Saturday, August 3, 2013

Lakshman Achuthan On The Current (Not Coming) U.S. Recession

Lakshman discusses why his leading indicator index (ECRI) forecasts that the United States entered into recession in late 2012.

Some context before hearing Achuthan's well thought out discussion comes from Shadow Stats, which shows that using the real CPI inflation deflator (inflation is subtracted from GDP to show real growth) instead of the government's CPLie index, the United States economy has been in a recession for almost a full decade running (blue line below).


This would help explain the continuous shift from high paying full time jobs to low paying part time jobs as stock prices are enjoying new highs every trading day.



h/t Shadow Stats, Zero Hedge, Bloomberg

Reinhart & Rogoff Are Correct: Another Walk Through The World Of Common Sense

The mantra that "government spending is good for the economy and austerity is bad for the economy" has been relentless and incessant since the Reinhart & Rogoff 90% debt to GDP debate broke out in April of this year. I commented on this topic during the initial hysteria back in April in Using Common Sense Instead Of Economic Text Books

I was expecting this conversation to die down and some form of rational thinking to enter the discussion, but unfortunately it has not. It breaks my heart to know that college students are paying their universities $50,000 to $100,000 a year to receive economic poison for their minds. I came across the following article this morning from an economics professor and an undergraduate student at the University Of Michigan titled After crunching Reinhart & Rogoff data, we've concluded that high debt does not slow growth.


People will be able to look back years from now and realize how stupid this statement is, but in our current market atmosphere after reading headlines like that over and over and over again, I think regular people on the street are unfortunately starting to believe it. I know that regular readers of this site can easily brush aside such nonsensical statements, but we'll review the topic very briefly here again just in case anyone is starting to get nervous that common sense no longer applies to the world of economics.

The article above reminds me of the research that was written back in the mid 2000's regarding mortgage loans. At the time, the top researchers from both Wall Street and Academia "proved" that mortgages were safe because a history of data points said so. They had 50 years of data showing a steady and continuous rise in home prices combined with 50 years of data showing that the default rates on mortgage loans were extremely small.

Now think back to that time, before the crash, what someone might think reading a paper like that with fancy graphs coming from a professor. We know now that the reason there was no trouble in the mortgage market was the irrational psychology around the purchases of the debt. Mortgage debt was in a bubble. It was only when the psychology around the safety of these mortgages changed just slightly that the entire house of cards came crumbling down, and their data sets were thrown out the window.

This is easy to understand looking at it today as we have all heard this story countless times. We look back now and marvel at how every single Wall Street bank and every single academic paper across the country could have gotten it so wrong.


Fast forward 8 years later to today. We are currently at the grand finale of a 70 year debt super cycle and, more specifically, the grand finale of a 30 year global government debt cycle. Investors are paying a price for bonds today (accepting a lower interest rate) that is more out of line with the value of those bonds than any time in the history of the financial system. The current bubble in almost all debt, but specifically government debt, is the greatest and most irrational bubble the world has ever seen.

Does that sound crazy? Here's a quick perspective on probably the first bubble that pops into your head that would easily seem far more irrational: the tech bubble of the 1990's. This was a period when hundreds of start ups across the United States were building Internet companies from their garage, taking them public with no earnings, and receiving astronomical valuations that would double or triple during the first day of trading. Insane? Yes. Completely.

Here is the difference: there was a chance, even if it was just a 0.0001%, that something could occur that would allow these companies to reach those valuations. They could have put together a business plan that could one day become a highly profitably entity.

Looking at the balance sheet of countries today such as Japan or the United States a 5th grader with a calculator can spend a few minutes to see that the debt of these countries will never be repaid at full value. There is a 0.00% chance that it will occur. 

The market has priced these securities with close to 100% certainty that their money will be returned at full value. To find a bubble of this irrationality you would have to go all the way back to the tulip bulb mania of 1637.


When this mania subsides, which could be this month or it could be 5 years from now, interest rates on these bonds will explode (shocking everyone and destroying every academic model). The additional cost to carry and roll the current debt is going to be combined with the cost to take on new debt in the market. For many countries, the interest payments are going to overwhelm the outflow of capital.

As that capital, which is considered a future stimulus for economic growth and has been priced into every future model, is diverted away from the real economy it will slow growth considerably. Economies now depend on government stimulus more than ever for a large percentage of their annual GDP.  As an example, a very small portion of spending has been diverted away from the countries of Greece and Spain (they are still borrowing and spending with the help of bailouts and the central bank) and their countries have entered depressions unlike anything we have seen in decades. 

When the psychology toward government debt changes the prices of these bonds will collapse, and every academic paper and analytic model currently used by Wall Street will become another marvel in the annals of history. They will take their place alongside the subprime mortgage papers written in 2005.

For more on the impact of rising rates see the 2013 Second Half Outlook.


Marc Faber Discusses China & Their Impact On The Global Economy

Thursday, August 1, 2013

A Look A The New Real Estate Mania

Robert Shiller, of the Case-Shiller home price index, took some time to speak with CNBC this week after his home price data was released for the month of May (which is an average of March-April-May home prices). The following chart shows the Case Shiller home price movement in red with the Core Logic home price index in blue.


Shiller continuously used the word "bubble" throughout the interview to describe the froth currently seen in many of the major real estate markets (video below). He sees tremendous momentum in the current real estate bubble and says that an investor today can probably survive the collapse if "they can get out in a year." Words that the flippers out there love to hear.

The problems he sees beyond the current artificial momentum are the same we have discussed here numerous times. The first is interest rates, which as the chart below shows, has caused the average home payment to rise 40% in just the last few weeks. We know the real affordability has fallen even further than the chart shows because the opposite side of the ledger, how people make these payments (real income), continues to fall during our current depression.


His second concern is the tremendous power that Wall Street has exerted on the market with the rent to own model. The following shows the enormous amount of inventory that Blackstone has been able to accumulate over the past few years, making them the largest home rental company in the country.


This model has already begun to saturate some of the largest markets. The following is a snap shot of the available inventory to rent in the Phoenix market in March of this year.


Just a few months later, the following shows what this inventory looks like today:


While we know that supply is soaring, what about the other half of the economics curve; rental prices? The following charts shows that home rental prices have continued to reach a new high month after month. Along with record low interest rates, the large banks purchasing these properties have priced in a continued rise in these rents.


This of course will be an issue if the all important real income in America, what is used to make rental payments every month, continues to decline. Or if the supply pictures like the ones shown above continue to swell. This is why Blackstone is already in discussion to create a new Rental Mortgage Backed Security. The same type of structure used to bundle mortgages back in the early 2000's will now be used to bundle rent payments.

I hope I don't have to explain how this story will end, as you only need to pick up one of the countless books about the 2008 financial crisis to learn about it.

For much more on this topic see:

2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake


 

 h/t Wall Street Journal, The Big Picture, Calculated Risk, Zero Hedge

Monday, July 29, 2013

2013 Second Half Outlook: Municipal Bond Market

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake
2013 Second Half Outlook: Municipal Bond Market

Ernest Hemingway was once asked how it is that entities goes bankrupt? And he responded, "very slowly, then all at once."


That quote perfectly summarizes the current bankruptcy process of many government entities around the world. This past week the "all at once" occurred in the city of Detroit when they entered Chapter 9.

Before we discuss the negative aspects of the municipal bond market I'd like to first review the positives.

There are 90,000 municipalities in the United States. For perspective on the size of that number, there are only 6,000 U.S. stocks (and 1,000 ETFs). Each individual municipality, just like each individual stock, has its own balance sheet, economic outlook, and story.

Few analysts take the time to look in depth at the accounting of individual municipalities, while there are thousands and thousands of analysts looking over the accounting of stocks. Municipalities tend to get "lumped together" which is unfair because while many will go bankrupt over the next few years, most are healthy investments (in terms of default risk). Only 61 local governments have gone through Chapter 9 since 1954.

The municipal bond market trouble that is coming will not shake the financial system the way the housing market did back in 2008 because it is only $3.7 trillion in size vs. the $14 trillion mortgage market back then. Only a small part of that $3.7 trillion is in major danger.

Detroit's bankruptcy was the largest in history, by far:


The most important part of this event, for those living outside of Detroit, will be the legal battle that will take place in the courtrooms regarding how bond holders, unionized government workers, and pensions are handled. Many troubled municipalities have made promises that they simply will be unable to keep in the years ahead. When the unions do not renegotiate the terms, the only (and best) option for the city is bankruptcy.

I will not even guess how the Detroit situation will play out because I have no idea how. It will be important to follow because it will set the precedent that will be used as the blue print for the rest of the country. We know, as of this writing, that bankruptcy Judge Steven Rhodes has blocked lawsuits by public employees and pension funds.

The Detroit bankruptcy will have other ramifications, one being that it will trigger an avalanche of ratings downgrades. Other major cities to keep an eye on in the months ahead are Philadelphia, Houston, LA, New York City, Baltimore, Miami, and Chicago. Due to their financial troubles, the Detroit bankruptcy will cause the ratings agencies to re-evaluate their current credit ratings.

Lower credit ratings brings less demand for bonds and higher interest payments. This only compounds the problems because their borrowing costs will rise when they need capital the most.

As we just discussed looking at the real estate market, a rise in treasury yields creates an increase in borrowing costs for all assets. The same will occur in the municipal bond market. Rising rates will push some cities that currently have no funding problems into trouble, and it will push those that are already in trouble over the edge. Only the strongest will continue to thrive, and municipal bond rates have already begun to surge:


The following shows money moving out of muni bond funds in late May, and unlike other debt markets, the money has not yet returned.


This highlights the dangers of general bond funds or mutual funds. Investors up until recently have been pouring money into these securities unaware that they are laced with toxic muni debt that has only survived due to the artificially low interest rate environment.

How cities got into so much trouble can be summed up quickly and easily: The cities that experienced the greatest home price appreciation during the bubble priced in the increase in real estate taxes into their models. They created bloated spending programs and locked in pension and employment payment programs at astronomically high levels. These pension programs have been underfunded and used as a piggy bank since the turn of the new century.


Then home prices collapsed, along with many of their economies, and the revenue source disappeared. They have been helped by the federal government and the fortunate timing of our current bond bubble to stay alive.

While the real estate bust has been the culprit for most of the market's woes, some cities face additional problems such as a major employer leaving which reduces demand for workers. This then leads to a population decline in that city. Detroit is a perfect example with their manufacturing industry decimated over the last 60 years.


This market will create investment opportunity during the coming debt crisis. Many of these municipalities actually have a fundamentally stronger balance sheet than the federal government. Actually, most do. As the bond market continues to deteriorate and rates rise there could be a panic in the municipal market as more and more local governments turn toward bankruptcy. Many of the stronger cities may see a severe decline in bond prices, allowing the astute investor the opportunity to pick up some great bargains. We are well away fromm that point, but it is something to begin researching now (with a financial professional) as part of your shopping list for when the real crises arrives.

For more on the municipal market I would listen to this excellent interview with Meredith Whitney:

The Fate Of The States: How Municipal Debt Will Reshape America

While she has become the focus of negativity around the municipal market, anyone who has taken the time to read her work understands that she sees the coming changes as an economic growth opportunity for many areas of the United States. As companies, jobs, and workers leave the most indebted states they will migrate to the states where they are less taxed and have less regulation.