Written by Jim Welsh
Macro Tides Report for February 2016
The Impact of Lending Standards on Monetary Policy
There are two components to the availability and cost of credit. The easiest way to visualize the process is to consider the Federal Reserve as the spigot and the banking system as the nozzle at the end of the liquidity hose.
The Federal Reserve is the primary component since it determines the amount of credit flowing into the banking system and financial system, and puts a floor under the cost of credit through the level of the federal funds rate. Although the Fed has ended its quantitative easing programs, the size of the Fed’s balance sheet is not shrinking since it continues to roll over any Treasury bond that matures with a new purchase. In December the Fed increased the federal funds rate by .25%, and it has averaged about .37% since that action. This bold move followed seven years of holding the federal funds rate at .12%. Referring to the Fed’s decision to increase the funds rate as tightening seems a bit hysterical, and calling it the first step toward normalizing interest rates is an exaggeration since the second step may not be taken for many months or not at all in 2016. The second component affecting the availability and cost of credit is the banking system. Banks open the nozzle wider when they loosen lending standards, and narrow the flow of credit when they raise lending standards. They also affect the cost of credit by either increasing or decreasing the spread between their cost of funds and the rate at which they make a loan to corporations or consumers.
While the role of the banking system is secondary to the Federal Reserve, it is still important. One of the best ways to monitor how banks are affecting the availability of credit is through lending standards. As banks increase lending standards they are effectively tightening monetary policy. When banks increase the spread between their cost of funds and the rate they charge for a loan, they are increasing the cost of credit. In other words, banks can increase or lower the availability and cost of credit, irrespective of what the Fed is doing through monetary policy.
Each quarter the Federal Reserve conducts the Senior Loan Survey of Lending Practices, and reports whether banks are lowering or tightening lending standards, changing the spread between banks cost of money and loan rates, and the level of demand for credit. The January 2016 survey revealed that more banks are raising lending standards and the spread on the loans they make, and that the demand for loans from companies is falling. These are not positive portents for the U.S. economy. In early 2007 banks began to increase lending standards which I thought was significant. Here’s an excerpt from the March 26, 2007 issue of Macro Tides,
“An intense debate is raging on whether the woes in the sub-prime mortgage market will spread to other areas of mortgage lending. As far as I’m concerned, it already has spread in one important way – lending standards. In January 2007, the Federal Reserve’s quarterly lending survey found that more institutions had increased lending standards more than at any time since 1991. Let’s think about what that means in the real world. Even though the Fed has kept rates unchanged for months, monetary policy has been effectively tightened by many lending institutions. Lending standards are not just being raised for sub-prime borrowers, but for borrowers across the board. Higher lending standards will curb demand, even as foreclosures increase. It is hard to believe that less demand and more supply will not depress home values more than we’ve already seen. When the Fed does lower rates, the higher lending standards will still be maintained for some extended time. If the economy warrants Fed easing, mortgage payment delinquencies and foreclosures will be rising. That is not an environment conducive to lowering lending standards, and lending institutions won’t. This means the drag on the economy from tighter lending standards will continue even after the Fed lowers rates. Since delinquency rates and foreclosure rates will continue to increase for sub-prime mortgages in coming months, accompanied by a rise in non sub-prime mortgages too, the level of risk for the markets and the economy from this problem will also increase. To put it simply, it is way too early to think the worst is already behind us.”
I do not expect a replay of 2007 when banks aggressively increased lending standards. The balance sheets of large banks in the U.S. are stronger, and their exposure to the debacle in the energy patch is much smaller and far less leveraged than the exposure to housing in 2007. I haven’t thought the U.S. was likely to enter a recession in the first half of 2016, nor have I thought that growth was likely to accelerate from the 2.4% or so it has average since 2012. As of February 16, the Federal Reserve of Atlanta’s GDP Now forecast for the first quarter is for GDP to grow 2.6%. This has reassured equity investors that the U.S. economy is not slipping into a recession, after growth slowed to just .7% in the fourth quarter. The increase in lending standards in the October 2015 and January 2016 surveys suggest that growth may slow in the second quarter. If growth does moderate, the Fed will be reluctant to raise rates again, until they are more certain that growth will remain healthy in the second half of 2016. If the economy leads the Fed not to raise rates, it may also be conducive for banks to increase lending standards further in coming quarters.
Panel 1 in the Survey Table below shows how lending standards tightened in 2007 (rising above 0 in red) for large, medium, and small firms until they began to fall in the first quarter of 2010 for large and medium firms (below 0 in green), and in the third quarter for small firms. It is not a coincidence that the trough in employment occurred in the first quarter of 2010. Panel 2 reflects the change in the spread between banks cost of funds and what they charge to lend money. In the fourth quarter of 2007, banks ramped up the spread to insulate their balance sheets from the higher risk of defaults as the economy slowed. In the second and third quarter of 2010, banks reduced the spread reflecting their confidence that the economy was improving. Panel 3 quantifies the demand for loans from large, medium, and small firms. In the second quarter of 2007, demand for loans plunged (below 0 in red) and remained negative through 2010. As confidence strengthened, businesses were again willing to borrow money to finance growth. Other than a dip in the fourth quarter of 2011, due to the European sovereign debt crisis and the 19% decline in the U.S.stock market in the third quarter, the pick-up in loan demand in the first quarter of 2011 remained positive through the end of 2015.
The reversals in lending standards, loan spreads, and demand for credit is not just due to the collapse in the energy sector, and is a warning that the U.S. economy is susceptible to a slowdown in coming months.
In January the unemployment U-3 rate fell to 4.9%, despite a slowdown in job growth to 151,000 jobs. The average monthly gain in jobs during 2015 was 228,000, and the annual rate of change in job growth has been slowing since August. The U-6 underemployment rate was 9.9%, so the spread between the U-3 rate and the U-6 rate was 5.0% (spread between the blue and green line in the Out of Work chart below), which indicates that there is still a fair amount of slack in the labor market. As I discussed in detail in the March 2015 Macro Strategy Review, the average monthly spread between the U3 and U6 unemployment rates was 3.85% from January 1994 and August 2008 based on data from the Bureau of Labor Statistics. The average annual gain in monthly wages from January 1994 through August 2008, using data from the Federal Reserve Bank of St. Louis, was 3.32%. I found that when the U-3 – U-6 spread was less than 3.85%, average monthly wages grew faster than 3.32%. This indicated that when the U3-U6 spread was below 3.85%, the labor market was tight enough to cause wages to rise faster than their longer term average. Conversely, when the U3-U6 spread was above 3.85%, wage growth was less than the long term average of 3.32%. Based on this research my conclusion in March 2015, was that wage growth was not likely to accelerate in coming months from the 2.2% it had averaged since 2010.
That analysis proved prescient, since wage growth remained mired at the 2.2% level until December and January when it rose to 2.5%. Fourteen states enacted an increase in their minimum wage rate in January so a small portion of the increase in January may be attributed to this one-time event. While the improvement in wage growth is certainly welcome, the U3-U6 spread of 5.0% suggests that it will be a slow slog before wage growth even returns in coming months to its longer term average of 3.32%.
The slowing in monthly job growth since August may be a harbinger of weaker job and income growth. Federal income and employment tax withholdings provide a timely and insightful view of coming changes in the labor market. A combination of job growth and wage gains supported a rise of more than 5% in tax withholdings through August. By the start of 2016 the annual rate of change had slowed to 4%, and dropped to 3.1% by the end of January. In 2007, year over year gains in withholding taxes began to weaken in October, three months before actual job losses were announced in January 2008. According to Christmas, Gray, and Challenger announced layoffs surged to 75,114 in January, an increase of 42% from January 2015. I don’t think the labor market is going to deteriorate as much as it did in early 2008, but collectively these statistics suggest job growth is likely to slow far more in coming months than most investors are expecting.
Based on the increase in lending standards, spreading weakness in the industrial sector due to the collapse in energy business investment and export growth due to the strength in the dollar, softening in the labor market, and the slowdown in the global economy, which is likely to get worse before it gets better, the U.S. economy is poised to slow in the second quarter. If I’m right, fears that the U.S. may slip into a recession will revive in coming months and lead to another decline in the stock market.
Global Economy Losing Steam as Trade Growth Contracts
Although exports only represent 13% of U.S. GDP, they have been a contributor to overall growth in the U.S. and global economy for decades. The only time exports have experienced an extended period of contraction in the U.S. during the past 40 years has been during periods of recession with one exception. Exports fell during the mid 1980’s due to the strength in the dollar and recovered after the Plaza accord in February 1985 paved the way for the dollar index to decline significantly against the currencies of our major trading partners. From its peak of 165 in February 1985, the dollar index plummeted to below 85 by the fall of 1987 and was one of the contributors to the stock market crash in October 1987. Exports fell modestly during 2001 and 2002 as the U.S. experienced a mild recession and plunged in the wake of the financial crisis in 2009 before strongly rebounding. U.S. exports continued to make new highs until the fourth quarter of 2014 but have slipped noticeably over the last 16 months due to the 25% rally in the dollar since May 2014. The weakness in export growth is not just limited to the U.S. but has gone global which is not good.
In January, China’s exports fell -11.2% from January 2015, after dropping -1.4% in December. Chinese export growth has been falling since 2010 when it grew by more than 40%. But for an economy that has been dependent on export growth to fuel domestic GDP, the down trend in exports is a negative. The weakness in exports isn’t limited to the U.S. and China, but has spread to other countries that are notably dependent on export growth. Singapore’s non-oil domestic exports fell -9.9% from a year earlier, as shipments to China, its largest trading partner, contracted at a faster pace. South Korea, which sends a quarter of its exports to China, reported that exports fell -18.8% from a year ago, the largest decline since August 2009. Exports in Indonesia contracted -20.7% in January from a year ago, while India’s exports fell in January for the 14th straight month and were -13.6% below year ago levels. These figures underscore the decline in global trade and the slowdown in China’s economy, which is why its trading partners are experiencing such a falloff in exports.
The container shipping industry serves as a bellwether for the health of the global economy, since 95% of the world’s manufactured goods are transported by shipping containers. The Danish conglomerate A.P. Moeller-Maersk is the world’s largest shipping firm. On February 10, it reported a $2.5 billion loss, and warned that the shipping industry wouldn’t improve in the first half of 2016 due slower growth in China and the industry’s overcapacity, which is estimated to be 30%. These factors have caused shipping rates to plummet to $431 per container on the Asia-to-Europe trade route from the $1,000 needed to break even. Maersk expected container demand to grow by 3% to 4% in 2015, but instead growth was only 1%. In 2016 Maersk has forecast growth to be 1% to 3%, which will not do much to solve the overcapacity problem plaguing the industry. Maersk has the strength to weather the storm, but there will be other firms that will not, and the bank loans and debt used to finance the glut of ships will not be repaid.
S&P Dow Jones Indices estimates that U.S. information technology companies generated 59% of their sales overseas in 2014, which is the latest data available. That compares to 48% for the companies in the broader S&P 500 index. Since September 2014, the Russian ruble has fallen more than 50%, the Brazilian real by almost 45%, while the Canadian and Australian dollars, Mexican peso and Turkish lira have lost more than 20% of their value versus the dollar. The strength in the dollar has been compounded by a weakening in each of these economies, with Russia and Brazil in deep recessions. The net result is many technology firms have experienced a significant loss of revenue, which has also negatively impacted earnings. Market researcher Gartner Inc. estimated that the increase in the value of the dollar took $217 billion from global information technology spending in 2015, which was more than what was lost to the financial crisis in 2009.
The basis for world trade is measured in dollars, so global GDP fell from $77.3 trillion in 2014 to $73.5 trillion in 2015, a decline of nearly 5% due to the strength in the dollar. This occurs since a decline in the Euro or any currency relative to the dollar reduces the value of domestic GDP by the amount a country’s currency lost versus the dollar. To counteract the currency impact, the IMF uses a formula involving purchasing power parity, which adjusts for the relative value of currencies. According to the IMF, global GDP grew 3.1% in 2015. The World Bank estimates that global GDP grew 2.4% in 2015, since it uses a different methodology than the IMF. No matter how it is calculated, global growth was the weakest in 2015 in years.
According to the International Monetary Fund, the Chinese economy was responsible for roughly one-third of world growth over the past seven years. Since last August when China took the first step in devaluing its currency, global investors have learned that what happens in China doesn’t stay in China. Much of the economic growth since 2007 was financed by a surge of debt, as China’s total debt rose from $7.4 trillion to $28.2 trillion as of June 30, 2015. Despite robust economic growth, China’s debt-to-GDP ratio has soared to 282% as of June 2015 from 158%. The fundamental problem facing policy makers in China is that debt continues to grow faster than GDP. Each new dollar (Yuan) of debt is generating less economic growth, so the debt burden is continuing to increase, which is unsustainable longer term.
To relieve some of the burden of servicing all that debt, the People’s Bank of China has cut interest rates, but falling producers prices has negated much of the potential benefit for manufacturers. In January, the producer price index was -5.3% below year ago levels and that was an improvement from December and November when prices YOY were down -.5.9%. Although the weighted average lending rate has dropped from 6.78% in the fourth quarter of 2014 to 5.27% in 2015, the real rate is above 11% after adjusting for declining producer prices.
In the June 2013 Macro Strategy Review, I wrote:
“At some point (perhaps 2014 or 2015) China could prove vulnerable to large capital outflows that undermines its growth story, creates liquidity problems for China’s state-run banking system, and potentially deflates the credit bubble that has been expanding in China since 2008.”
Since mid-2014, China’s foreign-exchange reserves have fallen from $4 trillion to $3.23 trillion at the end of January 2016, despite China’s efforts to stem the outflow of capital. As money leaves China, the Yuan (renminbi) is sold and converted into other currencies. The sale of the Yuan puts downward pressure on the Yuan’s value. To protect themselves from the additional loss of purchasing power from the lower value of the Yuan, wealthy Chinese investors have in recent months accelerated their selling of the Yuan and moving money out of China. In order to support the Yuan’s value, the Peoples Bank of China (PBOC) buys Yuan. However, the PBOC’s Yuan purchases represent a tightening of monetary policy which is the last thing the PBOC desires. This increases pressure on the PBOC to allow the Yuan to depreciate further. The PBOC is in a tough position. If the outflows continue, China may have to consider capital controls, so capital can’t leave the country, or consider a larger devaluation of the Yuan.
According to the International Monetary Fund, an economy the size of China needs $2.7 trillion of foreign reserves, or $1.5 trillion with strict capital controls. I think the PBOC would prefer to avoid strict capital controls and will attempt to manage the situation without taking that action. That said, if China’s foreign reserves continue their downward march, they may be forced to act. A devaluation of the Yuan or the enactment of capital controls would likely prove unsettling for financial markets.
As I have discussed in prior commentaries, emerging market dollar denominated debt has soared from $6 trillion to $9.6 trillion in the past five years. Since May 2014, many EM currencies have lost more than 20% of their value, which increases the burden of dollar denominated debt. This is why the Trade Weighted dollar index, which has a 59.6% weighting to emerging economies, is more relevant than the dollar index, which has no exposure to emerging economies.
Since March 13, 2015, the Trade Weighted dollar index has gained 4.9% through February 19, so the burden of dollar denominated debt has increased over the past year. As companies struggle to service dollar denominated debt, they are less likely to increase spending and hire new workers, which will continue to weigh on growth in many EM countries in coming months. Absent a meaningful pick-up in EM growth, the risk of defaults and banking loan losses from emerging market debt is increasing, since banks have increased their lending to emerging markets from $1 trillion to $3 trillion in the past five years.
The dollar index peaked at 100.31 on March 13, 2015 and is trading near 97.50 on February 24, so it down -2.7%. The primary reason the dollar index has been trending sideways for most of the past year is because the Euro has been stable, and it comprises 57.6% of the dollar index. Since the dollar index is the most widely quoted and followed, most strategists and investors are oblivious to the mounting pressure on EM dollar-denominated debt. Since the dollar index has not rallied as many strategists expected after the Fed increased the federal funds rate in December, they have concluded that the dollar index has topped. A number of prominent strategists have noted that the annual rate of change in the dollar index has dropped from its peak last March to less than 0% now, so the headwind from dollar strength has abated and will be supportive of improved growth going forward.
While it’s factually true that the annual rate of change has fallen below 0%, this ‘fact’ is meaningless in the real world for U.S. companies selling products in the European Union. Since May 2014, the dollar is still almost 20% higher versus the Euro. When a U.S. sales person tries to sell their products to an EU based customer, they can tout all the great features of their product, but the annual rate of change in the dollar index is not one of them. At the end of the day, the EU customer will point out that the U.S. products still cost 15% to 20% more than the comparable EU products. Unless the U.S. sales person is willing to cut prices, there are going to be fewer sales due to the strength in the dollar. This reality is being repeated in many countries whose currency has lost value versus the dollar, and was confirmed by numerous U.S. companies that reported how much the dollar had depressed their sales in the fourth quarter (Chart pg. 5).
(Chart February 9, 2007 – February 24, 2016)
Based on the longer term chart of the dollar index, I do not think the dollar has topped. Since the low in March 2008, the pattern in the dollar suggests that the dollar has completed wave (1) up in November 2008, a corrective wave (2) in April 2011, and since May 2014, has been moving higher in wave (3). Wave (3) has been subdividing and appears to have completed wave 1 in July 2012, wave 2 at the low in October 2013, with the high in March 2015 representing wave 3 of (3). Since that high, the dollar has been chopping sideways in wave 4. Once wave 4 is complete, the dollar index should rally to a higher high above last March, and potentially run to 103.00 to 106.00 in wave 5 of (3). My guess is that wave 5 in the dollar index will pressure stocks, emerging markets, and commodities, while suppoting Treasury bond prices.
Gold and Gold Stocks
I recommended buying the gold ETF (GLD) and the gold stock ETF (GDX) on December 30 and during February recommended selling into strength. In the Gold Update on February 5 I said,
“Sometime in 2016, GDX has the potential to trade above $20.00, so let that be a guide in terms of how aggressive you want to trade.”
Based on the instructions provided in that Update, 75% of GLD was sold on Friday February 5 at $110.70 or better, since it continued to rally after my email was sent and closed at $112.32. In the February 8 Gold Update, I recommended selling the remaining 25% at $114.60. The net gain on these GLD trades was 10.0%. Based on the instructions provided in the Updates, 25% of GDX was sold at $14.98, 25% at $16.05, and another 25% on Friday February 5 at $16.35 or better, since it continued to rally after my email was sent and closed at $17.05. The remaining 25% was sold at $17.80. The net gain on these GDX trades was 18.7%.
Needless to say, gold and the gold stocks have rallied more than I expected, and have gained in the last 3 weeks what I thought might take months! Today, February 24, GDX traded as high as $19.85 and GLD reached $119.86, before pulling back. Gold traded up to $1,263.90 on February 11, and it is likely to exceed this price level before a more meaningful correction develops. In the short term, gold may drop below the low of $1,191.50 on February 16, before the rally to a new high commences.
The strength exhibited by gold and the gold stocks strongly suggests that the bear market from the highs in September 2011 is over. The recent rally represents the first leg of a new bull market, which either ended at $1,263.90 or will if one more high is posted. Whatever high gold posts, a correction of 50% or more of the rally from the low of $1,046 is probable, before the next phase of the new bull market in gold and gold stocks kicks into gear. In other words, gold and gold stocks may endure a period of months correcting the recent large rally. If the dollar index does rally to a new high in coming months, it would likely pressure gold, especially after such a huge rally.
As noted in last month’s commentary, the imbalance between supply and demand has not improved and is likely to worsen in coming months. Iran is bringing more oil to a market that has been suffering from a glut of oil for 18 months. The average daily surplus during 2015 was in excess of 1.8 million barrels. Oil refineries will shut down for maintenance in preparation for the summer driving season, which could reduce demand for oil by 500,000 to 1 million barrels a day into early April. In late January oil tested $36.00 a barrel before dropping to a new low on February 11, before reversing higher after a report said the UAE oil minister said that OPEC was willing to talk about production levels. It is no coincidence that the S&P made its low also on February 11. Oil appears to have the potential to run up to the $36.00 a barrel level to complete the rally that began on January 20. I do not believe Saudi Arabia has any interest in cutting oil production. If correct, oil is likely to drop below the lows of January and February.
In the February 8 Weekly Technical Review, I thought there was a good chance the S&P 500 would dip below 1812 in coming days. The S&P did dip below 1812 on February 11 when it bottomed at 1810, before reversing sharply on a report that an oil minister from the United Arab Emirates said UAE was willing to discuss a reduction in oil production. In the February 11 Weekly Technical Review I said:
“Although sentiment is bearish enough to spark a rally back to 1934 – 1950, the problems facing the global economy suggest a decline below 1800 is likely after any short term bounce.”
The S&P proceeded to rally from the low on February 11 to a high of 1946 on February 22, just shy of the 1947 high on February 1. As I discussed in the February 16 Weekly Technical Review, the 50% retracement of the decline from 2116 on November 3 to 1810 on February 11 is 1963, so the odds favor the S&P pushing above the high of 1947 during this rally. Sentiment is also supportive of the current rally lasting longer, since investors have not jumped on the band wagon, as they did after the January 20 low.
The Major Trend Indicator indicated on January 6, that a bear market had become more likely with the S&P closing below 1993 at 1990. The bear market was confirmed on January 14. The 100% short position established on January 6 was pared to 50% on February 8, when the S&P closed at 1853. This portion of the short trade gained 6.8%. This morning, February 24, I reduced the short position in the S&P to 25%, when the S&P was trading under 1895. This portion of the short trade gained 4.7% from 1990 on January 6. The gain on the 75% of the closed short position is 4.59%.
The Major Trend Indicator is close to generating a bear market rally buy signal, which I will discuss in greater detail in the next Weekly Technical Review. I continue to believe that after this bear market rally ends, the S&P is likely to fall below 1800 and decline to at least 1600 in coming months.