What is Different this Time?

Rob Parenteau, CFA, is sole propreitor of MacroStrategy Edge, editor of the Richebacher Letter, and a research assistant with the Levy Institute of Economics

Retail sales remained fairly stable from January through May in dollar level terms. That is generally not what a debt deflation looks like, nor is it what a recovery looks like. A recovery requires rising retail sales, not stagnant retail sales. We suspect the fiscal stimulus is just offsetting the deflationary pressures that were unleashed in the second half of last year. Two offsetting waves are crashing into each other and perhaps canceling each other out, leaving nominal retail sales stagnant at 2005 levels. Stagnant sales can indeed stick around for months on end, as this was the case in the last recession from Q1 2000 into Q3 2001. However, this time around, the fiscal impulse is larger, but so too is the damage to household balance sheets. Not an easy situation to evaluate, but we believe equity investors need to see something better than stable retail sales if they are to take equity indexes appreciably higher.

Q1 2009 Flow of Funds results show the housing sector ran a financial surplus or net saving position of $341b in the past quarter, while paying down $155b in household debt. Monthly consumer installment credit points to the same household sector deleveraging with credit cards and non-revolving loans. We believe professional investors may be underestimating the importance of household sector deleveraging this time around. We have never seen households retire debt like this, now in three of the past four quarters, over more than a half century of results reported in the Flow of Funds accounts.

Household debt can only be reduced by three actions. Households can default on debt, and the debt is written off. Households can sell assets to another sector, and use the proceeds to pay off debt. Or households can save money by spending less than their income flows, and use the saving to retire debt. The rise in household net saving suggests the third method is playing a key role in household debt deleveraging, and this has import implications for the profile of any prospective consumer spending recovery, even one backed by massive fiscal stimulus. We suspect working from the usual business cycle playbook will not be especially rewarding in such an environment.

Furthermore, if banks are sitting on excess reserves, are perceived to now have sufficient capital, and are reporting an increased willingness to lend (which makes sense given the slope of the yield curve and the associated net interest margins), while consumers are intent on net paying down debt, then banks may need to consider a new business model. Loan volumes to households are going nowhere. Alternatively, they can ride the yield curve like they did in 1991-3, but here they will need to buy and hold longer dated Treasuries if they wish to avoid capital losses as Treasury bond yields back up.

Nevertheless, ETF’s on consumer discretionary stocks are up over 50% since the March 6th lows, and the ETF on banks are up over 100%. What do equity investors know that we may be missing?

Our beef with the equity market boils down to this: the widespread perception is that the old global growth model, dependent in no small part on the willingness of US consumers (and other consumers in the developed world) to deepen their deficit spending, can and will be revived. We would merely suggest with the level of household net worth to disposable income back to a level last seen in 1995 (before household deficit spending began), and with households extinguishing debt for the first time in over half a century, this assumption deserves to be questioned. Humpty Dumpty may not be able to be put together again.

Treasury results this week reported a trailing 12 month federal government fiscal deficit of over $1.1tr, well on track to break the CBO $1.8tr forecast by September end. The reality is that without some other sector increasing its deficit spending or reducing its net saving, attempts by some domestic firms and households to save out of their money income flows will simply show up as income shortfalls, and hence unexpected dissaving, by other domestic private firms and households. Call it the tyranny of double entry book keeping.

If the trade deficit is done shrinking (which means foreign net saving is done shrinking) as appears to be the case over the past three months, then the domestic private sector can only increase its net saving if the fiscal deficit increases. Without net saving, the domestic private sector will find it difficult to deleverage without dumping assets or defaulting on even more debt, which begs the Fisher debt deflation dynamics that have been discussed on this blog previously. Few but the Austrian School want to go there, and for good reason: debt deflations introduce instabilities and dislocations that most democracies cannot handle. These conclusions about financial balance flows from simple accounting, not high theory, yet they remain essential points that escapes many professional investors and economists. In a monetary production economy, one sector cannot net save unless another is prepared to deficit spend.

Just the same, even if fiscal deficit spending is the necessary counterpart to private net saving, and so a necessary condition for private sector deleveraging, we have noticed the percent of marketable privately held Treasury debt that comes due in a year or less has surged of late from just above 30% to nearly 45%. Short term debt was last this large a share of outstanding debt in the first Reagan administration.

We believe the dramatic shortening of the maturity privately held marketable federal government debt is very significant for two reasons. First, since the short end of the Treasury curve has been suppressed by the near ZIRP policy of the Fed, the net interest expense outlays on public debt have been suppressed. Since this is a line item on the expenditure side of the federal fiscal balance, Fed policy is also reducing the fiscal deficit from what it would otherwise be if the short end of the Treasury yield curve was closer to historically normal levels.

That means Chairman Bernanke may face more friction from the Administration than usual once he believes the time to lift the fed funds rate has arrived. That may be many quarters away, but questions about the Fed’s independence are already being raised, and would be inflamed by such a confrontation. It also means that if the short end of the Treasury yield curve starts to return to historical norms, interest expense will rise, and this will add to the fiscal deficit at the time. For deficit hawks, this introduces fears of compounding and a runaway public debt/income ratio.

However, it must not be forgotten that that the federal government’s interest expense must become somebody else’s income. The nuance under current conditions is with so much of the marketable federal debt held abroad, the creditors that benefit from bond coupon payments are less likely to be domestic households. With the Treasury issuing at the short end of the curve, and thereby minimizing current interest expense on the public debt, this is no big deal now, but what happens if interest rates return to historical norms?

Such a development not only suggests a larger current account deficit, as interest payments to foreign lenders reduce the trade balance, but it also takes a stream of income out of the range of federal government taxation, so a feedback loop that would otherwise reduce the budget deficit is thereby thwarted. To be clear, we are not fans of the “twin deficits” view since we find it neither holds true empirically nor theoretically, but this interest expense channel is one that could lead to spillover effects on the trade balance.

Looking at the unique aspects of this recession, we find the sharp reversal of household financial balances from a deep deficit position to a net saving position quite important. Households are reducing debt loads, in part with higher saving out of income flows, and this has implications for prospective bank loan volumes and sales revenue growth at consumer discretionary firms. Larger fiscal deficits are supporting the ability of households to net save, yet the shortening of maturity of Treasury debt issued, as well as the reaction of investors to a heavy calendar of issuance this year and beyond, is complicating matters. In addition, the shift of investors toward inflation hedges like oil is draining income from US households to foreign producers that tend to net save. We try not to be stubborn in our portfolio positioning – having learned the hard way that is a very expensive luxury – but we can think of two sectors that have led the US equity market charge, banks and consumer discretionary stocks, that can be questioned if we are correct that household deleveraging is unique to this business cycle recession and still matters.

The old saw on Wall Street is that it is never wise to conclude “this time, it is different”. Yet we believe it is in the early identification of the key differences, and in tracing out their implications, that macro analysis can add value to intelligent investors. Arbitraging the gap between reality and perception eventually tends to pay off – just make sure you can remain solvent as long as the thundering herd remains deluded!