Doug Noland: Conventional Wisdom

Conventional Wisdom is so often proved wrong. Thinking back over my career, it’s amazing how many times what is believed true without a doubt in the markets turns out completely erroneous. There’s no mystery behind this phenomenon. Responsibility lies foremost in flawed analytical frameworks. Fundamentally, bull market psychology rests on the basic premise that underlying fundamentals are sound – economic growth, earnings, inflation dynamics, new technologies, global trade, etc. No need to look further or dig any deeper.

When securities markets are strong (inflating), it’s taken as a given that the financial system is robust. The problem, however, is that the underlying finance fueling the recent bull market has been patently unsound – and has been so for three decades of recurring boom and bust cycles.

A wise person said that it’s not true that we don’t learn from history. It’s that our learning is dominated by recent history. It becomes too easy to ignore everything beyond the past few years. Over a relatively short time horizon, the previous bust cycle becomes ancient history. What matters for the markets – especially as the cycle evolves to the speculative phase – is the here and now. It’s assumed that everyone acquired understanding and insight from the crisis experience – especially policymakers. They’ll ensure there is no repeat; they have the tools and have amassed experience and comfort employing them. The previous crisis was a “100-year flood.” Good not to have to ponder a recurrence for a few generations.

Conventional Wisdom will look especially foolish when this protracted cycle comes to its fateful conclusion. Not only was the mortgage finance Bubble not the proverbial “100-year flood,” it set the stage for historic global government finance Bubble excesses. The real once-in-a-lifetime crisis lies in wait. Not only do we not learn from our mistakes, we instead seem to go out of our way to create bigger ones. This time much Bigger. This predicament was on full display this week.

April 26 – CNBC (Jeff Cox): “The $21 trillion debt the U.S. has amassed on its balance sheet isn’t weighing on the minds of credit rating agencies. Moody’s and Fitch in recent days have reaffirmed the nation’s top-notch credit standing, reasoning that even with the massive pile of IOUs, the nation has sufficient resources to keep its standing. ‘The affirmation of the US’ Aaa rating reflects the US’ exceptional economic strength, the very high strength of its institutions and its very low exposure to credit-related shocks given the unique and central roles of the US dollar and US Treasury bond market in the global financial system,’ Moody’s analysts said in a report…”

I tended to cut the rating agencies some slack after the mortgage finance Bubble collapse. Clearly, their models were deeply flawed, and they allowed financial interests to sway their judgement and outlook (during a lavish boom, who doesn’t?) In general, it becomes quite a challenge to accurately assess underlying Credit quality while the system is in the throes of such an extended self-reinforcing Credit boom. Clearly, the Credit rating agencies hold some responsibility for what in hindsight was atrocious ratings blunders throughout the mortgage universe. Yet when compared to Fed policies, the GSEs and Wall Street finance, the ratings companies were in the crisis causing minor leagues.

I’ll assume that the rating agencies received the message loud and clear: Don’t mess with the Uncle Sam’s “AAA.” If the U.S. Credit standing is today “top notch,” then we’ve reached the point of an incredibly extended Credit cycle where top notch basically means nothing. Our government is amassing debt and obligations it will not repay. There’s the $21 TN of rapidly expanding debt, along with tens of Trillions of future entitlements. And let’s not forget the government-sponsored enterprises. The GSEs ended 2017 with a record $8.857 TN of securities outstanding (record assets of $6.826 TN, along with a record $2.125 TN of guaranteed MBS).

April 25 – Financial Times (Alistair Gray): “From the spotted bronze pumpkin in the valet court to the light sculpture above the marble concierge desk, few expenses have been spared at Sky Residences. Residents of the glistening 71-storey tower in Manhattan’s Hell’s Kitchen have access to a basketball court, a private art collection and a billiards lounge. The luxury lifestyle does not come cheap: one-bedroom apartments are on the rental market for as much as $6,500 a month. High-earning New York professionals who live in the building take the rents in their stride, though they may be surprised to discover who financed it. Last summer, Freddie Mac, the home loans guarantor propped up by US taxpayers a decade ago after the subprime housing crisis, backed by a $550m loan to the building’s owners – Moinian Group, among New York’s largest private landlords, and SL Green Realty… It was the latest in a series of deals to support top-end commercial property developments by Freddie Mac and its counterpart Fannie Mae… By the end of last year the pair had a financial interest in almost $500bn of commercial mortgages, equivalent to 38% of the total outstanding across the US. That compares with almost $200bn, or 25% of the market, a decade ago.”

Did we learn nothing? GSE Securities ended 2008 at a then record $8.167 TN. Remember all the talk of GSE reform – and possibly even winding down the (insolvent) behemoth agencies? Not going to happen. Outstanding GSE Securities did decline to $7.560 TN by the end 2012. Then a funny thing happened along the path of reformation: GSE Securities expanded $238 billion in 2013, $150 billion in 2014, $221 billion in 2015, $352 billion in 2016 and another $337 billion in 2017. It adds up to GSE growth of about $1.3 TN in five years, as the GSEs once again become willing boom-time instigators. It’s worth adding that Fannie Mae increased “Total MBS and Other Guarantees” by about $23.5 billion during the first two months of 2018, with Freddie Mac’s up $16.4 billion in three months.

For years, I argued that the thinly capitalized GSEs were destined for failure. It’s not clear what I should be arguing these days. Their position is even more precarious, but no one could care less. The GSEs have become only bigger and have essentially no capital buffer – remitting earnings to their guardian, the U.S. Treasury. I suggest the ratings agencies ponder the trajectory of U.S. deficits in the event of a financial crisis and economic downturn. On top of exploding traditional deficits, taxpayers (more accurately, future generations) will be on the hook (again) for what will surely be massive recurring losses at the government-sponsored enterprises. A yield spike and the party marathon is over.

But why give one scintilla of attention to the GSEs when Amazon is reporting quarterly revenues of $51 billion, up 43% from comparable 2017. Net Income of $1.629 billion compares to Q1 17’s $724 million. Facebook’s $11.966 billion Q1 revenues were up 49%. Google saw revenues surge 26% y-o-y to $31.146 billion. Even Microsoft saw revenues jump 16%, to $26.819 billion.

If big tech revenue growth is not clear enough indication of a boom, I’m not sure where else to point. Indeed, it’s reached multiples of the late-nineties technology Arms Race. This degree of growth concurrent with three-month T-bills at only 1.75% indicates finance remains much too loose. And while mortgage borrowing costs have been rising modestly, housing data confirm that rates remain artificially low for this key economic sector as well. I would argue excesses at the upper-end of housing markets nationally exceed those from the mortgage financial Bubble period.

April 25 – Bloomberg (Vince Golle): “The U.S. housing market’s storyline for the last several years has been one of steady demand and limited supply, pushing prices ever higher. Now, a new chapter has opened up for the industry and its customers: soaring costs for building materials. Reports on Tuesday underscored both resilient purchase activity and accelerating home prices. The S&P CoreLogic Case-Shiller index showed property values in 20 major U.S. cities climbed 6.8% in February, the biggest year-over-year gain since June 2014. Government data revealed a faster-than-projected rate of new-home sales in March and huge upward revisions to the prior two months. Inventories of previously owned homes are plumbing the lowest levels in at least 19 years, a key reason why resilient demand by itself has fueled price appreciation that’s extending to the new-homes market. Now, with the costs of lumber and other building materials soaring together, buyers are unlikely to see any relief for some time.”

April 24 – Bloomberg (Katia Dmitrieva): “Sales of previously owned U.S. homes rose to a four-month high as buyers, fueled by a solid job market and tax cuts, quickly snapped up the limited number of available properties, National Association of Realtors data showed… Inventory of available properties fell 7.2% y/y to 1.67m, lowest for March in data back to 1999…”

Early in the mortgage finance Bubble, Conventional Wisdom held that home prices were supported by the limited availability of buildable lots across much of the country. Few anticipated the building boom that was to unfold over subsequent years. It just took the homebuilders some time to get situated. By 2003, housing starts exceeded two million units, the strongest level since the seventies.

I was reminded of this dynamic with last week’s release of stronger-than-expect March Housing Starts and Permits data. Building Permits were at the highest level since July 2007, with Starts near the high going back to 2007. And then there was this week’s reports on Transactions, Prices and Inventories. Case-Shiller had y-o-y price gains up 6.8% vs. estimates of 6.35%. After stabilizing somewhat in 2017, home price gains have accelerated.

February New Home Sales, at 694,000 (annualized), crushed estimates of 630,000. There was also a significant upward revision to January sales. New Home Sales are running at about the highest level since 2007. March Existing Home Sales (5.60 million annualized) were somewhat above estimates, also near highs since 2007. While up for the month (and somewhat above recent historic lows), the 1.67 million available inventory was down 7.2% y-o-y. At 3.6 months, meager home inventories are below levels from the mortgage finance Bubble era. Weekly mortgage purchase applications were 11% above the year ago level.

Ten-year Treasury yields traded to 3.03% in Wednesday trading, before settling back down to end the week little changed at 2.96%. During Wednesday’s session, benchmark MBS yields rose to 3.74%, at that point up eight bps for the week to the highest yield since July 2011. Conventional Wisdom holds that higher mortgage borrowing costs will temper home buying. At least at this point, I’m skeptical. Home price inflation continues to run significantly above after-tax mortgage borrowing costs – and is accelerating. There is likely decent pent-up home purchase demand – and a surge of increasingly anxious buyers cannot be ruled out.

The narrative over recent years – really, since the financial crisis – has been that inflation is no longer an issue. From the standpoint of monetary policy and, accordingly, for financial markets, inflation has been thoroughly suppressed: global overcapacity and wage stagnation have from a secular standpoint quashed inflationary pressures. It would seem time for Conventional Wisdom to start wising up.

I tend to believe that so-called “globalization” has been misunderstood from a global inflation perspective. Conventional thinking has it that the globalization of manufacturing, trade and finance will permanently contain inflationary pressures. But in the U.S. and elsewhere, there is a populist backlash against the loss of manufacturing and higher paying jobs to cheap imports. The rise of tariffs, protectionism and fair trade sentiments would seem to mark an important juncture for “globalization’s” headlock on inflation.

The aggressive U.S. stance with trade comes, not coincidently, with an aggressive posture toward fiscal policy. It’s the type of policy mix one might expect at the trough of the economic cycle. But nearing the 10-year anniversary of crisis onset? It may have taken longer than normal, but when it comes to inflation prospects we’re witnessing a plethora of typical late-cycle characteristics and developments.

April 27 – Bloomberg (Sho Chandra): “U.S. employment costs increased more than forecast in the first quarter as worker pay and benefits accelerated, according to Labor Department data… Employment cost index rose 0.8% q/q (est. 0.7%); after 0.6% gain. Wages and salaries advanced 0.9% q/q; benefits costs climbed 0.7%. Total compensation, which includes wages and benefits, climbed 2.7% over past 12 months, strongest since 3Q 2008, after 2.6% gain. Private-sector wages and salaries advanced 2.9% y/y, also the largest since 3Q 2008, after rising 2.8%.”

There is mounting evidence that wage growth has attained sustainable momentum. This dynamic should work over time to broaden inflationary pressures. Rising compensation comes as energy prices gain momentum, while import prices more generally risk surprising to the upside. Moreover, I believe housing has begun to demonstrate an increasingly vigorous inflationary bias. With notable gains in construction and sales transactions, rising prices and inflating home equity, the surprise going forward could be a meaningful jump in mortgage borrowings.

If a few pieces fall into place, before you know it we’ll have settled into an inflationary backdrop that looks a lot more normal than this deflated “r star” the Fed and economics community have been enchanted with over recent years. Conventional Wisdom that additional years of Fed accommodation will be required to sustain a 2.0% inflation target falls flat on its face. From my perspective, there are reasonable scenarios where a so-called “neutral” Fed funds rate of 4%, 5%, or perhaps even 6%, no longer seem unthinkable.

The other side of the story: there’s a serious global Bubble that risks bursting in spectacular fashion: Fragility in China, economic stagnation in Europe and vulnerabilities throughout EM. I’ll assume global fragilities go a long way in explaining 3% Treasury yields in the face of percolating U.S. inflationary pressures.

Conventional Wisdom holds that a flat yield curve indicates elevated recession risk. Some on the FOMC have cited the flatting curve as justification for proceeding cautiously with rate normalization. I would counter that 10-year Treasury yields remain low specifically because of global Bubble risk. The bond market discerns the likelihood that the Fed will at some point reverse course, moving to slash rates and redeploy bond purchases (QE). There is, as well, ongoing QE from the European Central Bank and Bank of Japan. Global bonds were supported this week from dovish indications from both central banks.

Developed bond markets were also likely supported by instability that seems to have afflicted EM currencies. The resurgent U.S. dollar came at the expense of the Polish zloty (down 2.1%), the Chilean peso (down 2.0%), the Hungarian forint (down 1.9%), the South African rand (down 1.8%), the Czech koruna (down 1.7%), the Argentine peso (down 1.7%), and the Colombian peso (down 1.6%). EM bonds were under additional pressure this week.

The dollar short and EM long are two prominent Crowded Trades. That both are currently moving against the Crowd adds credence to the incipient global de-risking/de-leveraging thesis. Unfolding pressure on global “carry trade” leverage? And it was another wild week in big tech. The Nasdaq100 traded as high as 6,721 during Monday trading, dropped as low as 6,427 by Wednesday, opened Friday trading at 6,750 before ending the week at 6,656. The VIX almost made it back to 20 Wednesday, before closing the week at 15.41.

I don’t see a VIX with a 15-handle doing justice to current stock market risk. Wednesday, in particular, had that unsettling dynamic of concurrent pressure on equities, Treasuries, corporate Credit and EM. On the other hand, if risk markets somehow turn quiescent, I would expect the bond market’s focus to rather swiftly shift back to supply and mounting inflation risk.


Original Post:  28 April 2018

Categories: Doug Noland, Perspectives