

10YRLess2Yr

Before that negative pink period comes another phenomenon. Above was the 10 year – 2 year difference in interest rates. Let’s call that the medium difference. There’s also the difference between two long term periods, the 20-year minus 10-year difference. I’ll call that the long difference. When we subtract the medium difference from the long, we get a difference in long term outlook. In a healthy economy, that difference should be positive, meaning that investors are being paid for taking risks over a longer period. When that difference turns negative, it shows that there are underlying distortions in the risks and rewards of loaning money. That distortion will show first before the flattening of the yield curve.

DiffRates1995-2018

As you can see, the difference today is positive, a welcome sign that a recession is not likely within the year.

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Tidbits

The actuaries for Social Security and Medicare use an assumption that our average life expectancy will increase .77% per year (Reuters article)  If you are expected to live till 85 this year, then that expectation will grow to 85 years and eight months next year. That’s a nice birthday present!

U.S. lumber mills can supply only two-thirds of the lumber needed by homebuilders. The other third comes from Canada. Recent import tariffs now add about $6300 to the price of a new home (Albuquerque Journal).

The Unemployment Delinquency Cycle

June 4, 2017

I’m scratching my head. No, it’s not dandruff. The BLS released their estimate of job gains in May and it was 100,000 less than the ADP estimate of private payroll growth. We’d all like to see these two monthly estimates track each other closely, which they tend to do. In an economy with 146 million workers, a 100,000 jobs is only 7/100ths of a percent, but this discrepancy comes just two months after a HYUUUGE spread of 200,000 job gains in the March estimates.

A simple solution to multiple surveys? I average them. The result is 191,000 job gains in May, close to that healthy growth threshold of 200,000. In the chart below I’ve shown the average of the two estimates for the past five years and highlighted the downward trend of the peaks. Reasons include a decline in oil and gas industry jobs, and a natural feature of a mature recovery.

PayemsADPAvg

We saw the same pattern of declining job gains from the early part of 2006 through late 2007 before the average dipped below zero. Boosted by a hot housing market in the early part of the decade, construction employment began to cool in 2006.

PayemsADPAvg2002-2010

Some areas of the country are particularly hot. Denver’s 2.1% unemployment rate is absurdly low as is the state’s rate of 2.3%. Both are at historic lows, less than the go-go years of the dot-com boom. Colorado’s rate is the lowest among the 50 states (BLS). While income inequality has been rising in other hot metro areas like San Francisco, it has fallen in the Denver metro area.

There is a downside to strong growth. Back in “ye olden days,” like the 1970s and 1980s, I was introduced to a rule of thumb. It stuck with me because it seemed too simple. Here’s the rule: whenever the unemployment rate gets below 5% in an area, the price of some key component of  the economy is rising much faster than its long term average.   Lower unemployment leads to a mispricing of some asset.

Let’s turn to the other component of this credit cycle: loan delinquency.  The institutions who loan money expect that a certain percentage of borrowers will default. Lenders include the cost of those defaults when they calculate interest rates and loan service fees. The non-defaulting borrowers pay for the defaulters. During recessions, the delinquency rate on consumer loans usually rises above 4%. When unemployment is low and growth is strong, the delinquency rate goes below 3%.  Lower delinquency leads to a mispricing of credit risk.

Let’s review these two mispricings. The price of an asset is a price on some future flow of use or income that will come from the asset.  The interest rate on a loan is the price of money and the price of risk.  Let’s put these two mispricing together and we have another rule of thumb: as the difference, or spread, between the unemployment rate and the delinquency rate on consumer loans gets closer to zero, the more likely that the economy is overheating. A rising spread indicates a coming recession because unemployment responds faster than the delinquency rate to economic decline and increases at a faster rate. The spread changes direction and grows.

UnemployDelinquencySpread

Here’s the process. As the unemployment rate decreases, lending terms and loan criteria become more favorable. When we buy stuff on credit, we commit a portion of our future income stream to a creditor. When an economy begins to decline and unemployment increases, some income streams become a trickle or stop altogether. A loan payment is missed, then another, and those in more fragile economic circumstances default on their loans.

As the delinquency rate rises, lending policies begin to tighten again, making it more difficult to qualify for loans. Many businesses depend on the flow of credit, so this tightening causes a decline in sales, which causes businesses to lay off a few more people, which further increases both the unemployment rate and the delinquency rate. This reinforces the downward trend.

The NBER is the official arbiter of the beginning and end of recessions but often doesn’t set these dates until several years later.  This change in the direction of the spread is a timely indicator of trouble ahead. An understanding of the credit cycle is crucial to an understanding of the business cycle, which influences the prices of our non-cash assets.

Next week I’ll take a look at the cycle of asset pricing.

Caution: Strong Growth Ahead

This week, the Congressional Budget Office (CBO) released their estimate of the fiscal impact of the AHCA, the draft version of the Republican health care reform plan. I’ll take a look at the CBO methodology later in this post. For those who may be tiring of the almost constant focus on the AHCA, let’s turn our attention to some economic indicators.

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CWPI (Constant Weighted Purchasing Index)

February’s survey of purchasing managers (PMI) indicated a broad base of confidence among purchasing managers in most industries. New orders in manufacturing are surging, an expansion more typical in the early stages of recovery after recession. Regardless of how one feels about Trump, there is a sense of renewal in the business community. Consumer Confidence is at record highs. Confident of finding another job, the number of employees who are quitting their jobs is at a 16 year high.

The CWPI is a composite of both the manufacturing and non-manufacturing PMI surveys and is weighted toward the two strongest indicators of future growth, employment and new orders. Since October, the composite has been rising from mild to strong growth.

CWPI201702

For most of 2016, new orders and employment were below their five year average.  Since October, they have been above that average.

EmpNewOrders201702

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Housing

The Housing Market Index released by the National Assn of Homebuilders just set a multi-year record. Housing starts are strong and single family homes under construction are the best in ten years. A popular ETF of homebuilders, XHB, is nearing a recovery high set in August 2015. 58,000 construction employees found work during a particularly warm February. Now the big picture. As a percent of the working age population, housing starts are still at multi-decade lows.

HouseStartsPctWorkPop201702

There has been an upshift toward multi-family units in some cities but, in a broad historical context, these are also near all time lows as a percent of the working age population.

MultiFamPctWorkPop201702

A primary driver of new housing construction, both single and multi-family, is the growth in new households, which is still soft. In 2016, households grew by 1%, below the 30 year average of 1.2%, and far below the 70 year average of 1.7%.

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Consumer Credit

Here’s an interesting data series from the FRED database at the Federal Reserve: the percent of people with subprime credit in each county. Click on the link and zoom in to see the data for a particular county. In New York City, Manhattan has a 16% subprime rate, less than half the 35% rate of the nearby Bronx. Give the link a few seconds to load the data and display the map.

Subprime

On July 1st, the credit rating agencies will remove tax liens and judgments from their records if liens do not include the full name, address, SSN or date of birth of the debtor. This will raise the credit scores of hundreds of thousands of subprime consumers.

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Real Estate Pricing Tool

Trulia has a heat map, by zip code, of the median home price per square foot. I will include this handy tool on the tool page.

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IRS Data

Of the 145 million returns filed, 46 million itemized deductions. Under the Republican draft of tax reform (PDF), almost all deductions would be eliminated in favor of a standard deduction that is almost twice as large as current law, $12,000 vs. $6300. (Deductions, Child Credits ). Half of capital gains, interest and dividends would not be taxed. For most filers, the dreaded 1040 tax form is only 14 lines. Publishers of tax software like Intuit are sure to lobby against such simplicity.

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Health insurance reform is the prerequisite to tax reform.  If House Speaker Paul Ryan encounters strong resistance in his own party to health insurance reform, his tax reform plan will be stymied as well.

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AHCA

This past Monday, the Congressional Budget Office released their “score” (summary report and full PDF report) of the American Health Care Act, or AHCA. Score is a euphemism for the 10 year cost estimate that the CBO customarily gives on proposed legislation.

The CBO was careful to stress the uncertainty of their estimate. A critical component is the human response to changing incentives and the tentativeness of future state legislation. With most major legislation, the CBO estimates the macroeconomic effects. They did not include such an analysis in this report and note that fact. In short, the CBO is saying “take this estimate with a grain of salt.”

The headline number was the amount of people estimated to lose their health insurance over the next ten years – a whopping 24 million. Democrats used this ballpark estimate as a defining fact as they bludgeoned the plan. How did the CBO come up with their numbers?

Medicaid is the health insurance program for low income families and individuals.  When the program was introduced in 1965, enrollment was 1/4 million.  Today, 74 million are on the program.  The federal government and states share the costs of the program; the federal share averages 57%. Under the ACA’s Medicaid expansion, low income individuals younger than 65 without children could enroll.  An increase in the income threshold enabled more people to qualify for the program.  The federal share was guaranteed to not fall below 90% of those individuals enrolled under the expansion guidelines.

Medicaid (CMS) reports that 16.3 million people were added to Medicaid under the ACA expansion program and represent almost 75% of all enrollment under ACA. California has 12% of the U.S. population, but accounts for more than 25% of additional enrollees under Medicaid expansion. (State-by-state Medicaid enrollment ) Only 31 states adopted Medicaid expansion. The CBO estimates that those 16.3 million are 50% of the total pool of individuals that would be eligible if all states adopted the expansion program. So the CBO estimate of the total pool is almost 33 million.

Undere current law, the CBO estimates that additional states will adopt expansion so that 80% of the estimated total pool, or 26.4 million, will be enrolled under Medicaid expansion by 2026.  Under the AHCA, the CBO estimates that only 30% of that eligible population of 33 million, about 10 million, will be enrolled as of 2026. 26.4 million (under ACA) – 10 million (under AHCA) equals 16 million whom the CBO estimates will lose coverage under Medicaid. Note that this is a lot of blue sky math.

To summarize the ten year loss estimate under the rollback of Medicaid expansion: 6 million current enrollees and 10 million anticipated enrollees.

Medicaid expansion accounts for 16 million fewer enrollees. Where are the remaining 8 million missing? In the non-group private market. Currently, there are 11.5 – 12 million enrolled in these individual plans, an increase of about 5 million over the 6.6 million enrollees in 2007 (Health and Human Services brief) . The CBO estimates that, in 2018 and 2019, 2 million additional enrollees would take advantage of the ACA subsidies to buy policies. That results in a potential pool of about 14 million. Under the AHCA, the CBO estimates that the non-group private insurance market will return to its former level of 6 – 7 million, a loss of about 8 million.

Voila! 16 million under Medicaid expansion + 8 million in non-group private insurance = 24 million loss.

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Side Note

How do people get their health insurance?
74 million people, about 25% of the population, are enrolled in Medicaid. Half of Medicaid enrollees are children.
55 million, about 16% of the population, are on Medicare.
Over 150 million, or 50% of the population, are enrolled in an employer group plan (Kaiser Family Foundation).
Approximately 27 million, or 9% of the population, are uninsured.

Before the ACA, almost 50 million, or 16% of the population, were classified as uninsured. About 6 million of these uninsured had high deductible insurance plans called catastrophic plans. Offered by large insurance companies, they contained exclusions for pre-existing conditions, did not cover pregnancy, or mental disease, but were adequate for many self-employed tradespeople, contractors, consultants and farmers. (Info) In late 2013, the ACA redefined catastrophic plans by specifying the minimum benefits that a catastrophic plan must offer and, in 2014, began offering these plans through the state health care exchanges.

Central Banks

September 14, 2014

This week I’ll take a look at the latest JOLTS report from the BLS and an annual assessment of  global financial risks by the Bank of International Settlements.

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JOLTS

The BLS releases their Job Openings and Labor Turnover Survey (JOLTS) with a one month lag.  This past week’s release covered survey data for July.  The number of employees quitting their jobs is regarded as a sign of confidence in finding another job.  When it is rising, confidence is increasing.  The latest survey is optimistic.

The number of job openings have accelerated since the January lows.  In June, they passed the peak reached in 2007.

However, since May, the growth of job openings in the private sector has stalled.

The number of new hires continues to increase but we should put this in perspective.  The hire rate, of percentage of new hires to the total number of employees, has only just surpassed the lows of the early 2000s after the dot com bust and the 2001 recession.  This “churn” rate is still low, even below the level at the start of the 2008 Recession.

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Consumer Credit

Auto sales and the loans to finance them have been strong but consumers have been slow to crank up the balances on their credit cards.  Although the latest consumer credit report indicates that consumers have loosened their wallets in the past few months, the overall picture is rather flat.

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China 

China reported growth in factory output that was below all estimates at 6.9% and below target growth of 7.5%.  The Purchasing Managers Index, a barometer of industrial production,  shows that both China and Brazil are hovering at the neutral mark while the global index shows moderate growth.  Home prices in China have fallen for 4 months in a row.  As growth momentum slows, the clamor quickens for more easing by the central bank.

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Bank of International Settlements Annual Report

The Bank of International Settlements (BIS) is the clearing house for central banks around the world, including the Federal Reserve and the European Central Bank. It is the central banker’s central bank that facilitates and monitors money and debt flows among the nations.  The BIS has cast a particularly watchful eye on Asian economies, who are about 15 years into their financial cycle.

Their annual June 2014 report sounds a word of caution, emphasizing that central bankers should focus more on the financial cycle than the business cycle as they construct and administer monetary policy:

To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective – one in which the financial cycle takes centre stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.

In Chapter 4 the BIS notes the high levels of private sector debt relative to output, particularly in emerging economies. In a low interest environment, households and companies “feast” on debt, leaving them particularly vulnerable when interest rates rise to more normal levels.  International companies in emerging markets can tap the global securities market for funding and much of this private debt remains off the radar of the central bank in a country’s economy.

Financial booms in which surging asset prices and rapid credit growth reinforce each other tend to be driven by prolonged accommodative monetary and financial conditions, often in combination with financial innovation. Loose financing conditions, in turn, feed into the real economy, leading to excessive leverage in some sectors and overinvestment in the industries particularly in vogue, such as real estate. If a shock hits the economy, overextended households or firms often find themselves unable to service their debt. Sectoral misallocations built up during the boom further aggravate this vicious cycle.

While there is no consensus on the definition of a financial cycle, the peak of each cycle is marked by some degree of stress that encompasses a region of the world and can have a global effect.  Emphasizing the global component of financial cycles, the BIS is indirectly encouraging central bankers to communicate with each other.  Money flows largely ignore national borders.  It is not enough for a central banker to sit back, confident in the sage and prudent policies of their nation. Each banker should ask themselves: what are the neighbors doing that could impact my nation’s economy and financial soundness?

Financial cycles tend to last 15 – 20 years, two to three times the length of the business cycle.  It takes time to build up high levels of debt, to lower credit standards and become complacent about downside risks. There may be no clearly identifiable cause that precipitates a financial crisis.

Different regions have different cycles.  More advanced western economies have been on a downward recovery phase after the crisis of 2008 while emerging economies in the east are near the apex of their cycle.  Asian economies experienced their last peak at the start of the millenium.  They have had 15 years to inflate asset and property prices, to lower credit standards and accumulate debt, all hallmarks of a developing environment for a financial crisis.

The report notes that borrowers in China are especially vulnerable to rising interest rates but that many economies in the region would be pushed into crisis should interest rates rise just 2.5%, as they did a decade ago.

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Takeaways

Employee confidence and hiring are strong but private sector hiring may be stalling.  The next crisis?  Look east, young man.