Tyndall Monthly Commentary: USA buying now but will pay later

US consumers have started borrowing again and while this may give the US economy a short-term boost it could cause big problems further down the track.

Thursday, November 1st 2012, 4:10PM

It has become almost an accepted fact that the US private sector economy is currently deleveraging and that it is this that is in some way holding back the economy’s rate of overall economic growth. Over recent quarters, though, it has become apparent – at least to those willing to look – that far from deleveraging, the US private and public sectors are now showing a clear tendency to re-leverage and we firmly believe that it is this renewed credit boom process that is currently allowing the US economy to buck the global trend towards a new bout of economic weakness and therefore to produce the still-reasonable headline real economy data. We are concerned, though, that this counter-trend growth may yet come at a considerable cost in the longer term.

Specifically, we find that US households are slowly beginning to re-leverage in absolute terms through the greater use of consumer credit to top up their still-modest rate of overall income growth. What is often overlooked in any discussion of the US consumers’ position, though, is that were the Federal Government not borrowing quite so much, then it is very likely that the US household sector’s financial position and in particular its income growth would be very much softer than it is currently. For example, if the Federal Government were to either raise taxes and/or reduce its expenditure, then household disposable income receipts would weaken as they have in Europe for similar reasons. It is for this reason that we would fear the advent of any “US fiscal cliff” were it to occur but we can also suggest that US household incomes – and hence the current reasonable rate of US consumer spending growth – are at least partially dependent at present on the government’s own continued rapid rate of borrowing growth, as well as the consumer’s own borrowing exploits.

We might suggest that all that has really happened at a top-down level is that the household sector’s once-heavy borrowing that occurred prior to the GFC has been replaced by public sector borrowing since the GFC. Since it is households that will one day have to bear the brunt of servicing the government’s debt burden, though, we see little difference between the pre- and post-GFC “household” credit expansions. Therefore, it is safe to assume that not that much has really changed over recent years in just how the US consumer affords to sustain their “excessive” level of overall expenditure – much of it is still based on the notion of someone borrowing large sums. This state of affairs is not always recognised by many commentators. It is even less well appreciated, though, just how aggressive US corporations are being in their level of borrowing at present.

Although the ratio of corporate debt to nominal GDP did fall immediately following the GFC as companies repaid substantial quantities of bank debt, the ratio of debt to incomes has been rising once again over recent quarters. Central to this re-leveraging of the corporate sector has been a dramatic resurgence in new issue activity within the corporate bond markets, which seem to be enjoying one of their longest and most aggressive issuance booms experienced within the last 50 years. Certainly, if we scale the corporate bond issuance by the level of nominal GDP, we find that the current boom in issuance exceeds not only that during in the mid-1980s credit boom but it may even exceed that witnessed during the tech/NASDAQ bubble of the late 1990s.
In the 12 months to June, incorporated businesses borrowed just shy of USD400 billion on a net basis through corporate bond markets and this represented the equivalent of almost 3% of national GDP. In addition, we also find that over the first part of 2012, the corporate sector also began to make more use of conventional Commercial & Industrial bank loans as well, with the result that US total corporate debt outstanding is currently rising by the equivalent of 4-5% of national GDP per annum. Hence, far from de-leveraging, the US corporate sector is re-leveraging at present.

Consequently, at a basic top-down level, the US is in reality already trending back to the situation that prevailed prior to the GFC, in that fundamentally poor “value-added” real income and productivity trends are being topped up by credit flows (now relatively more public-sector- than private-sector-oriented flows, but credit flows nonetheless) so that some degree of headline expenditure growth can be maintained.

Many investors will recall, though, that the economy’s poor fundamental position in the mid-2000s was, for a while at least, completely ignored by the financial markets as they became hostage to the inflating effects of yet another aspect of the credit boom process – namely the “mega flows” that resulted from a combination of easy central bank liquidity policies and financial deregulation (particularly with regard to derivatives and structured credit).

Today, we find that the FRB and some other central banks are overtly and deliberately attempting to lift financial sector liquidity and thereby striving to create a new 2006-style credit boom through Q-Eternity in the hope that this will help the wider economy, but on this occasion the regulators and the related collateral famine situation (that is, the shortage of suitable collateral within the financial system that can be used to facilitate credit transactions between different financial sector entities, such as between banks and investment banks) are attempting to push the other way by creating a physical constraint on the financial sector’s ability to expand.

If the regulators/impact of the collateral famine do prevail over the wishes of the reflationists, then, over the next few months, the financial markets will have to recognise the problems in the real economy and likely suffer as a result (a process that may have begun over recent weeks?). If the central banks and the large investment banks that would return us to the hectic rates of asset growth within the financial system that we witnessed in the mid-2000s hold sway, though, then we may yet achieve a bull market in asset prices in the near term.

It therefore seems that we are at an important crossroads for financial markets. If credit flows within the system do not pick up as a result of the regulatory and collateral situation, then the QE glow will quickly fade within financial markets, but, if intra-financial-system credit flows do revive in a replay of the situation that prevailed in 2006, then we may see a powerful new, but dangerous, bull phase in financial markets in the near term. We use the term “dangerous” because not only will this new phase involve the creation of more financial system leverage, but because it will likely contain with it the seeds of its own destruction.

If Q-Eternity works as some hope, then at least some of the EM debt markets will likely see yet more large capital inflows (Mexico & the ASEAN economies seem the most likely at this juncture) and the resulting surge in liquidity in these economies will likely cause a new economic expansion. At this point, the countries concerned will likely begin consuming more of their own output and their current account positions will likely be deteriorating (as has generally been the case over the last thirty years), with the result that the current excessive level of inventories within world trade will be absorbed and world trade prices will therefore then begin rising strongly once again, just as they did in 1994, early 2000, 2004, early 2007, 2010 and 2011.

The sharp-eyed will have noted that each of these periods in which we witnessed world trade price inflation rates rise as a result of resurgent domestic demand trends within the emerging markets subsequently resulted in inflation shocks and tighter monetary policy settings in the West (either higher rates or, more recently, the suspension of QE regimes), which proved highly deflationary to the credit booms that were occurring within the global financial system at those times (that is, the bond rout of 1994, the bursting of the NASDAQ bubble in 2000, 2004’s albeit temporary but quite significant market upset, the mid-2010 and mid-2011 selloffs and the start of the GFC in mid-2007).

Given these precedents, we can suggest that even if Q-Eternity does work as perhaps is hoped and it does lead to some form of global recovery that revives world trade, it will carry with it the seeds of its own destruction when it ultimately causes world trade prices to rise later in 2013 and the QE to be abandoned. As 2007-8 revealed, if this import-price-initiated tightening occurs at a time in which the financial system has become particularly overleveraged, as it seems to have a predilection to doing, then the effects may be very uncomfortable. If there is a rally in risk markets as intra-system credit flows revive over the next few months (and we shall be watching the data closely for signs of this occurring), then investors should try to enjoy it while it lasts, but also to try not to be the last to leave the Fed’s latest attempt at creating a party in the asset markets once global inflationary pressures start to build again, as they surely will under such a situation.

Andrew Hunt
International Economist, London

« Harbour Monthly Commentary: Second time lucky

Hamish Douglass Unplugged - Latest Video from Adviser Briefing - August 2012 »

Special Offers