Previous articles have summarized the challenges of global imbalances for investors in Europe and in the BIC (China, India and Brazil) economies. Those two articles can be reviewed for a summary of the imbalances. Herein we will turn to the current situation for U.S. investors.
Household Debt, Wages and Employment
Between 1985 and 2008, household debt as a percent of disposable personal income more than doubled, rising from 62% to 135%. At the end of 2010, the ratio was 120%, still well above the 89% it averaged in the 1990‟s. The average household would need to cut $26,172 of debt to get back to 1990‟s levels. More than half of the $500 billion decline in household debt since 2008 has been the result of defaults on mortgages, credit cards, and auto loans. This “improvement” has come at the expense of lenders, rather than from consumers paying off debt from income gains. It would have been far healthier if the ratio was declining due to solid gains in disposable income. Unfortunately, just the opposite has occurred.
According to the Commerce Department, real private sector wages have increased just 4.2% over the past ten years. This compares to the record of the past 35 years, the 10-year gain in real wages has averaged more than 25%. This is the first recovery since World War II that there has been no gain in wages and salaries during the seven quarters after a recession’s end.
According to the Federal Reserve, homeowners took out a total of $2.69 trillion of equity in their homes between 2004 and 2006. Coupled with the weak growth in incomes since 2001, this extraction of home equity is the primary reason why household debt as a percent of disposable income soared between 2002 and 2007. As consumers spent most of the $2.69 trillion of equity they pulled out of their homes, GDP growth was stronger in those years than it otherwise would have been. Going forward, the debt induced growth in GDP during the housing bubble years will not only be missing, but now consumers have to service and pay down that debt, which will prove an additional drag on their spending and GDP growth.
Over the last year, average weekly wages have increased 2.4%. However, the overall consumer price index has risen 3.6%, so real after inflation wages actually dropped -1.2%. In order for the ratio of household debt to disposable income to decline from its current level of 120% to the 89% it averaged in the 1990’s, disposable income must grow by 33%, debt levels must be reduced by 25%, or a combination of both must take place. Given the sorry state of income growth during the last decade and past year, this imbalance is going to take many years to correct. Once debt has been pared, the next long term economic expansion that can last for a decade or longer will take hold. Of course, an increase in defaults would speed up the process, but at the expense of more impairment to bank balance sheets. That would likely force the banks to be even more careful and tight fisted with their lending, and potentially require the banks to beef up their capital.
In May, only 54,000 private sector jobs were added, and the unemployment rate ticked up to 9.1%. Every month we have highlighted how weak job creation has been in this recovery, when compared to every other post World War II recovery.
Half of the private sector workers in the United States are employed by small businesses, and more than 60% of all new jobs are created by small businesses. For the first time since last September, more small businesses planned to shrink their work force than increase it. This suggests job growth will remain muted in coming months. However, the meager gain in jobs during May likely overstated how weak the labor market really is, just as the three prior months, which averaged more than 200,000 new jobs, overstated its strength. Our guess is that job growth will bounce back to over 120,000 in coming months. This should provide some comfort to those worried about an immediate double dip in the economy.
According to the Case-Shiller Home Price Index, home prices are off 31.6% from the 2006 peak, and down 3.5% from a year ago. In 2006, home owner equity was 57% of the median homes value. It is now down to 38%, as of March 31. In April, 37% of all sales were distressed sales, according to the National Association of Realtors. Zillow.com estimated that at the end of the first quarter, 28.4% of home owners with mortgages were underwater. Future demand will be far weaker, with so many homeowners effectively trapped in their home. Although housing activity will pick up during the summer, we continue to expect home prices to fall further in most areas of the country.
Home-equity loans account for 10% of the mortgage market. According to CoreLogic, 38% of homeowners, who withdrew home equity via a home-equity loan, are underwater. CoreLogic also found that borrowers with a home-equity loan averaged $83,000 of negative equity, versus $52,000 for those with no second mortgage. According to the Federal Reserve, nearly 75% of the $950 billion in home equity loans were held by commercial banks. More than 40% of the total is held by Wells Fargo, Bank of America, JP Morgan, and Chase. If home prices fall as we expect, one or more of these banks will eventually be forced to increase their loan loss reserves.
According to LPS Applied Analytics, 4.2 million homeowners are either seriously delinquent, or in the foreclosure pipeline. Incredibly, two-thirds have made no payments for at least a year, and 30% have gone for more than two years. As these 4.2 million homes are dumped on the market during the next two years, home prices are likely to weaken further, which will increase the number of existing homeowners that are underwater going forward. This is a vicious cycle that will take another one to two years to work through.
We continue to believe economic growth will not rebound as smartly in the second half, as the majority of economists and strategists are forecasting. Yes, Japan will bounce back, but there are far greater forces at work, and imbalances that must be addressed which will keep growth near 2.0%, and well below the historical average well into 2012.
We continue to believe that the yield on the 10-year Treasury bond will remain range bound between 2.6% and 3.65%. With the yield currently resting near 3.0%, it is in the middle of the range.
If the economy grows as slowly as we expect in the second half, and the risk of a European debt crisis remains visible on the horizon, there is no compelling reason to sell Treasury bonds. In addition, there is a possibility that Congress may make meaningful progress on paring the multi-trillion dollar deficit forecast for the next 10 years. We were heartened that AARP last week softened its stance on Social Security, and will at least be open to modest changes. In the past, they have been steadfast in their opposition to any changes in benefits or increase in the retirement age. If we are to make any serious headway on true deficit reduction, this is the type of compromise all parties involved must make, including tax increases. Dogmatic adherence to ideology has played a significant role in the lack of progress on most of the important issues facing America for far too long. In the past, most threats to our country came from forces outside our borders, so it was far easier to rally public support. We created the current fiscal crisis ourselves. The solutions will require sacrifices by the majority of Americans, with some bearing more of the brunt than others. That won’t be “fair”, and for some, it will be a divisive issue. WE must overcome every issue that divides US.
There are a number of reasons why the dollar has either made a significant low, or will soon. Sentiment towards the Dollar remains uniformly negative, which has resulted in a huge short position against the Dollar. The brewing sovereign debt crisis in Europe will eventually make the dollar look like the least ugly girl at the dance. If real progress is made on deficit reduction, it will surprise almost everyone (including us). It will also help to make the U.S. look like less of a basket case, when compared to Europe, and certainly Japan. Any spark that results in Dollar buying will ignite a sharp short covering rally. Technically, the Dollar appears to be “turning the corner”, as downside momentum wanes. Last month we recommended buying the Dollar ETF UUP at $21.56. Hold the position.
Strangely, it would be more bearish for gold to make a new high above $1,578.00, than if it declined from current levels. Here’s why. A new high in Gold would not be confirmed by a new high in silver, and the gold stocks. Gold is less than 2% from a new high, but silver is more than 25% below its prior peak, and the gold stocks, as measured by HUI and the XAU, are 14.4% and 13.9% off their respective peaks. It appears that Gold may be finishing a diagonal fifth wave, if it pushes to a new high. Aggressive traders can establish a small short position at $1,550, and add if gold climbs to $1,587.00. If Gold does make a new high, we may send out a special update.
In our June 12 Special Update, we suggested that the S&P was within 1% to 2% of a trading low. We noted that various measures of sentiment had very quickly shifted from extreme optimism in early April, to a far more cautious attitude toward the market. The market was also fairly oversold, and the S&P was just above the 200 day simple and exponential moving averages. Since the close of 1270.98 on June 10, the S&P has traded down to 1258.07, and up to 1298.61. We expect the choppy trading will continue for a while. The market sold off today, after the Federal Reserve lowered its estimate for 2011 GDP growth to 2.7% – 2.9% from April’s estimate of 3.1% – 3.3%. We have been expecting the economy to slow, so this change was not a surprise. However, most economists have forecast that the economy will rebound in the second half, so the Fed’s downgrade was a dampener. We think the odds favor another run in the market to above the April high at 1,370. For this to happen, these are the fundamental factors that must fall into place. Greece must receive additional funding in a way that does not trigger a default, according to the rating agencies. All bets are off, if Greece is deemed in default. It is unlikely Greece will ever be able to repay the loans it has already received, and providing Greece with more money is simply throwing good money after bad. But, human nature being what it is, (as best exemplified by politicians), Greece will get more funding. Hoping everything will work out is easier than dealing with another crisis in the short run. It would also be helpful if the June employment report shows that more than 120,000 jobs were created, when it is announced on July 1. (The jobs report is normally announced on the first Friday of the month.) This would allay fears that a double dip is right around the corner. In the June 12 Update, we recommended taking a half position in the S&P 500 ETF SPY, which opened at $127.89 on June 13. For now, keep the stop at 1,230 on the S&P, which should translate to roughly $123.00 on SPY. We will send out a Special Update when it’s time to add to this position. The market conveniently bounced off the S&P’s 200 day averages, maybe too conveniently. A quick sharp drop below these averages may be necessary, before a sustainable advance takes hold.
BIC Problems for Investors by MacroTides
Europe in Trouble by MacroTides
The Week Ahead: Another Bernanke Press Conference by Jeff Miller
Comparing World Markets by Doug Short
Stock market Cycle Analysis by Erik McCurdy
Why the $VIX Isn’t Surging by Albertarocks
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at [email protected].