Takeaway: The recessionary bell tolled loudly in yesterday afternoon's Senior Loan Officer Survey data as banks are tightening the screws on credit.
How The Economic Machine Works
For anyone interested in a simple and (moderately) entertaining primer on the role credit plays in economic growth, we recommend Ray Dalio's youtube video "How The Economic Machine Works". In a nutshell, he explains how credit is simply the pull forward of consumption, which is why the credit cycle drives the business cycle. With that in mind, the Senior Loan Officer Survey data out yesterday afternoon is indeed troubling.
Two of Three C&I Measures, CRE Standards, and Expectations are Negative
The Fed released its 1Q16 Senior Loan Officer Survey yesterday afternoon. The survey was conducted between December 29 and January 12 and covers lending standards and loan demand across business and consumer loan categories.
In the previous survey (4Q15) banks began tightening, on net, C&I and CRE lending standards. This quarter (1Q16) not only did the net percentages of lenders tightening standards for those categories increase, but demand for C&I loans declined. Additionally, the Fed's survey this quarter included special questions regarding forward expectations, and loan officers indicated that they expected a further tightening of standards, increasing of spreads, decreasing volumes, and deteriorating credit quality over the course of 2016.
A small silver lining is that consumer lending showed benign conditions; a net positive, albeit sequentially smaller, percentage of banks continued to report easing of consumer lending standards.
Here is the main takeaways this quarter:
1. A net percentage of banks tightened C&I lending standards for the second quarter in a row. Moreover, demand for C&I loans inflected into negative territory this quarter. 11% of banks saw C&I loan demand decrease from large and medium firms (13% saw it decrease from small firms), signaling that borrowers expect a decreased need for capital.
Here's why this matters. We've gone back historically and looked at the Senior Loan Officer Survey many different ways in an effort to discern its usefulness as a forward indicator. After much trial and error, our biggest takeaway is that when two of the three C&I questions have turned negative historically, it has portended a recession in the near future. This isn't coincident, it's causal. Banks tightening the screws, increasing the price of money or reporting reduced demand for money all portend a slowing of econimc activity. The problem is that the cyclical activity tends to autocorrelate, or self-reinforce. In other words, banks tighten credit => consumption/investment decline => workers are laid off => delinquencies rise => banks further tighten credit => and so on and so forth. Below is a chart showing the three questions in the C&I survey back to 1990. To be clear, we've inverted the primary y-axis and we've also reversed the demand question so that all three categories are directionally consistent, i.e. when credit is constricting/price is rising/demand is falling, the survey measures on this chart fall, and vice versa.
Perhaps of equal interest is the fact that the Fed has historically had an enormous policy cushion in response to recessions. The table below shows that since 1969, the Fed has eased by an average of 750 bps in response to every recession. The last two cycles have seen the Fed ease by 560 bps and 520 bps. The challenge this time around is that the Fed's current policy cushion is 36 bps.
To summarize, credit conditions are tightening, which has historically ushered in a recession, and the Fed's short by around 5 percentage points on its ability to soften the blow.
The Data: The percentage of banks tightening C&I lending standards for large and medium firms increased to 8.3% in 1Q16. This is the only instance since the last recession that a net positive percentage of banks tightened standards two quarters in a row. The chart below illustrates.
Here's the Second Most Important Takeaway This Quarter:
2. CRE Tightening. Commercial real estate lending also saw continued tightening this quarter across all three categories: C&D, Nonfarm Nonresidential and Multifamily. Unfortunately, the survey format changed with the 4Q13 survey when the Fed replaced the single category of CRE loans with the three aforementioned subcategories. As such, it's not possible to compare apples to apples historically. That said, in the 10 quarters since the new format began, this marks the third (and third consecutive) quarter in which standards have tightened on C&D loans. It marks the second (and second consecutive) quarter in which Nonfarm Nonresidential loans have seen standards tighten. The Multifamily category has been bouncing between easing and tightening over the last two years, but it has never reached as high as the 22.6% of banks tightening this quarter.
And Here's the Third:
3. Banks expect things to get worse throughout 2016. This quarter's survey included special questions on lenders' forward expectations for standards, spreads, volumes, and quality, and the results are not inspiring. The first chart below shows that banks expect standards to tighten in all commercial and industrial categories in 2016. They also expect to increase spreads across all surveyed loan categories. Also, while banks expect increasing C&I volumes, a significant percentage of banks expect CRE, multifamily, and GSE-eligible residential mortgage volumes to decrease over 2016. Finally, the second chart below shows a sea of red in expectations for credit quality. There is not a single category in which banks expect improvement in credit quality. To put it simply, a net positive percentage of senior loan officers believe that we have reached and moved past the inflection point of deteriorating credit conditions.
Given the increased number of negative responses and the negative forward expectations, we appear to have reached the inflection point signaling that Financial equity prices are past their peak. Unlike the prior positive tick in 1Q12, this time the economic cycle is showing many signs of being late stage, and the survey has deteriorated further quarter over quarter.
The chart below looks at the historical C&I lending standards (LHS) juxtaposed against the S&P 500 Financials Index (RHS). C&I lending standards have historically begun tightening coincident with or ahead of peaks in Financial equity prices. We've highlighted in green the periods during which Financials stocks have risen. In the 1990s it was clear that lending standards were tightening by late 1999, suggesting the roll was near. In the 2003-2007 period standards began to tighten in 2007.
A Quick Review of the Senior Loan Officer Survey by Category:
C&I: The Canary In the Coal Mine
C&I loans continue again signaled the credit cycle peak with standards tightening for two quarters in a row now. The net percentage of banks tightening standards for loans to large firms moved from +7.3% in 4Q15 to 8.3% in 1Q16. Additionally, +4.2% of banks tightened standards for C&I loans to small firms.
CRE: Tightening Across the Board
Banks continued to tightening standards for all three CRE categories in 1Q16. Additionally, the percentage tightening standards for multifamily loans, which had previously swung back and forth from negative (good) to positive (bad), is definitively positive (bad) at +22.6% in 1Q16. This inflection in CRE standards adds to our concern over the inflection in C&I standards.
Meanwhile, demand for all three categories of CRE loans increased, albeit at sequentially lower percentages, in the first quarter.
Residential Mortgage: Mixed
Starting in 1Q15, the Federal Reserve broke the survey's residential Prime and Nontraditional categories into six new categories and kept the Subprime category for a total of seven different categories. The six new categories include: (GSE-Eligible, Government, QM non-jumbo/non-GSE eligible, QM jumbo, Non-QM jumbo, and Non-QM/non-jumbo). The categories we're most interested in are the GSE-Eligible (Fannie/Freddie) and Government categories (FHA/VA) since these two categories account for ~90% of all origination volume. The GSE-Eligible category showed 14.3% of banks, net, eased standards Q/Q in 1Q16. Government standards were unchanged. Standards for Subprime auto were also unchanged, an improvement from the 20% tightening in 4Q15. All four other categories eased.
We pay little attention to the demand component of the Fed's Survey because it reflects shifting refi demand and isn't a good barometer for purchase activity. Nevertheless, we include both charts below.
Consumer Loans: Easing
Standards for credit cards, auto loans, and consumer loans ex-cards and autos all eased in the third quarter.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
In this HedgeyeTV video excerpt, Potomac Research Group Senior Telecommunications & Cable analyst Paul Glenchur discusses how key FCC decisions on the set-top box market, net neutrality and sponsored mobile data could affect companies like Verizon, Netflix, and Facebook with Hedgeye Internet & Media analyst Hesham Shaaban. Glenchur also weighs in on what a Republican presidency would mean for mergers and acquisitions in the telecommunications sector.
Paul Glenchur, Senior Analyst, Telecommunications-Cable
Paul Glenchur is ranked among leading telecommunications policy specialists, combining his legal background with industry experience. Prior to joining Potomac Research, Mr. Glenchur was the senior telecom and cable analyst with Schwab Washington Research and later the senior telecom policy analyst with the Stanford Group. Mr. Glenchur also has an extensive legal background – he served as an attorney on the FCC’s cable and common carrier bureau, as an associate with the Washington law firm of Miller and Chevalier, and as Counsel to the Assistant Secretary of Energy for Congressional Affairs. Before moving to Washington, he was a judicial law clerk to Judge Thomas Tang of the U.S. Court of Appeals for the Ninth Circuit. Mr. Glenchur is a graduate of the University of California at Berkeley and earned his J.D. at the University of California Hastings College of the Law, where he was an editor of the law review. Mr. Glenchur is a member of the Federal Communications Bar and has testified before House and Senate committees on telecommunications issues. He is also a member of the Supreme Court and Ninth Circuit bars.
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Takeaway: Please join us for our call Thursday, Feb 4th at 1:00pm EST. Dialing instructions will be published Thursday morning.
We will be hosting our quarterly INTERNET BEST IDEAS Update Call this Thursday, February 4th at 1pm EST. We will be reviewing the major themes and incremental developments to our Best Idea Short theses (YELP, TWTR), and will be discussing two recently-closed Best Ideas that we have added to our Bench in the opposite direction (LNKD as a potential Short, P as a potential Long). The emphasis of this call will be to outline our view over various durations (particularly 2016) as well as the upcoming catalyst calendar; identifying the major catalysts and risks to each company over the near-to-intermediate term.
Join us for our call Thursday, Feb 4th at 1:00pm EST. Dialing instructions will be published Thursday morning.
KEY TOPICS WILL INCLUDE
- TWTR: Aggressive monetization tactics creating structural headwinds; why there is at least one more leg down to the short.
- YELP: Sell-side refuses to acknowledge its attrition, so estimates still too high. Question if mgmt will repeat 2015 mistake and guide to them
- LNKD: Closed Long, Potential Short. Selling environment appears to be deteriorating, could be beginning of challenging trend
- P: Covered Short, Potential Long. Dead money or Call Option? Depends on how mgmt chooses to proceed post Web IV
Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to learn more.
"... One of the most important relationships there is in macro is between PROFITS and STOCKS. And, unless it’s different this time, US stocks have always crashed (greater than 20% draw-down from prior peak) when US corporate profits go negative for 2 consecutive quarters."
“The Americans cannot protect themselves as they cannot pretend to have a Navy.”
That’s a truthful British quote from 1783 in Observations of the Commerce of the American States (when the USA didn’t have a real Navy). It’s also the opening volley in a book I started reading this past weekend called Thomas Jefferson and The Tripoli Pirates.
I kind of feel like a pirate these days. ‘Argh! Here I am, permee-bulls – I’m here to take your booty!’ And the reason why I’m not fazed by any of these bear market bounces is twofold: neither the corporate profit (slowing) nor credit signals (widening) have changed.
The levered long beta bulls can crowd all their holdings into two stocks (Google and Facebook), but they cannot pretend to have either accelerating GDP or earnings growth in the 1st half of 2016. Ex-ing everything out won’t change that. Protect yourself.
Click here to join Hedgeye CEO Keith McCullough live on The Macro Show at 9am.
Back to the Global Macro Grind…
If you have friends who want to ex-out the American Socialist vote in Iowa last night, they can do that too. People are partisan – the economic data isn’t. Yesterday’s ISM report of 48.2 for JAN signaled:
- The 4th straight “contraction” (survey reading below 50)
- A year-over-year decline of -6% (last JAN the ISM was at 53.9)
- A sharp slow-down in the Employment component at 45.9 (vs. 48.0 DEC and 54.1 in JAN of last yr)
But no worries, if you ex-that-out, and just call it “transitory” (like the 1H 2015 US Employment and Consumption growth cycle highs were), you might end up summarizing the current macro market risks as follows:
“At this point, it is difficult to judge the likely implications of this volatility.”
-Federal Reserve Vice Chair Stanley Fischer
“It will take some time here to understand what is going on.”
-Dallas Fed Head, Robert Kaplan
“It appears we have slower growth… and may need a longer period of accommodation.”
-San Francisco Fed Head, John Williams
That last quote cracks me up the most as there was no more cocksure Federal Reserve pro-cyclical (bullish on late cycle indicators post the peak) economist than our friend from Berkeley, John Williams. Only 5 weeks ago, the guy wanted 5 “rate hikes” in 2016. #lol
And I get it. For a day, the “market liked an easier Fed.” Or at least the US stock market liked not going straight down (it still closed down on the day mind you) as the US Dollar finally dropped -0.6% on that.
But most of the playbook “Dollar Down” ideas (like Oil for example) didn’t cooperate at all with the “Fed is easy, buy everything” narrative. It reversed last week’s bear market bounce, dropping -6.6% on the day (WTI is down another -2.3% this a.m. to $30.88).
The Fed can get less-hawkish, but they cannot pretend to have US profit growth.
We’re almost half way through earnings season (215 of 500 companies in the SP500 have reported) and here’s the score:
- Total SP500 SALES -2.4% y/y and EPS -3.7% y/y
- Energy (13 of 40 reported) SALES -34.8%, EPS -70.6%
- Materials (13 of 27 reported) SALES -14.2%, EPS -32.7%
- Industrials (36 of 65 reported) SALES -7.7%, EPS -4.8%
- Financials (45 of 90 reported) SALES +1.2%, EPS -3.4%
- Information Technology (36 of 65 reported) SALES -1.2%, EPS -2.5%
But if you ex-out all of that negative year-over-year earnings growth (i.e. 287 companies in the aforementioned sectors or 57% of the SP500), you can pretend that there’s nothing to worry about.
Reality is that there’s only one firm that mapped and measured the probability of this happening (from the July cycle peak) 7 months ago. And that same firm is reminding you that this US equity market (and long-term Bond Yield) selloff isn’t over.
One of the most important relationships there is in macro is between PROFITS and STOCKS. And, unless it’s different this time, US stocks have always crashed (greater than 20% draw-down from prior peak) when US corporate profits go negative for 2 consecutive quarters.
Our immediate-term Global Macro Risk Ranges are now (with intermediate-term TREND research views in brackets):
UST 10yr Yield 1.91-2.06% (bearish)
SPX 1 (bearish)
NASDAQ 4 (bearish)
Nikkei 159 (bearish)
DAX 9 (bearish)
VIX 19.22-28.11 (bullish)
USD 98.48-100.01 (bullish)
EUR/USD 1.07-1.09 (bearish)
YEN 119.15-121.41 (bearish)
Oil (WTI) 27.62-33.21 (bearish)
Nat Gas 2.01-2.29 (bearish)
Gold 1098-1135 (bullish)
Copper 1.95-2.09 (bearish)
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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