The corporate financing gap

Source: Federal Reserve, me

It’s always worth keeping an eye on what’s happening to the US non-financial sector financing gap. The chart above shows the financing gap (line 54 in table F.102) expressed as a percentage of nominal GDP. When the figure is negative, it indicates that the non-financial sector is not generating enough internal funds to fund capital expenditure and has to seek outside funds from capital markets or the banking sector.

Much to my surprise, in the last quarter of 2010, the corporate sector was a net generator of liquidity. This may go someway to explain the buoyancy of the equity market. There was due to a big drop in inventory build (c$120bn). This is probably an end of year adjustment as the previous year seems to show the same pattern. If this is a correct interpretation, then the non-financial corporate sector is likely to resume its financing gap as was evident in the first three-quarters of 2010.

A normal level would be a deficit of about 1% of GDP or $150bn. Equity issuance over 2010 was a negative $274bn balanced by $355bn of credit market issuance. If companies continue to buy back equity, then the equity market will be supported, but debt markets will have to absorb the balance and some. With the Fed winding down QE2, this will be a challenge for bond markets. Although the Fed has not been active in the corporate bond market, purchases of Treasuries and MBS will have displaced investors into corporate bonds.

Tobin’s q suggests that, logically, managements will issue equity as the market value of equity is above the replacement cost of enterprises. However, management incentives are skewed towards equity returns. Therefore, as long as bond yields are low, managements are likely to issue bonds in preference to equity and probably continue to retire equity. This suggests that the equity market will continue to have support from share buy-backs unless corporate bond yields rise enough to make bond issuance unattractive. Hence, an immediate collapse in the equity market is unlikely, but the seeds for the next downturn are starting to be sown with the re-gearing of the non-financial corporate sector.

 

Tobin’s q

Tobin’s q has a fairly mixed reception amongst investment practitioners. For some it’s a stock market valuation tool. Others dismiss it as flawed and irrelevant.The Wikipedia entry gives a summary of these arguments.

Q compares the replacement value of corporate assets with the equity market value of those assets. When q is above one the market is value assets above replacement cost. Below one means investors are valuing assets below replacement cost. A q above one, means, other things being equal, companies will issue equity to expand; below one means it is cheaper to buy companies than to invest in new productive assets.

While this may be an oversimplification, and averages hide a multitude of sins, it does give a yard stick to gauge whether companies are more likely to issue equity or to buy other companies or buy back their own shares. It  is easy to calculate q from the Federal Reserve’s Flow of Funds data for the US. Interestingly, q is now 1.1 (for 4Q10), having been well below 1 at the nadir of the credit crunch.

Source: Federal Reserve, me

Is this relevant? On its own I would say no. However, if we take into account the latest data on corporate lending, it seems likely that the equity market will see more equity issuance. Since November 2010, the US bank system has started to increase credit to the US non-financial business sector. I will have a look at the non-financial sector corporate financing gap when I have a chance, but I would expect it to have become positive, i.e. the US non-financial sector has a positive requirement for funding.

This has several implications:

1. The non-financial corporate sector has been a net supplier of liquidity to the financial system. If it is now a net absorber of liquidity, then this is another reason to believe that the liquidity environment is starting to tighten.
2. If there is no compensating move to increase saving by the personal sector or decrease dissaving by the government sector, the US trade deficit will worsen.
3. The equity market will see increasing issuance, making further upward progress in equity prices more difficult to achieve.
4. More equity issuance is likely to absorb liquidity from other asset classes, making rises in bond yields more likely.

Again, I’m not advocating a collapse in equity markets, but just pointing out that the environment is getting tougher. High corporate profit margins, rising input costs, tightening liquidity and, now, the possibility of higher equity issuance all make further progress by the US equity market more difficult, although the peak of the current cycle is still probably ahead rather than behind. Watch out for a broad-based top emerging over the next 12-18 months.

 

Stuff the fundamentals

Source: St. Louis Fed, me

Even a cursory read of Gordon Pepper’s “The Liquidity Theory of Asset Prices” will convince you that liquidity in the broadest sense is the real driver of asset prices. Fundamentals may determine relative prices, but liquidity determines the overall level of asset prices.

The chart above illustrates how the S&P 500 Index is joined at the hip to liquidity creation by the Federal Reserve. The Fed has created bank reserves and market related credit through asset purchases, boosting equity prices. We shouldn’t be surprised as Bernanke has explicitly stated this as policy.

Although many (like myself) believe that this is a misguided policy as it enriches the few without helping the many, it doesn’t matter. If that’s the policy, that’s the policy and we have to live with it.

Recent comments by Jeffrey Lacker suggest that any move to institute a QE3 programme would meet fierce resistance. So, come June, QE will end. Not only that, but as assets mature, they won’t be replaced, so the Fed’s balance sheet will slowly shrink, other things being equal.

This suggests that the liquidity environment will become more constrained and that the equity market will find it harder to progress. If we add in the peaking of the corporate profit margin cycle, perhaps some pressure on corporate revenue growth and that the corporate sector has become a borrower from the banking sector, it doesn’t take a genius to see that the tail winds that the market has enjoyed over the past two years are going to become weaker and turn into head winds.

Will the market collapse? I think that is unlikely. More likely is a broad topping pattern over the next year or so. If you look at the chart you can see that the market has gone from following the Fed to leading the Fed, or at least it has taken the Fed’s pronouncements at face value. Last year, the market started to rally when the Fed announced QE2 rather than wait for the buying to begin.

Recently, the market has fallen back, partly due to other factors, but partly due to the anticipation of the end of QE2. Unless the Middle East goes pear-shaped, a period of sideways movement with rallies and declines looks the most plausible outcome. However, if the domestic political environment in the US becomes more hostile to the Fed and the politicians start to actively lobby for a pro-active reduction in the size of the Fed’s balance sheet, then it would be very unsettling for the equity market.

It will be interesting to see whether this becomes an issue in next year’s presidential elections. There’s plenty of Fed haters out there and it’s the sort of thing that could produce a band wagon effect. The Fed has failed Joe Sixpack. Why would he want to support Bernanke?

A pat on the back for me

What’s all over today’s FT? Worries about peak corporate profit margins and pressure on earnings, as I suggested in a previous post on March 8th.

Page 17: Earnings growth set to slow.

Page 34: Earnings slowdown puts rally in spotlight.

I presume there’s some broker research on this. Perhaps they got the idea from this blog.

 

What’s going on at US banks?

One of the biggest frustrations about not having Datastream is the length of time it takes to capture and manipulate data. This has taken me two hours, whereas in the old days it would have taken me five minutes.

It’s always worth looking at what is going on in the US banking system as it affects both the real economy and monetary policy.

Source: St Louis Fed, me

The chart above shows bank assets by category as a percentage of total assets. The recent jump in consumer loans represents the inability to securitise, so it’s probably best to ignore them. What stands out is that the banks have swapped “risky” assets, like business loans for “safe” assets like government securities in a very similar way to the last recession. Government securities represent a similar percent of assets as the peak in the 2001 recession. In that cycle, the Fed decided to raise interest rates cautiously so that the yield curve didn’t flatten too quickly. This was to avoid a vicious bond market sell-off as happened in 1994, the previous time there had been a tightening cycle after a recession. The question is: will the Fed follow the 1994 model or the 2003 model? My hunch is they will be cautious and won’t want to jack rates up too quickly. The Fed also faces a tricky political problem as next year is a Presidential election year. Unless the Fed’s hand is forced, I think they will be cautious in raising rates.

Source: St Louis Fed, me

Another reason for caution is that US banks are still heavily burdened with Real Estate loans. Given their sensitivity to bond yields and the amount of CMBS that needs to be refinanced over the next three years, I don’t think the Fed will be brave. Raising rates too quickly would risk another banking crisis, this time focussed on mid and small cap banks which have the highest exposure to real estate loans.

Source: St Louis Fed, me

As I’ve said before, Fed monetary policy is driven by two main factors: employment and credit conditions. It monitors credit conditions through its Senior Loan Officer Survey and by credit growth. Looking at year-on-year credit growth (above), banks have continued to increase their securities portfolios. Business loans have stopped shrinking. Ignore consumer loans as they are distorted by the securitisation issue I’ve mentioned.

Source: St Louis Fed, me

Looking at 3m-on-3m, business loans are now starting to expand and holdings in government securities are declining. It looks like banks are tentatively re-risking their balance sheets. The fact that they are pushing to pay dividends also suggests a higher level of confidence. From the Fed’s perspective, normality seems to be reasserting itself.

What does this mean? Assuming that the Middle East calms down (a big proviso at the moment), the Fed is going to come under increasing pressure to normalise policy in the second half of this year. Banks seem to have turned sellers of the Treasury market. With the Fed also winding down QE2, the Treasury market looks vulnerable to a further rise in yields. If all the banks try to head for the door at once, then another 1994 sell-off is not beyond the realms of possibility.

That would be very embarrassing if it happened in 2012, an election year. Could Obama be hit with a triple whammy of budgetary impasse, Middle East policy failure and crashing markets? Worth thinking about.

Life after QE

We are being prepared for the end of QE2 by the Federal Reserve. Not much came out of this week’s meeting, but the April meeting is likely to be more forthcoming. The two guiding lights of interest rate policy for the Fed are employment and credit conditions. The Fed has always waited until it is sure that unemployment has peaked and that banks are loosening credit conditions.

The US unemployment rate peaked at 10.1% in October 2009. In the last three months, the rate has fallen from 9.8% to 8.9%. We can argue about whether the numbers are true and about the participation rate, but the bald fact is the headline unemployment rate is now falling and recent comments from Fed officials indicate that their thinking is that the recovery has gained momentum and that employment conditions are improving.

There is also evidence that credit conditions are easing. Consumer credit has been rising. The Senior Loan Officer Survey has been improving. There is also evidence that banks are taking risk again through the re-emergence of cov-lite loans etc. The repo market also appears to be booming. The Fed must be a bit irritated that credit conditions have not improved in the all important mortgage market and barely improved in the SME sector. It may be starting to get worried about excessive speculation and leverage in capital markets.

Arguably, QE2 has been a failure in the two areas where the Fed most wanted to stimulate credit availability: housing and small businesses. This is not surprising, given that banks would rather use free money to speculate in asset markets where they can apply a lot of money very quickly and potentially earn a rapid return. Remuneration structures at a senior level also tilt the playing field towards market operations rather than traditional loans. For instance, QE2 has been a failure in the mortgage market as mortgage rates have risen since QE2 started. Of course, the counter-factual of what would have happened without QE2 is difficult to know.

It is possible that the effects of the Japanese earthquake might blow plans off course, but generally natural catastrophes have remarkably limited impacts on the global economy despite the enormous human tragedy. Having said that, central banks are likely to provide additional liquidity to calm markets, if necessary.

So what is the immediate outlook? In the same way that bond yields fell when QE2 was announced and before the Fed commenced buying, there is some evidence that recent rises in bond yields might partly reflect an anticipation that the QE2 programme is coming to an end. Bill Gross thinks that yields will rise further. Who am I to disagree, but the rise may not be as dramatic as some fear. From the current rhetoric, it seems unlikely that interest rates will rise before the end of the year, especially as the FOMC appear to believe that the current rise in energy and commodity prices is transitory.

It will be interesting to see how the Fed manages the transition from exceptional monetary accommodation to “normality”. I think this will be exceptionally hard as the liquidity support has generally flowed into asset markets of one description or another. Banks may be even more sensitive to asset prices than before, particularly where transactions have been wrapped up in complex repo structures. While banks may be able to weather an initial tightening of policy, the tipping point from easy to tight credit conditions may occur at much lower interest rates than in previous cycles, much like Japan.

The lesson of Japan since its real estate bust is that remarkably small changes in policy can tip the economy from expansion to contraction. While I don’t think the US is in such an extreme position, I do believe that it is more vulnerable to shifts in monetary and fiscal policy and that the banking system is likely to amplify those sensitivities. Looking back to the 1930s, one lesson is that the authorities underestimated the sensitivities of banks to a change in the reserve requirements in 1936, which induced the 1937 recession.

The mechanisms may be different this time, but the psychology could be the same. At the first whiff of trouble, banks are likely to swing from risk taking to risk aversion. Capital positions and balance sheets are still highly vulnerable, so another credit crunch is not out of the question.

The bloated balance sheets of central banks adds another dimension, which wasn’t present in the 1930s.On the one hand, the asset purchases made by central banks is a useful monetary tool to influence the banking system. On the other hand, it exposes them to the risk of a collapse in confidence in a way that has never been tested before.

At the moment, the Fed and BoE are probably in profit from their operations taking into account both asset values and seigniorage profits from QE. Indeed the Fed made a record $52.1bn profit in 2009. This could reverse if assets are sold below purchase price, perfectly possible if bond yields rise in anticipation of large-scale sales. Seigniorage profits will also decline markedly. If swings are violent, the solvency of the bank itself could be called into question.

The ECB is under a different kind of threat as its asset purchases have been more modest. The biggest threat to the ECB is the liquidity provision to Greece, Ireland and Portugal. If any of these countries defaulted, then the ECB could suffer significant losses and its solvency called into question.

These are difficult waters to chart, even leaving aside the impact of the Japanese earthquake and the unrest in the Middle East. Central banks will need the wisdom of Solomon to successfully extricate themselves from the extraordinary measures of the past three years.

Two things are reasonably certain. Central banks will find it almost impossible to accurately calibrate their withdrawal, so the exit will either be too quick and cause a recession (hello ECB), or too slow and cause a pulse of inflation (hello Fed, BoE). The second is that markets will not allow this kind of action in the next downturn, which will have to play out in a more traditional manner. Watch out for a severe liquidity squeeze in the next downturn.

 

 

 

Could the unthinkable be happening?

I have been in the camp that China’s economy cannot change quickly enough to enable a benign global rebalancing. A wise man always looks for evidence to contradict his views so that he can test whether his views are still tenable. I came across this interesting post from John Ross, which suggests that China’s trade surplus is declining rapidly. The lunar New Year has produced distortions so the next few months data is vital to see whether his contention is true. If there is confirmation in the data, then a lot people, myself included, are going to have to reassess their views.

The squeezing of Joe Sixpack

I thought I would share another chart from my analysis of the NIPA corporate profit series. The chart below show employee costs as a percentage of revenue (gross value added) of the whole corporate sector.

Source: BEA, me

What it shows very clearly is that the labour costs as percentage of revenues has been falling remorselessly since 1970. Increased profit margins, outsourcing, capital intensity and the financialisation of the economy all explanations. However, what it does graphically illustrate is that for your ordinary Joe, wages have been under pressure. Over the past twenty years or so, until 2007, this was offset, to a degree, by increased borrowing and the decline of the savings rate.

We know that the top decile of the population has seen increasing wealth, as the Gini coefficient demonstrates. If you own outright assets of some description, equities or real estate in particular, you have done very nicely, not withstanding the volatility of asset values.

What this says to me is that there will be pressure to reverse this trend at some stage. How this will come about, I don’t know. A benign resolution would be the gradual reassertion of the power of employees in wage bargaining. A more malign resolution might involve social unrest and government intervention. Can a democratic nation continue to see the vast majority of its population squeezed for the benefit of a small minority? That’s an interesting question.

An extreme answer would be to look at what is happening in the Arab world. To be sure, these are autocratic kleptocracies. However, is the scooping of vast bonuses by the Wall Street elite, backstopped by the general populace really that much different? While the parallels are by no means exact, the potential for serious social conflict is obvious.

Brian Rix would be proud

I’ve refrained from saying anything on the Eurozone recently. It is rapidly descending into a farce that Brian Rix would be proud of. It was said of Yassir Arrafat that he never wasted an opportunity to waste an opporunity. Much the same could be said of those in charge of the Eurozone. Every time there is a period of calm they sit back and congratulate themselves and then a new storm breaks. The credit rating  downgrades of Greece and Spain shouldn’t be a huge surprise (do credit rating agencies retain any credibility?). The bank stress test provided an opportunity to get ahead of the game. It now looks like a fudge and a wasted opportunity.

The failure to bite the bullet early makes each succeeding attempt more difficult and onerous. We all know at the heart of the Euro problem is the need to restructure sovereign debt and as a result many banks will need capital injections. If you’ve not read it, have a look at Michael Lewis’ article on Ireland. This is a country that has no real hope of digging its way out the hole its in. Just get real and restructure Ireland’s debts so it can function as an economy and a country again. Of course the dirty little secret is that if Ireland and the others restructure their debts, the German banking system will require recapitalising.

US corporate revenue growth

Source: BEA, me

The chart above is the companion to the two I posted on Tuesday about profit margins and growth. From the same set of statistics, you can get revenue growth. In 3Q10, YoY percentage revenue growth for US non-financial corporates was 6.5%, which is around the levels seen in the previous two economic expansions. If profit margins are peaking, then, at best, profit growth is likely to be similar to revenue growth. So underlying earnings growth in 2H11 and 2012 could be around 6%.

However, it is plausible to suggest that trend revenue growth could be weaker than this, given weaker underlying real GDP growth. Additionally, if you look back to the 1970s and early 1980s, revenue growth volatility was much greater, reflecting greater economic volatility. The higher absolute level of revenue growth was mainly down to higher inflation. With inflation lower now than in the 1970s, and economic volatility likely to be as great, the chances of more frequent periods of weak revenue growth are higher.

Another thing to bear in mind is that it wouldn’t take much of a squeeze in margins in 2012/13 to produce flat earnings or even a decline. Swings in margins have a more pronounced impact on earnings than swings in revenue growth (although they are obviously related). Hence, I think the risks of more volatility and a potential decline in equity markets become greater through 2012 and into 2013.

About to peak?

Source: BEA, me

Looking at the chart above, what do you think are the prospects for US non-financial sector corporate profit margins? They look near the peak to me. The last data point is 3Q10, so the odds must be that the cycle will peak this year. The recent trough of the current cycle was at a level that, in the past, has been associated with the peak of the cycle. Companies are very profitable. That is not new news and is factored into equity prices.

It seems very likely that non-financial sector corporate profit margins will start to deteriorate this year. Firstly, employment is picking up, so marginal profitability is likely to decline. Secondly, capital expenditure will rise as corporates have been investing less than depreciation. Thirdly, they will have to carry higher stocks. Fourthly, volumes have been boosted by the re-stocking cycle, which should fall away this year. Fifthly, nominal GDP growth is likely to slow as stimulus packages wind down and government spending comes under pressure. Sixth, rising input costs from energy and commodities.

Source: BEA, me

The chart above shows year-on-year profit growth for the US non-financial corporate sector. It looks like it’s already peaked. So the peak of the profit growth cycle has already been reached. This doesn’t mean an immediate reversal into profit declines. What it suggests is that companies will find it harder and harder to generate profit growth over the next few years. It also suggests that there could be a switch away from cyclical sectors in the equity market to stable or growth sectors like pharmaceuticals.

The NIPA profit series is not the same as market earnings, but it is a truer picture of underlying earnings trends than the make-believe earnings releases that appear in company reports as they are complied from tax submissions. All too frequent restatements of company earnings curiously never make it into S&P index earnings numbers.

I’ve used non-financial sector profits because I believe they more truly reflect real profits in the economy. Financial sector profits are just transfer payments. Also financial sector profits are dogged by issues over the timing of profit recognition and the fungibility of income and capital related profits. I have come to the conclusion that financial sector profits, as declared by most companies, are largely worthless as a number. They rely on too many assumptions, most of which have proved to be erroneous in the recent crisis. For financial companies, the balance sheet is more important than the P&L. Unfortunately the true value of assets and liabilities has become increasingly difficult to assess.

Closer to the edge?

In an interview with the Telegraph, Mervyn King, the Governor of the Bank of England said,

“…the institutions bailed out were those at the heart of the crisis. Hedge funds were allowed to fail, 3,000 of them have gone, but banks weren’t.” Could there be a repeat? “Yes! The problem is still there. The ‘search for yield’ goes on. Imbalances are beginning to grow again.”

Yes, but that’s a function of the exceptionally low policy interest rates that central banks have imposed. It’s a bit disingenuous to castigate banks for seeking yield when you are the one providing the incentive. The problem with exceptionally low interest rates (judged relative to nominal GDP growth) is that they produce a distortion of capital allocation. They encourage the grope for yield and leverage.

It’s ironic that the ECB is probably going to raise rates first, when they should keep them low to aid the periphery. As the Telegraph points out today, ECB monetary policy is being driven by Germany to the detriment of Club Med. The Eurozone needs German wages to increase at a rapid pace and for German inflation to be structurally higher. If the ECB raises rates, it will be another step closer to the cliff.

Should the US and UK raise rates? I don’t think it would make a huge difference one way or the other unless it was by at least 150bp. What the Fed and the BoE/FSA need to do is to rein in the risk appetite of banks in the wrong areas. By that I mean that credit to SMEs should be encouraged, but leverage applied to convoluted derivative and structured bets needs to be dampened.

In the end, policy, both monetary and macroprudential, is in a bugger’s muddle in my view. At some stage in the next two to three years it will end with another crisis and a recession. Only when the excessive risk taking in the financial sector and overleverage of the personal sector is addressed, will there be a solid recovery. To be optimistic, the next down turn will provide some great buying opportunities in the equity market, but we need to see a level of capitulation and revulsion that was not evident in the last crisis.