Investing Ideas Updates:

  • CAG: With earnings season coming to an end for consumer staples, we received an interesting data point in support of our thesis on Con Agra (CAG) in the form of Treehouse Foods’ (THS) first quarter results.  THS is another publicly traded private label manufacturer and while reported sales disappointed versus consensus, gross margins improved 30 basis points year over year (60 excluding the impact of a recent acquisition that was dilutive to gross margins).  We think these results may be the early signs of the gross margin tailwind that is part of our investment thesis on CAG.  Lower commodities flowing through the income statement with a significant impact on margins, particularly for private label manufacturers.  Further, THS management commented that 2013 looked to be a year of “modest industry volume growth”, compared to the negative results of the last two years.  We see early signs of growing strength in private label, a trend which will accrue to the benefit of CAG. (Please click here to see the latest Stock Report on CAG.)
  • DRI: Restaurants sector head Howard Penney writes about the casual dining sector this week. “Initial indications are that April may have been another sluggish month for casual dining. For some people this might come as disappointing news. What happened to the Easter “shift” from March to April? Knowing some chains weakness at the end of March, this had shifted to strength in early April. This suggests that balance of April was weak.  Sluggish sales trends are not being borne out in the casual dining stock, which have outperformed the S&P 500 by 340bps over the past month and 1080bps year-to-date.” Darden (DRI) remains one of his favorites. (Please click here to see the latest Stock Report on DRI.)
  • FDX: Shares of FedEx (FDX) moved significantly higher in the past week, with no particularly obvious catalyst for the gains, writes Industrials sector head Jay Van Sciver.  While we continue to believe the shares are an excellent long-term value, we might look for a pullback before initiating a position given recent volatility. (Please click here to see the latest Stock Report on FDX.)
  • HOLX: Health Care sector head Tom Tobin says this week’s earnings call confirms his bullish stance on Hologic (HOLX).  Tobin wasn’t “expecting management to fumble the sales channel in China,” or to miscalculate attrition in their core business. But he thinks concerns such as unreliable management and lower than expected reimbursements may be fully priced into the stock.  On the macro level, there are compelling factors to sweep HOLX to higher prices.  These include acceleration in their core customer base – unlike the decline in the broad healthcare market; an accelerating growth / replacement cycle in the mammography business; and accelerating “physician utilization” (more people going to the doctor more frequently.)  On the stock side, Tobin says HOLX is trading at the low end of the multiple range for its group – after a recent price decline that he thinks was overdone – and short interest has doubled in the past six months, providing a possible slingshot effect if a sudden bull rush causes a short squeeze. (Please click here to see the latest Stock Report on HOLX.)
  • MPEL: Melco Crown Entertainment (MPEL) reported earnings Wednesday, and most impressive in the quarter was that the mix continued to shift towards more the profitable premium mass market.  Additionally, fixed costs were controlled, leading to very good margins, despite bad luck at CoD (their largest property).  As for the smoking ban at casinos in Macau, our Gaming, Lodging and Leisure team said “not a big deal.” The ban is a partial ban in roughly 50% of the casino. We initially thought that it would impact mass margins due to the fact that most Chinese like to smoke and if they need to leave the tables for a puff that may lead to a decline in play.  The ban was implemented in January and we have seen no evidence of this. (Please click here to see the latest Stock Report on MPEL.)


INVESTING IDEAS NEWSLETTER - Screen Shot 2013 05 10 at 8.43.20 PM


Macro Theme of the Week: Making Up The Numbers

We are essentially rewriting economic history,

-          Brent Moulton, US Bureau of Economic Analysis

The BEA, the Bureau of Economic Analysis, is the federal agency charged with creating and maintaining the nation’s economic statistics.  Mr. Moulton, who manages the National Accounts, was commenting on forthcoming changes in the formula of GDP, but there are other schemes afoot to make the nation’s finances look different.  Why do these changes matter?


Hedgeye senior Macro analyst Christian Drake tried to make some sense of this and points out some important policy effects.


Deflating the Inflation

Recently, there has been emergent political support for changing the way the government calculates inflation.  CPI, the Consumer Price Index, is the current standard measure for calculating general price level changes of goods and services in the economy.  Select lawmakers, including President Obama, have voiced support for changing the calculation of inflation from the current CPI standard, to a new methodology called “chained CPI”. 


“Chaining” is a calculation that assumes consumers will substitute goods as prices rise.  If beef prices rise, for example, the Chained CPI assumes the average consumer will transition to chicken, soy, canned tuna fish and – in the AARP Armageddon scenario – tins of cat food.  This is an application of the economists’ notion that people operate efficiently in their own self interest.  Presumably the trade-off between a fixed amount of money and an equivalent caloric and protein intake is “efficient,” where “efficiency” means that the transition takes place smoothly and predictably within an identified population group.


According to research by the Bureau of Economic Analysis (BEA) and Bureau of Labor Statistics (BLS), Chained CPI tends to report inflation around 0.25% lower than current measures of CPI.  The AARP says that, under chained CPI, cost of living adjustments (COLA) for retired people would be reduced by about $3 for every $1000.  While this doesn’t look like a lot of money, it makes a difference if that $1000 is all you have to live on.  And it keeps compounding. 


The AARP gives an example of an individual receiving a $1,250 monthly Social Security check.  Chained CPI would reduce this year’s COLA $45 – and by $91.32 in 2014.  For most readers of this newsletter, a difference of $91 a year might not make a meaningful difference.  More to the point, by the time you are old enough to worry about retirement and the COLA, Social Security may not exist any longer.  Meanwhile, Drake says Congress won’t even have to say they are reducing benefits.  All they will need to do is “point at the BLS and offer up some vague, technical statistical jargon.” 

It’s reassuring to know that different departments of government can work so effectively together.


If It’s July, This Must Be Belgium

Every five years, the BEA does a comprehensive revision of the National Income and Product Accounts (NIPA) based on an economic census of some 4 million US businesses.  As the BEA point out, “Comprehensive NIPA revisions differ from annual NIPA revisions primarily because of the scope of the changes.”  In other words, “comprehensive” is bigger than not comprehensive, because it is… uh… comprehensive.  Your taxpayer dollars at work.


This year the BEA is also changing the way GDP is calculated (see this week’s Term of the Week, below, for more detail on GDP.)


GDP, which measures the value of goods and services produced in the US, was last revised in 1999, when the value of computer software produced in the US was added to the calculation of the national accounts.  The BEA’s Brent Moulton – whom we quote above – explains that the new measure will include R&D expenditures, and “entertainment, literary and artistic originals” such as motion pictures, books and recordings, but also “long-lasting” television programs. 


According to the Financial Times (April 21st, “Data Shift To Lift US Economy 3%”) the revision will cause the economy of the US to balloon by around half a trillion dollars –  “equivalent to adding a country as big as Belgium” to the global economy.  The GDP revision will cause BEA to restate the national accounts going back to 1929.  Its effect will also fall unevenly on states.  Says the FT, state-level GDP “will soar in small states that host a lot of military R&D,” projecting that New Mexico’s GDP could rise by 10% and Maryland’s by 6%, literally at the stroke of a pen.


Here’s another wrinkle: the new measure will record what pension plans have promised to pay out, rather than the amounts of cash they pay into the plans.  This will result in a large number of pension plans showing deficits, which is realistic, if not reassuring.  BEA’s Moulton notes there are plenty of underfunded pension plans in the government sector, covering (or rather, notcompletely covering) both state and federal workers. 


Hedgeye’s Drake says it’s way too early to determine all the effects of this change.  But he notes that “any metric in which GDP is the denominator (Debt/GDP, etc) goes down” which could have policy implications.


If you have been following the tempest in the ivory tower over Harvard’s Reinhart and Rogoff (authors of the book This Time Is Different) you know that academics and policy makers are arguing over what is a “dangerous” level of national debt.  Reinhart and Rogoff tried to demonstrate, based on the first-ever compilation of hundreds of years’ worth of figures, that countries take on large amounts of public debt at their peril.  Their research has been challenged recently when an error was discovered in their calculations.  R & R have acknowledged the mistake, but they say their fundamental thesis remains sound: a country shouldn’t borrow more than it can handle.


How much is too much?  We won’t spoil the surprise ending – because no one knows.  R & R posit 90% as an upper bound.  The challenge to their work, combined with a sudden inflation in reported GDP, could provide congressional cover for incremental debt and deficit spending.


So come July, the national accounts will become more robust, literally overnight.  We would be speculating if we suggested that new issuance of Treasury debt – based on an economy that is all of a sudden much stronger than it was yesterday – might also convince Fed chairman Bernanke of the need to increase his bond buying spree.


How much more does GDP have to go up before Bernanke raises his ante from $85 billion a month to, say $100 billion?


As Dr. Seuss says, “I do not know.  Go ask your Dad.”


Special Sector Spotlight: Is the Affordable Care Act (ACA) – Obamacare - Driving Hiring?

Financial sector head Josh Steiner addressed this question in a note to institutions earlier this week. Here’s an excerpt from his note. Steiner writes:


“Why is the labor market showing accelerating improvement? One hypothesis we've been considering is the ACA impact on low-wage, high employment industries like restaurants, hotels, etc. Under ACA, i.e., Obamacare, employers with 50+ employees must provide healthcare to employees who work 30 hours or more per week. Part-time (those under 30 hours) and temp workers are exempted from the requirement. Industries like restaurants and hotels, that employ huge numbers of relatively low-wage earners, would see their costs rise materially under ACA. Not surprisingly, many employers are quietly seeking to sidestep ACA by cutting workers to sub-30 hours and offsetting the lost hours by hiring additional part-time and temp workers.


Anecdotally, we've been reading a lot of articles about temp agencies seeing significantly higher demand of late. We ran across one that quoted an analyst at another firm saying that when Massachusetts implemented its universal healthcare plan, growth in hiring of temp workers in the state ran at six times the national average.


One thing to consider is that companies are treading very cautiously here from a public relations standpoint. No employer wants to be seen as intentionally seeking to sidestep ACA requirements. So much of this is going on under the radar. As counterintuitive as it may seem, we think ACA is actually creating jobs in significant numbers, while simultaneously reducing many workers from full-time (40 hrs+) to part-time (sub 30).”


Investment Term: GDP

Gross Domestic Product (GDP) measures the market value of all goods and services produced within a country.  In 1991 the BEA replaced Gross National Product (GNP) with GDP, noting that most other countries in the world already had adopted GDP as their measure of economic activity.  You might point out that the US has stubbornly refused to adopt the metric system, so why the big deal over GNP / GDP?  You would be right, but things don’t always have to make sense if you’re an economist.  Or a government policy maker.


The simple difference is GNP measures all the output from economic activity owned by a country, while GDP measures economic output that takes place within a country.


Since political decisions are made based on economic realities – and since economists have a very different concept of “reality” from the likes of you and me – it should not surprise you to learn that GDP is a politically charged idea.


GDP is calculated according to a simple formula:

            GDP = C + I + G + (X-M)


Translation: “GDP equals private Consumption, plus private Investment, plus Government spending, plus the net of Exports minusImports.


“Gross” means the calculation doesn’t differentiate on what the outputs are used for.  “Domestic” means the production takes places within a nation’s borders. 


GDP covers “officially acknowledged” economic goods and services, excluding revenues from illegal activities.  As states pass legislation to legalize casino gambling, their GDP goes up.  The shift by states to legalize medical marijuana also boosts those states’ GDP, and the nation’s, as well as boosting the tax base.


Remember what Hedgeye’s Drake noted above: all economic measures that have GDP in the denominator suddenly get smaller when GDP is recalculated to a bigger number.  As we said, the most obvious immediate policy implications are for COLA adjustments – which affect labor negotiations and retired persons – and debt issuance, which affects everyone.


The Global Standard

Updating GDP brings the US into conformity with the international United Nations System of National Accounts (SNA), whose goal is to make it possible to compare “apples to apples” when comparing global economic activity.


The SNA covers a comprehensive list of “national accounts,” such as Gross Output, Redistribution and Social Spending, Household Expenditures, Domestic Flow of Funds, and a national Balance Sheet and Balance of Payments – the record of international trade transactions.


Bringing the US GDP up to the SNA actually makes us look better in comparison to other nations, by boosting our numbers – all the way back to 1929.  It remains to be seen whether the effect of the SNA will be to raise every nation’s economic profile – a meaningless gesture if it is across the board – or to provide much greater specificity (what economists call “granularity”) into comparisons.


Economics and its Discontents

But surprise, surprise – some folks are critical of the SNA, and of global economic policies in general.


Critics of the SNA point out that all it measures is money.  Economists and academics reply, That’s what it’s supposed to measure.  But the broader criticism – that Economics is supposed to be in service of improving people’s lives – is certainly valid.  We are not the only ones troubled by the increasing trend on the part of elected policy makers to turn key policy decisions over to appointed academics. 


Of all the arguments over the SNA, most criticism has been leveled at GDP because of its importance and visibility in global policy making.  And perhaps the most credible argument against GDP comes from Nobel Prize-winning economist Joseph Stiglitz, who says policy makers need an equally robust measure of “wellbeing” to balance GDP – which is, after all, just a measure of how much money an economy generates.  If you believe “money can’t buy happiness,” then you will understand this argument.


Stiglitz, in fact, believes that money can actually destroy happiness if that is all you focus on, and he has written extensively on the social inequality that stems from what he considers misguided economic policies. 

Here are some key criticisms of GDP.  You can decide what you think.

  • GDP is a purely commercial measure that fails to reflect what people “experience” in a society.  – This may reflect the simple reality that laws are made by people in power, and power comes from having lots of money.  You can criticize that all you like.  It probably won’t change.
  • Women’s contribution to the economy is largely not reflected, since much of what many women do is housework and child care, enabling men to be active in the work force. – Some economists try to compensate by imputing the value of “domestic labor” to the national accounts.  And what about women who drop out of college to care for younger siblings to their mothers can work?  Until there is a robust scale for measuring this kind of non-remunerative work, it will be hard to judge the relative value of the contribution of family members who are not defined as being in the Labor Force.
  • GDP growth in advanced economies has been weak in recent years.  Thus GDP no longer measures societal change accurately, making it a poor policy tool. – This is a really Slippery Slope with frightening implications.  If your Domestic economy isn’t Producing Domestically, then you have a problem.  It needs lots of fixes – from “shovel-ready” projects, to overhaul of the tax code, to entitlement reform.  For politicians it’s easier to come up with new ways to measure economic activity rather than admit they have utterly failed us.  Needless to say, economists like this outcome too, as it provides job security.

This last point is a key example of how reliance on a single measure can lead to disastrous policy making. 

When a huge number of financial stocks broke down in the early days of the Financial Crisis, FINRA, the financial services self-regulatory body, changed listing requirements so companies would not have to be de-listed, even though they were trading well below $5 a share.  FINRA said the low prices did not realistically reflect the “quality” of the companies.  We would argue that the low prices did accurately reflect the quality of the US economy, of the financial markets, and especially of the financial firms, which had lost their credibility.  The refusal to face that reality was the regulators’ contribution to Too Big To Fail.  And it worked!  After all, everyone at FINRA still has a job.


Says Stiglitz, You’re not going to arrive at a right conclusion if you measure the wrong thing.


The Economic Data calendar for the week of the 13th of May through the 17th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.



Trade of the Day: TCB

Takeaway: Keith booked a nice profit in this financial stock, selling it, in part, because TCB’s CEO had done the same.

Keith sold TCF Financial (TCB) at 12:53pm today at $14.55 a share, booking a whopping 26.3% gain after holding the stock for six months.


Keith writes, “After a great run in the stock, I'll say goodbye to TCB today - primarily because their CEO (partly) did. (CEO William) Cooper selling 12.5% of his stake up here implies he probably isn't selling the company anytime soon. That takeout premium is why we held it. Fundamentals are good here, but the stock's valuation and six month return reflects most of that.”


Trade of the Day: TCB - tcb

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This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.

Still Bullish: SP500 Levels, Refreshed

Takeaway: Our bull case remains the non-consensus one.

This note was originally published May 10, 2013 at 12:09 in Macro

POSITION: 12 LONGS, 7 SHORTS @Hedgeye        


The latest bear market correction lasted for 6 hours of trading. While we’re finally seeing an end to everyone and their brother trying to call the top, we aren’t getting any explicit sell signals other than very immediate-term TRADE overboughts.


The fundamental bull case (#StrongDollar, Commodity Tax Cut, Employment/Housing #GrowthAccelerating) is now strengthening as the market rises. And now Treasuries and Oil are starting to look like Gold did, before the epic fall.


Across our core risk management durations, here are the lines that matter to me most:


  1. Immediate-term TRADE overbought = 1646
  2. Immediate-term TRADE support = 1610
  3. Intermediate-term TREND support = 1535


In other words, I keep getting signals for higher-lows of immediate-term support as the market continues to signal higher all-time highs of resistance.


Our bull case remains the non-consensus one.


 Still Bullish: SP500 Levels, Refreshed - SPX


Takeaway: Today's preannouncement is in line with why we like RH so much. While we wouldn't chase it now we still think this is at least a $60 stock.

It's pretty safe  to assume that the few analysts that actually like RH just saw the stock blow through their price targets. We, however, still think that this is at least a $60+ stock over 2-years. Our note from a few weeks ago was titled #CONFIDENCE (see below), and today's positive preannouncement -- and 41% comp (WHAT?!?) certainly support our view. In short...


"This remains one of our favorite longs. Its so rare to find a defendable high-end brand with such an obvious, yet fixable, distribution problem. Having stores that are only large enough to showcase 20-25% of the company’s product is like having a fleet of Ferraris and only a two-car garage. This is the one instance in retail where bigger stores is not only a positive, but it is a necessity. As these stores grow, the company can scale into new categories (kitchen, kids, art, flooring, art, collectibles, textiles, etc…), and subdivide existing ones  to drive productivity.


We think that the earnings guidance of $1.29-$1.37 for the year will prove conservative by at least 10%, and ultimately this is a company with $3 in earnings power over 3-years.  If that’s right, we’re looking at over a 20% CAGR in EPS, which makes 20x $3 in the realm of possibility. Granted, that is by the end of 2014, so there’s some time to go. But until people start to realize this potential, we’re not concerned about the stock being expensive."


The biggest obstacle at this point is timing.  With over 1mm shares short at the same time we're seeing decreased opacity in the model, an equity offering that cures one of the biggest points of pushback we've gotten on the name (sparse liquidity), and such a material step-up in business levels (comps going from +26% in 4Q to +41% in 1Q) -- it's no shocker that the stock is behaving like it is today.


That said, we would not chase it right here, right now.  We'd treat this one like a fine wine -- simply let it breathe for a little while. At a minimum, we'd wait to see how it reacts when another 4-4.5mm shares enters the float with the company's secondary. If the stock trades down, then we'd look to get involved. If it holds current levels, then we'd buy it anyway.






Takeaway: Several near-term risks were mitigated this qtr. In addition, we're taking up our 'already high' long-term growth forecast. 2 yrs = $60.


RH’s $0.02 ps beat far understates the significance of the company’s earnings report. After running the numbers and listening to the call, we walked away with the following thoughts:


1)      Confirmation that this management team is executing on one of the most intriguing business opportunities in retail. Comping 26% on top of a 22% in the same quarter last year, and that’s before the launch of new businesses like Tableware and Objects of Curiosity.


2)      Not only is the Design Gallery pipeline robust, but management seemed to have a (borderline odd) epiphany that it could open significantly larger stores with far more favorable rent structures than previously anticipated. Given that increased furniture sales will put a natural damper on margins over time, lower occupancy hurdles are a nice offset.


3)      We made a rather significant change to our model, in that we took the average size of a Design Gallery up from 25,000 square feet to nearly 35,000 over the next three years. The Boston store, for example, is nearly 50,000 square feet. With a weighted average of 35k sq feet and our estimate of 15 Galleries by the end of 2015, it gets us to weighted average square footage growth of 15% by that time period. The interesting element here is that bears (and even common logic) will say that current comp trends will roll, and over 2-3 years we’ll be looking at a stabilization in sales/square foot trends. With that being the case, the acceleration in square footage still drives 15-20% top line growth through this model. We think that’s the biggest part of this story that people are missing.  


4)      Find us a company that is taking UP expectations for both revenue and earnings for the upcoming quarter and year. It would have been easy enough for them to give initial guidance right in line with existing estimates. #confidence.


5)      De-risking Sentiment. Like it or not, sentiment is a major factor with this stock. We’ve been positive on the name since the IPO, and when we bring it up with investors it’s pretty clear to us that it’s not too far from JCP as it relates to being hated. The two most common reasons. 1) There’s not enough float. 2) The company is probably going to do a secondary (that probably explains why 1.4mm shares of the 4.2mm float is short). That’s ironic when you think about it. Half the people don’t like the lack of float, and the other half don’t like the one event that could fix the ‘small float’ problem. 


Regardless, there are three things that happened this quarter that we think de-risk sentiment and improves ownership characteristics for RH.

  1. First, simple as it may be, the fact that RH finally ended what may be the longest quiet period in modern retail history is a positive. Other retailers are getting ready to report 1Q in 3-4 weeks, and RH is just getting out its 4Q numbers. It’s been a black hole of info, and it has not helped sentiment one bit. That’s over.
  2. IPO-related charges are out finally known, booked, and out of the way.  They made financial modeling a bear – and now that’s no longer an issue.  
  3. While we usually could care less about company guidance, the fact that RH issued quarterly and annual guidance is a massive positive for a levered and newly public company like this.

The reality is that so many people have had zero appetite for the name given such little float, funky accounting, no guidance, and such a huge delay in the earnings report.  The 4Q print ameliorated many of these concerns.


In the end, this remains one of our favorite longs. Its so rare to find a defendable high-end brand with such an obvious, yet fixable, distribution problem. Having stores that are only large enough to showcase 20-25% of the company’s product is like having a fleet of Ferraris and only a two-car garage. This is the one instance in retail where bigger stores is not only a positive, but it is a necessity. As these stores grow, the company can scale into new categories (kitchen, kids, art, flooring, art, collectibles, textiles, etc…), and subdivide existing ones  to drive productivity.


We think that the earnings guidance of $1.29-$1.37 for the year will prove conservative by at least 10%, and ultimately this is a company with $3 in earnings power over 3-years.  If that’s right, we’re looking at over a 20% CAGR in EPS, which makes 20x $3 in the realm of possibility. Granted, that is by the end of 2014, so there’s some time to go. But until people start to realize this potential, we’re not concerned about the stock being expensive.

Domestic Debt & Credit Trends: A Visual Tour

Summary Bullets:  

  • Loan Demand:  Commercial and Residential Real Estate demand continues to improve. C&I loan trends remain positive but decelerated in 2Q.
  • Credit Standards:  Credit Standards across Commercial & Consumer loan categories continue to ease.  Given rising demand, improving macro, & the pro-cyclical nature of bank credit policy, further credit standard easing is likely.
  • Household Debt:  Household Debt/GDP has retraced most of the exponential move in debt growth over the 2000-2008 period.  Meaningful downside remains to the long-term average, but we’re currently just north of trend growth. 
  • Debt Service:  Household debt service ratio’s continue to decline, making new 30Y lows in 4Q12.
  • Debt Growth/Credit Impulse:  The decline in debt growth has decelerated and is set to turn positive in 2013.  The Credit impulse (Flow of Debt) should remain supportive of consumption in the intermediate term.
  • Savings Rate:  Despite Household deleveraging and a lower debt burden, negative-to-flat real wage growth and tax law changes have continued to drive the trend in personal savings lower. 
  • Debt Capacity:  Ongoing labor market improvement (higher income) alongside rising net worth (higher collateral values), primarily via housing and financial asset re-flation, should continue to support incremental debt capacity.
  • Corporate Margins:  Corporate Margins and after-tax Corporate profits as a % of GDP are both at Peak.  Current market valuation and multiple upside should be understood within the context of that risk.   



From a Long-cycle and very Top Down perspective the underlying drivers of credit are fairly straightforward.  As Ray Dalio and Bridgewater have highlighted, and would we agree, fundamentally, a lender needs to believe 1.) they have a reasonable chance of being paid back an amount greater than the rate of inflation and 2.) that they will be paid back with dollars of similar purchasing power.   Given where we are in the cycle, this simplified approach can help explain much of the directional trend in household credit. 


Into and out of the financial crises, credit tightened as lender’s were justifiably worried that debtor’s wouldn’t be able to repay obligations or generate required returns on capital and, with the fed in full easing mode, it was also exceedingly uncertain that the purchasing power of the dollar would hold.  With the domestic macro data showing sustained, albeit modest, improvement and the Fed turning more hawkish on the margin, both credit and currency devaluation risk continue to reverse.    


Incomes are rising as employment continues its slow grind higher, household debt and debt service ratio’s continue to decline while household net worth has returned to nominal, pre-crises highs alongside higher savings and real estate and financial asset re-flation. 


In short, the drivers of incremental household capacity for credit – rising incomes and asset (collateral) values – drive demand with lending standards and bank credit policy reacting pro-cyclically.  Capacity for household credit expansion has improved, loan demand has begun to percolate, and credit standard easing remains ongoing. 


In the immediate/intermediate term, the flow of credit should remain supportive of consumption and positive growth in nominal debt could occur alongside a further decline in household debt ratio’s.        


2Q13 Senior Loan Officer Survey:  Demand Steady, Credit Standards Ease Further


The Fed released its 2Q13 Senior Loan Officer Survey earlier this week. On balance, the release was positive as lending standards continued to ease alongside pockets of relative strength for loan demand.  The Highlights:


Stronger:  Net percentage of banks tightening credits standards for Commercial Real estate (CRE) loans in 2Q13 declined -20.9%, the lowest level since the crises, while CRE loan demand remained strong with 40.3% of banks reporting stronger sequential demand.  On the Residential Real Estate side, net easing of standards on prime mortgage loans continued with 7.8% of banks reporting lower standards. Home loan demand from prime borrowed rose significantly with (net) 39.1% of banks reporting increased demand. 


Weaker: C&I loan demand remained positive but cooled sequentially with banks reporting a net 5.9% increase in demand vs 19.1% in 1Q13.  


Domestic Debt & Credit Trends:  A Visual Tour - Senior loan Officer Survey Standards 2Q13


Domestic Debt & Credit Trends:  A Visual Tour - Senior loan Officer Survey Demand 2Q13 


CREDIT FLOW:  The idea of the Credit Impulse, popularized by Biggs, Meyer & Pick (2010), centers on the idea that it’s the flow, not the stock, of credit that matters relative to economic growth. The implication is that if the change in net new credit is positive, credit can still support demand even if the nominal stock of total debt is still declining.  Put differently, a deceleration in the rate of decline of debt equates to a positive change in net new credit that can give economic activity a boost.  By and large, the empirical appears to bear out the theory.    


The first chart below illustrates the Credit Impulse (Household and Non-Financial Corporate Debt, Flow of Funds data) vs. the Y/Y change in consumer and business demand (represented by the y/y change for the Consumption and Investment components of GDP) along with the Y/Y change in total household and Non-financial corporate debt.  As can be seen, the trend in private sector demand growth tracks the credit impulse closely and leads the positive inflection in y/y debt growth. 


The second chart shows the Credit impulse vs. the ‘Banks Willingness to Lend’ measure from the Senior Loan Officer Survey (above).  Again, the Trend relationship is strong and with Willingness to Lend accelerating in 2Q13 the read through for credit catalyzed private consumption remains favorable.   


Domestic Debt & Credit Trends:  A Visual Tour - Credit Impulse vs. Private Demand


Domestic Debt & Credit Trends:  A Visual Tour - Credit Impulse vs. Bank Willingness to Lend


Household Debt to GDP:  Household Debt/GDP remains in decline as nominal debt continues to fall y/y alongside ongoing, modest GDP growth.  We’re currently 16.7% off peak 2009 Debt/GDP levels and while there is still meaningful downside to the long-term average, we’ve nearly retraced back to (1) trend.  


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt to GDP


Household Debt vs. Consumption: Beginning in ~2000,  growth in Household debt decoupled from household consumption as debt growth went exponential.  As growth in household debt accelerated, debt became increasingly ineffectual in driving incremental consumption.  That is, marginal consumption declined as a dollar increase in debt drove increasingly less than a dollar increase in consumption.


This dynamic is a typical antecedent of financial crises whereby incremental debt is used to speculatively acquire already overpriced (financial) assets instead of going towards entreprenurial or productive output/investment.  


Domestic Debt & Credit Trends:  A Visual Tour - HH Debt vs Consumption


Domestic Debt & Credit Trends:  A Visual Tour - HH Debt vs Chg in PCE


Household Debt Burden:  Debt Service Ratio’s continue to trend lower due to a combination of organic delevering, low interest rates, and nominal earnings growth.  Both the Household Debt Service and Financial Obligation ratio’s made new 30Y lows in 4Q12.  


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt Burden


Debt Growth vs. Income Growth:  In the long-term debt cycle, debt growth can exceed income growth until debt to income levels reach a critical  upper bound at which point cash flows to service debt (income) become inadequate to meet debt service obligations and monetary policy is impotent to help as interest rates cannot be lowered further in support of easing household debt burdens. 


In the wake of the financial crisis and through to the present, income growth has run at a positive spread to debt growth.  Debt growth has already inflected and given positive mortgage, auto, and consumer loan trends YTD is likely to turn positive in 2013.  The closing of the delta between income and debt growth represent the upside to credit driven consumption.   


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt Growth vs Income Growth


HEADWINDS:  Corporate Profits, Real Wage Growth & Personal Savings…and a Valuation Reminder

Peak corporate earnings as a % of GDP, trend deceleration in Real Wages and a trough in Labor’s Share of national income obviously aren’t supportive of aggregate demand acceleration and credit expansion longer-term. 


Despite Household deleveraging and a lower debt burden, negative-to-flat real wage growth and tax law changes have continued to drive the trend in personal savings lower.  Higher payroll taxes in 1Q13 had a discrete impact on personal savings as individuals reduced savings to maintain consumption in the face of higher taxes.    


A quick valuation reminder as it relates to peak returns to capital  - while the SPX isn’t particularly expensive on a historical basis, its important to contextualize that “cheapness “ within the construct of peak margins and mean reversion risk to peak corporate profits.   


Domestic Debt & Credit Trends:  A Visual Tour - Corporate Profit vs Real Wages


Domestic Debt & Credit Trends:  A Visual Tour - Real Weeky Earnings vs Savings Rate


Domestic Debt & Credit Trends:  A Visual Tour - SPX valuation vs Peak Profits



Christian B. Drake

Senior Analyst 

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