Written by Jim Welsh
Macro Tides Monthly Report 10 April 2017
U.S. Economy Consumer confidence as measured by the Conference Board is at the highest level since 2000. The National Federation of Small Business Optimism Index hasn’t been this high since 2004. (Chart below courtesy of dshort.com, larger image after the page break.)
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The large rally in the stock market has likely been a contributing factor, but the prospect of less regulation has buoyed small business owners. The prospect of the government taking a little less out of their paycheck has made consumers feel better, but they haven’t started spending the expected increase in net pay yet. The increase in optimism is readily apparent in Bloomberg’s U.S. Economic Surprise Indicators. However, it also shows that hard data, based on current economic activity, hasn’t improved much. In the past, optimism has waned and declined back to reality, as it did in 2014 and likely repeated in 2017.
I expected economic growth to slow in the first quarter for a number of reasons. The Atlanta Federal Reserve’s GDP Now estimate for first quarter GDP is 0.6% as of April 7, down from 2.1% in the fourth quarter. In the December issue of Macro Tides I wrote,
“Investors will become impatient when they realize the economy is not going to benefit from Trump’s proposed changes until the second half of 2017 at the earliest, and the legislative progress isn’t as smooth as currently expected. If the economy slows a bit in the first quarter, investor’s impatience could become disappointment. It is going to take a number of quarters before individual and corporate tax rates, a reduction in the burden of excessive regulation, and infrastructure spending lift growth as much as expected.”
In the November issue of Macro Tides I reviewed the health of the auto sector. I noted that car sales financed by sub-prime auto loans were up 11% in 2015 and a stunning 124% since 2010, according to Equifax. According to Experian Automotive, leasing made up more than 32% of sales in 2016, up from 13.5% in June 2009. Since 2007 the average amount financed has risen 23%, but aggressive leasing deals and low interest rates have allowed the monthly paymnent to only increase by 6%. This helps explain why leasing has become so popular.
A glut of 3.1 million cars were expected to come off a leases in 2016, with another 3.5 million piling up in 2017. This was expected to weigh on used car prices and it has. In February used car prices were down 8% from a year ago and at the lowest level since 2010, according to the National Automobile Dealers Association (NADA) Used Car Guide.
To offset the pressure from used car prices, car manufacturers have increased incentives to more than 10% of the sticker price for a record 8 months in a row. As noted in the March issue of Macro Tides, car manufacturers increased incentives to a record $3,830 per vehicle in February, up 10% from February 2016. Despite the hefty sales incentives, sales have plunged from an annual rate of 18.7 million vehicles in December to 16.53 million in March.
As sales have slowed, inventory has built up on dealer’s lots and is now the highest since 2004. In a healthy sales environemnt car dealers will have an inventory level of 60 to 70 days. In March, GM had 98 days of inventory, while Ford had 80 days. For the industry as a whole, inventory day levels are the highest since July 2009.
I expected banks to increase lending standards since the delinquency rate for auto loans has been creeping higher since 2014 despite a growing economy. Other than auto and student loans, the delinquency rate for other forms of consumer credit have been falling since 2010. This has led banks to increase lending standards and lower auto lending. The combination of tighter lending standards and higher interest rates will increase the cost of leasing and auto financing in general and result in lower vehicle sales.
These factors will also weigh on buyers who still owe money on their existing car. In 2016, 32% of new car buyers owed on average $4,322 on their trade in. Banks and auto financing arms of the manufacturers have been willing to roll the unpaid balance into the loan for the new car. Anyone want to guess how long that game will continue? As I forecast last November,
“The coming slowdown in car manufacturing will turn what has been a positive growth sector into a modest drag on GDP growth in coming quarters.”
In March, ISM manufacturing production fell sharply in all likelihood due to less production in the automotive sector. Given the level of inventories in March, it will be hard for the car manufacturers not to cut production of sedans in coming months. While the ISM Manufacturing PMI gets all the headlines, a further decline in production will eventually spill over and cause the ISM Manufacturing PMI to weaken.
After the election, the majority of economists and strategists forecast that the yield on the 10-year Treasury bond would rise to at least 3.0% and probably higher. I didn’t agree with this assessment. As I have discussed in my Weekly Technical Review and March Macro Tides, I thought the yield on the 10- year Treasury Bond would fall from 2.6% to 2.3% and possibly as low as 2.2%. To date the yield has fallen from 2.62% to 2.33% which has helped keep mortgages from rising in recent months. There are other factors that are likely to be headwinds for housing.
Housing prices have been rising far faster than average hourly earnings since 2012. Although the gap between home prices and earnings doesn’t look quite as elevated as it was in 2006-2007, the ratio of median home prices to median income is actually more extreme now. In November 2007, the median home price was $249,100 and median income was $58,003, according to the Census Bureau. The ratio of median home prices to median income was 4.3 in November 2007. In February 2017, the median home price was $296,200, median income was $58,714, and the ratio was 5.0.
Housing prices will be vulnerable to another meaningful decline during the next recession, which will contribute to the next recession being deeper and less responsive to lower interest rates.
To fully appreciate how extreme the current level is one needs to view the relationship between median home prices and median income going back to the mid 1960’s. The following is an excerpt from my monthly analysis in the September 24, 2007 issue of The Financial Commentator. (name was changed from The Financial Commentator to Macro Tides in 2010)
“Between 1968 and 2000, the ratio of the median home price to median house hold income fluctuated in a narrow rage of 2.8 and 3.2. During this 32 year period, increases in home prices were supported by a rise in household income. This relationship provided underlying support for home prices, even when recessions developed in 1970, 1974, 1982, 1990, and 2001. However, between 2000 and 2006, the ratio rose from its long term average of 3.0 to 4.5. This means median home pirces have the potential to fall 33% should the ratio fall back to its long term average. If national median home prices sink by 20% in coming years, it would slash $4 trillion from homeowners wealth.”
According to Census Bureau data, median and average home prices fell -17.7% and -21.3% from their peak in 2007 to their trough in 2009.
The reason why the ratio of median home prices to median income was so stable between 1968 and 2000 was because banks wouldn’t approve a mortgage loan if the mortgage payment exceeded 33% of a borrower’s monthly income. The inverse of 1/3 is 3 to 1.
Between 2000 and 2007, lending standards were lowered to spur home ownership, as banks approved no-doc loans and no verification of income. The average FICO score for a mortgage was 721, but in the go-go years between 2004 and 2007 it was consistently lower. After the financial crisis, banks were forced to increase lending standards. Since 2008, the average FICO score for a mortgage has been 763. Only 20% of the population has a FICO score above 800, with 39% above 750.
Based on FICO scores, a little over 40% of the population can’t qualify for a mortgage. And as the ratio of median home prices to median income rises, more potential home buyers won’t have the necessary down payment. Until the over kill regulation imposed by Dodd-Frank is loosened, lending standards are not likely to be lowered.
Home prices have rebounded due to low inventories of homes for sale. The inventory of homes for sale has remained low, as underwater owners waited for the price of their home to recover. Ironically, the Federal Reserve’s low rate and quantitative easing purchases of mortgages have made it unattractive, and for some, unaffordable to move, since they would have to pay a higher mortgage rate than they currently have.
Since mid 2016 commercial banks have cut back on their residential real estate lending. By the end of 2016, the 13-week annualized change was actually negative. Housing’s contribution to GDP is 40% below the average between 1959 and 2016, which is another reason the current recovery has been only 60% as strong as the 10 prior post World War II recoveries.
Since the end of the third quarter last year, the annual increase in Commercial and Industiral loans by U.S. banks has retreated from over 8% to 3% in February. There is no way to know if the decline is due to companies postponing borrowing until the details of Trump’s corporate tax cut plans are finalized or something else.
Either way the fall off in lending is not a positive for economic growth in the near term. If lending improves after Congress passes legislation, we’ll know the weakness was due to companies waiting for the details before committing to an icnrease in investment. This is another reason why the Republicans need to get their act together.
In the February issue of Macro Tides I discussed the overall health of comercials real estate. As noted, the Federal Reserve’s January 2017 Senior Loan Officer Opinion Survey was released on February 7 and it contained valuable information about commercial real estate. Since the first quarter of 2016, banks have significantly tightened their lending standards for multi-family apartment buildings. In the fourth quarter of 2015, only 7.4% of banks had increased lending standards. Since mid-2016, more than 30% of large banks tightened standards every quarter, which means standards have been progressively raised.
Since the end of 2015, demand for multi-family loans has declined from an increase of 20.6% to a decline -7.2% in the January survey. The increase in lending standards by banks has likely been in response to an increase in the vacancy rate for apartments and falling rate of increase in rent growth. Upward pressure on the vacancy rate and downward pressure on rents is likely to increase in 2017.
According to Axiometrics Inc., 378,000 new apartments are expected to be completed across the country this year, which is 35% more than the 20 year average. The downward pressure on rent increases is likely to increase due to the new supply.
Commercial real estate volume fell by $58.3 billion in 2016, according to data firm Real Capital Analytics. The 11% decline was the first annual decrease since 2009. According to Reis Inc., 30 metropolitan areas experienced an increase in vacancy in 2016 versus 2015, as more retail stores closed. Total returns from commercial real estate rose 9.2% in the twelve months through September 30, 2016. The total return as of September 30, 2015 was 13.5%, so last year’s falloff was large and the lowest total return in six years.
The Green Street U.S. Commercial Property Index has been flat since mid-2016, after rising 107% from its March 2009 low. I don’t think it is a coincidence that the Green Street Index stalled just as banks got serious about tightening lending standards.
Based on cap rates, every sector of real estate is more overpriced today than it was in 2007. The Fed’s buying of Treasury bonds has certainly contributed to the ongoing search for yield and willingness to accept lower cap rates for REITs, Apartment Buildings, and Regional Malls. The rising tide of store closures will continue to pressure the valuation of shopping centers and Regional Malls, as more retail chains are Amazoned.
The economy has slowed from the third quarter’s GDP growth rate of 3.5% to 2.1% in the fourth quarter, and likely under 1.5% in the first quarter of 2017. Investors have been more than willing to overlook this information and have chosen instead to salivate over the prospect of better growth from tax cuts, reductions in regualtions, and a spurt of infrastrucfture spending. It appears that the timing and size of tax cuts will not be as large as financial markets priced in immediately after the election.
A review of the automotive sector, housing, commercial real estate, and bank lending suggests that an acceleration of growth is not likely at least through the second quarter. Whether investors will remain patient is the question. My guess is that the allure of tax cuts and reduction in regulatory burdens will keeep selling pressure muted and limit the downside in the stock market. Ironically, the stock market may be most vulnerable either just before or just after Congress passes tax reduction legislation.
China
China’s annual economic growth has been slowing since 2007, and their efforts to sustain growth has made China more vulnerable to a financial dislocation that could trigger the next global economic slowdown or crisis. In the last few years the Chinese government and People’s Bank of China have alternated between efforts to temper a real estate bubble, corporate debt bubble, housing bubbles, and widespread excess capacity in many basic industries, only to reverse course to restimulate growth through more debt, more government infrastructure spending, new waves of speculation in real estate, Chinese stocks, and a number of commodity markets. Underlying the swings in policy is a progressive deterioration in the soundness of the Chinese banking system and health of state owned enterprises.
Non-performing loans have risen sharply since 2013, but are likely far higher than Chinese regulators and banks are willing to recognize. The International Monetary Fund (IMF) estimates that the non-performing loan ratio is 15%, far higher than the “official” rate of 2%.
Banks net interest margin, the difference between what a bank pays for deposits and earns in interest from loans, has narrowed from 2.7% to 2.2% in December 2016. A smaller net interest margin squeezes a banks profit.
Since the end of 2016, the PBOC has tightened monetary policy, which has pushed short term funding costs from 2.7% in October to 4.2% in March. The PBOC’s effort is working as corporate bond issuance has slowed from a torrent in the third quarter to a trickle in early 2017.
Since 2009 Chinese corporations have been on a borrowing binge, so the PBOC’s action is prudent. However, a symptom of the growing fragility within the banking system was exposed when a number of small rural banks failed to repay short-term loans to other lenders. To prevent the defaults from evolving into a full blown credit crisis, the PBOC injected $43.6 billion into the financial system on March 22.
Much like U.S. banks prior to the financial crisis, Chinese banks have become more dependent on short term wholesale funding. Since 2013, banks have tripled their reliance on short term funding in 2016 to $4 trillion. As U.S. banks painfully learned in 2008, short term funding may provide access to cheap money, but when liquidity dries up a credit crisis soon follows.
Small and mid-sized banks have been issuing Negotiable Certificates of Deposits (NCD) since 2013, when they were introduced. Banks use the proceeds received from NCD’s to reinvest in higher yielding longer term corporate bonds and wealth management products.
Some banks are borrowing against the value of wealth management products so they can buy more wealth management products. This leveraging of money raised from NCD’s leaves banks vulnerable to an increase in short term rates. If short term borrowing rates exceed the yield of the corporate bonds purchased with NCD’s, banks lose money and could be forced to sell corporate bonds and wealth management products.
For banks leveraging their ownership of wealth management products, the losses and pain would be magnified. The issuance of NCD’s has grown from $89 billion to $1.65 trillion in 2016. In the first three months of 2017, banks raised $639 billion of NCD’s, up 65% from March 2016. The assessment of NCD’s by a senior analyst at China Merchants Bank sums it up well:
“NCD’s carry a lot of risk, and if not handled properly could lead to a system wide liquidty crisis.”
Corporate and household debt has soared $19 trillion since January 2009. With so much debt and widespread excess capacity, infrastructure sectors like steel, cement, aluminum, glass, and other basic industries are running at less than 70% of capacity. As a result, an increasing number of bankruptcies are occurring. In February, retail sales slowed to 9.5%, the slowest pace in eleven years.
As the Chinese economy continues to slow in coming years, the cash flow squeeze on over indebted corporations will translate to an increase of bad loans for banks and more bond defaults. S&P global estimates Chinese banks will need to raise $1.7 trillion to cover the coming surge in bad loans by 2020. Total credit in the Chinese banking system is 106%, up from 80% in 2013. For midsized banks it’s 130%. When the levee breaks, it will likely take more than $1.7 trillion to plug the leak.
Federal Reserve
As expected, the Fed raised the federal funds rate at the March 15 FOMC meeting, and immediately following the hike, investors shifted their focus to the June meeting for the next rate increase. As I wrote in the March 10 issue of Macro Tides,
“While this expectation is reasonable, there is a risk it may be questioned if GDP growth remains below 2% and the Republicans are unable to pass health care reform and tax cuts as quickly as expected. This could create a trading opportunity in the Treasury bond market and lead to a decline in yields.”
I forecast that first quarter GDP would slow from the fourth quarter and it now appears Q1 GDP is likely to come in closer to 1.0% than 2.0%, down from 2.1% in Q4. Republicans failed to pass health care reform, and the prospects for tax cuts have been pushed further into the future. As discussed for several weeks in my Weekly Technical Review, I thought the yield on the 10-year Treasury bond could fall from 2.6% to 2.3%. On Friday April 7, it traded down to 2.271% before rebounding.
As discussed earlier, the weakness in car sales will impact manufacturing negatively in coming months, and housing, apartment construction, and commercial real estate could soften more. If incoming economic data supports this analysis, Treasury bond yields could fall further as investors lower the odds of a June rate hike. The influence of the Freedom Caucus within the Republican Party will likely result in smaller individual and corporate tax cuts than investors expected following the election and could delay when legislation is actually passed beyond the Congressional August recess.
Inflation has rebounded from the lows in the first quarter of 2016, when oil bottomed below $30 a barrel. The year-over-year comparisons thus make it appear that inflation is more robust than it probably is. As the impact of the rebound in oil prices fades in coming months so will the upward pressure on inflation and its trajectory.
As discussed in the February issue of Macro Tides, apartment rent increases have already begun to trend lower and will continue to do so in coming months. This is important since Shelter is 42% of the Consumer Price Index and apartment rents are included within the Shelter category.
It must be noted that the Fed has said it will be willing to allow inflation to run above its 2.0% target, as that target is considered a long term equilibrium level and not an absolute ceiling.
After the election the consensus view was that the coming fiscal stimulus would force the Fed to raise rates at least 3 times, with some calling for 5 increases in 2017. This outlook was buttressed by the belief that inflation would rise as economic growth accelerated and wage growth picked up. This is why the overwhelming view has been that the yield on the 10-year Treasury bond would zoom to 3.0%.
In anticipation of this surge in interest rates, investors and hedge funds established record short positions in the Treasury futures market that would profit from higher interest rates. I’ve discussed the extreme positioning in the futures market in the Weekly Technical Review and believed it would lead to a decline in rates, as those short positions were covered if rates didn’t rise as expected.
A measure of how quickly investors jumped on the inflation band wagon is reflected in the number of articles discussing inflation or reflation. The 50 day average jumped from near zero just before the election to 1500 in early April. Just as concerns about deflation proved over done in early 2015, my guess is that current worries about inflation are also unwarranted and nearing a peak. This is another reason why I have expected the yield on the 10-year Treasury to fall from 2.6% to 2.3%, and potentially down to 2.2% as short positions are covered when the yield closes below 2.3%.
Emerging Markets
In the January 9 issue of Macro Tides I discussed my expectation of a decline in the Dollar, which would boost Gold and Gold stocks as well as emerging markets.
“If the Dollar weakens as I expect, the Emerging Market ETF (EEM) could follow the same pattern as Gold. The pattern suggests that EEM could rally to $42.00 – $44.00 during 2017 in a wave C rally.”
After peaking on January 3, the Dollar index declined from 103.82 to a low of 98.85 on March 27. I think the low on March 27 could be followed by a rally to at least 101.5 – 102.20 and potentially above the January high, as discussed in detail in my Weekly Technical Review. During the Dollar’s pullback, gold rallied from $1122.00 to $1169.00, and the Emerging Market ETF (EEM) jumped from $35.91 on January 9 to $40.23 on March 21.
There are a number of reasons why EEM could be vulnerable to a decline to $37.50 in coming weeks. After bottoming on March 27, the Dollar has been trading well and closed at 101.13 on Friday April 7, so a test of resistance near 102.00 – 102.25 is looming. If the Dollar manages to close above 102.25, the odds of bettering the January high of 103.82 will rise significantly. Additional Dollar strength could pressure EM currencies and EM equity markets, especially if the Dollar posts a new high.
Emerging market equity markets have outperformed the S&P 500 since the end of December, and the improvement in relative performance has resulted in large money flows into EM stocks and bonds and a nice rally in EM currencies. As a result of the rally, EM currencies and equities are overbought, and the level of enthusiasm toward EM equities has become overdone.
The recent price high in EEM was not confirmed by various technical momentum indicators, suggesting upside momentum is waning. (RSI divergences indicated by falling red trend lines on EEM chart.)
Two prior negative divergences EEM during the past year were followed by a decline of 6.3% and 10.1%. The first downside target for EEM is the March 9 low of $37.39, which would represent a decline of 7.0% from the recent high, with the potential of a 9.3% decline to $36.50 (pink horizontal trend line EEM chart).
Longer term, EEM could experience a rally to $44.00 – $45.00, testing the highs of 2015, 2014, and 2013. A close above $45.00 would open the door for a move to the 2011 high near $50.00. As you can see, the Major Trend Indicator provided a timely Buy signal on February 18, 2016 when EEM closed at $30.38.
Gold and Gold Stocks
Irrespective of some weakness in the very short term, longer term, I think gold can rally above $1385, while GDX has the potential to rally to $31.00 before the end of 2017.
Dollar
After the current rally runs its course, either stalling at 102.25 or after a new high, my guess is that the Dollar is likely to test the May 2016 low of 91.88 before the end of 2017. If a decline of this magnitude materializes, it would benefit emerging markets, gold, and gold stocks.
Eurozone
Inflation in the European Union has rebounded from -0.2% in February 2016 to 2.0% in February 2017, before dipping to 1.5% in March. The rebound in oil on inflation in the Eurozone is clearly evident, especially compared to core inflation which was just .7% in March.
As the annual rate of change in oil prices moderates in comings months, the EU’s CPI will recede. Economic growth has firmed, as GDP was 1.6% in 2016 and is projected to improve modestly in 2017 to 1.7%.
The ECB trimmed its monthly purchases of sovereign and corporate bonds from $80 billion a month to $60 in April, which it has said it will continue through 2017. The key question for European and global bond markets is if and when the ECB will indicate it will further reduce its purchases in 2018.
Banks supervised by the ECB hold more than $1 trillion of nonperforming loans (NPL) on their books, with Italian banks burdened by more than $300 billion alone. To put this into perspective, NPL’s represent 9% of EU GDP and 6.4% of total EU bank loans. In the U.S., nonperforming loans represent 1.47% of total loans. There have been recommendations of creating a European ‘bad bank’ to hold all the nonperforming loans and using public money to fund the bad bank, but nothing has been decided.
Until a formal resolution is determined on how to manage the EU bank’s NPL’s, I suspect Mario Draghi won’t be in a hurry to cut the ECB’s monthly purchases. However, this must be monitored closely since the reduction in ECB purchases could result in a rise in European bond yields, especially in Germany. If German bond yields rise, U.S. Treasury bond yields are likely to rise too. This taper risk could become a reality before the end of 2017. A secondary factor could be how the negotiations proceed between the EU and Britain, as both parties try to reestablish an economic relationship after Brexit.
U.S Stocks
If you are interested in the outlook for the S&P and various sectors of the U.S. stock market, my Weekly Technical Review covers it all in great detail. Since the peak on March 1 at 2401 on the S&P 500, I have expected the S&P to fall to at least 2311. When the current correction ends, a rally to a new all-time high is expected. If a new high occurs and is accompanied by negative diverging momentum on various technical indicators, a major top and the end of the bull market from March 2009 is possible, which will be discussed in the Weekly Technical Review, published here at GEI early every Tuesday morning.
@JimWelsh.Macro
