“Old Enough to Know Better, Young Enough Not To Care”
Let me tell you a story.
Since my cold is getting worse at an accelerating rate this morning, it’ll be a short story:
The year is 1980 and interest rates in the U.S. are cresting to their stagflationary peak (Fed Funds peaked at 22.4% in 1981).
Our early chapter protagonist – one iconoclastic central banker – Mr. Paul Volcker successfully broke the inflationary cycle and in an ironic plot twist also birthed our story’s antagonist: policy and the multi-decade accommodative interest rate cycle.
Mysteriously (or not), #Inequality – hereto a noncharacter – is unwittingly thrust into the spotlight and begins his ascent higher alongside the progression of the interest rate cycle.
Ahh … the plot thickens.
But before further character development, a bit of backstory.
35+ years of falling bond yields:
- Gets bond bulls paid (you must own bonds to benefit mind you)
- Increase the value of assets via the Present Value effect (again, you have to own financial assets to benefit)
- Serve to drive financial innovation, the “financialization” of markets and disproportionate growth in the finance economy
For those not holding financial assets, the benefits of expansionary policy and declining interest rates are more insidious as it:
- Spurs household demand by making credit cheaper and reducing the incentive to save, driving investment and household consumption of goods and services higher
- Lower highs and lower lows in interest rates in each successive cycle support onboarding of incremental debt as the costs of servicing debt are marched lower (see the beauty of a graphic by Bob Rich below).
Back to the Global Macro Grind …
Perhaps perversely, under a bureaucratic system perpetuating political short-termism and a monetary policy mandate calling for full employment, the solution to rising debt-to-income levels stemming from lower interest rates and accommodative monetary policy, is even lower interest rates, more expansionary policy, and currency devaluation.
Lower interest rates and a depreciating currency reduce the cost of servicing debt while further increases in aggregate demand and financial asset price appreciation support an ongoing rise in incomes.
Under this story arc, policy supports a growing economic pie and the wealthy benefit directly - and can increase consumption while maintaining a static income-to-consumption ratio (…also, remember, they are the ones financing and getting paid on the cumulating debt).
The lower income quartiles, meanwhile, can enjoy increased consumption at the cost of rising leverage. Rising Household debt can offset consumption differences created by rising income inequality and policy can support the perceived prosperity dance so long as there remains cushion for further reduction in rates.
With our Stasis, Trigger and Conflict thus established, this leaves us with 5 points in a typical story structure:
- The Surprise
- The Critical Choice
- The Climax
- The Reversal
- The Resolution
The last three (or four) points are unfolding in real-time as NIRP and the currency war race-to-the-bottom crescendo and drive us towards some version of a tragi-comical catharsis.
So let’s detail the Surprise and the Critical Choice with some relevant digression along the way.
The (Un)Surprise: For our story here, the net of a multi-decade credit cycle are a few fold:
- Rising income inequality: the income distribution is increasingly top heavy with the top quintile/decile/1% taking down a larger share.
- Rising consumption skew: Consumption trends are increasingly hostage to what we’ll call the ‘wealth economy’ with the top 5% on the income distribution accounting for something on the order of ~40% of total consumption
- Credit: an outcropping of the credit cycle and financialization of the economy is that inflections in credit growth remain a primary marginal driver of aggregate spending.
So, the expansion and contraction of credit and the ebb and flow of high end consumerism are critical to understanding and projecting the slope of consumption growth.
Enter the (Growth) Foil: couple of developing realities:
- High End: High End consumption shows a strong relationship to financial market volatility with new home sales and higher ticket discretionary consumption a decreasing function of volatility. Volatility is marching steadily higher and as the climax of this weaving macro narrative progresses, the plot twists will continue to manifest as bouts of rising volatility.
- Credit: The Fed Senior Loan officer survey for 1Q16 showed a further tightening in corporate & commercial credit. Specifically, a net percentage of banks tightened C&I (commercial and Industrial) lending standards for the second quarter in a row. Moreover, demand for C&I loans inflected into negative territory this quarter. Eleven percent 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.
This matters because, historically, when two of the three C&I questions have turned negative, it has portended a recession in the near future (see Chart of the Day below).
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 economic activity.
Credit is pro-cyclical and just as it can serve to jumpstart or amplify a virtuous cycle on the upside, it can similarly serve to catalyze a negative self-reinforcing downcycle.
In other words, banks tighten credit => consumption/investment decline => job growth slows or workers are laid off => delinquencies rise => banks further tighten credit => and so on and so forth.
Very Dalio-esque, but it’s also how I lean towards intuiting the “economic machine”. But then again, I’m just a guy in a room with creative analytical license spinning commonsense narratives around data at 5am with minimal editing.
If you’re an Old Wall shop, you traffic in contrived sophistication and perceived scarcity value, it’s what you do.
If you’re consensus, you forecast 3% on the 10Y and serially revise your earnings/growth forecast lower every year, it’s what you do.
If you’re an active participant in this democratization of investment research experiment we’re conducting @Hedgeye, you try to simplify the complex. That and buy long bonds and bond proxies (Utilities, REITs, etc) when growth is slowing.
7-months of boring allocations to long bonds isn’t the positioning fabric dazzling macro narratives are weaved on or sexy marketing campaigns based but that’s okay. We’re old enough to know better, but still young enough not to care.
Post-Script | Recession Mongering: To be clear, our call has been that the probability of recession is rising and insufficiently discounted by markets. We don’t need an outright technical recession for our #GrowthSlowing call to manifest as recessionary price action in equities – we only need the prevailing opinion/sentiment/consensus to recouple with the more dismal underlying macro and corporate profit reality. Across a growing swath of companies (namely, smaller cap/lower liquidity/higher beta/higher leverage style factors) bear market price action has already commenced.
…. Oh yeah, and the domestic services sector showed further slowing yesterday as the ISM Services reading slowed to its lowest reading in two years and the EU cut its growth and inflation forecasts again this morning.
To real-life page turners and harmonious Resolutions,
Christian B. Drake
U.S. Macro Analyst