Q2 Flow of Funds Report

For all of you who are like, "Oh Ben is all about inflation" here is what you didn't understand. I wasn't ever calling for massive inflation in the future, I was saying it existed currently and still believe it does, but will be gone soon. So stagflation isn't an option. But what I am saying now isn't that much different from what I have been saying, but instead I am now calling for something in the future whereas in the past I was saying that inflation was rampant in the system and I stand by that and am willing to defend it as I was in front of the board. The one difference is that I don't think interests will rise significantly higher - as my major assumption is that Helicoptor Ben and the Plunge Protection Team will favor asset prices and economic illusionary output over the US dollar. ENJOY and email me if you would like the spreadsheet I mention.


WARNING: If your busy, don't like economics, don't like me, don't like me or economics - which is a surprisingly strong correlation - or don't want to read / look at a spreadsheet on credit expansion then please stop here and put this email in your delete basket.

So unlike most equity analysts, except for buddy's Gordon and Paul of course, I am always extremely interested in the quarterly Flow of Funds report that is put out by the Federal Reserve. My interest derives from the fact that the report details credit outstanding and credit growth in the US economy, and since credit drives our economy, YES CREDIT NOT ECONOMICs like jobs/income, I feel that if you want to understand the economy then it is imperative to understand credit. Thus, analyzing the data contained within the FoF report is necessary to understand the economy.

First the news and a quick overview. I am only going to discuss the credit portion of the report, but there is a lot of other valuable info in there like net worth, which rose by.1%. Anyways, total non-financial credit decelerated significantly, dropping 310bps from a Q106 annual growth rate of 9.5% to 6.4% for Q206.

The most amazing piece of this report to me was almost step function drop in gov't credit growth, which dropped from an accelerating 11.3% annual clip to -2.4% YoY - that is like a 1370bp drop in 90days. I would like to look more into that and see if it wasn't simply a recalculation of the series or something, but if it is legit then it represents the first time in GWB's tenure as president when gov't debt actually decreased in a quarter. (For fun look at the historical charts in the attached excel spreadsheet and see how Clinton drove down the gov't credit growth into negative territory during his tenure and GWB not only went back into positive but into sustained double digit gov't debt growth during his tenure - he has averaged 6.6% since he took office in 2001. Actually, the credit chart actually blows away the common misconception that Democrats expand debt for spending; if you look at the annual chart you will see that the gov't debt has always trending up during republican office terms - Nixon, Ford, Reagan, and Both Bush's - and has always trended down during democratic terms - Carter and Clinton.) Anyways, the gov't decrease was by far the biggest contributor to the deceleration - subtracting 238 bps from the total nonfinancial credit growth by itself.

The second biggest contributor to the decline was a 200 bp deceleration in business credit growth - 44% of total nonfinancial debt outstanding - which subtracted 63 basis points from total credit growth. I am not ultra familiar with this series, but from a simple mental model it would seem that it means less credit from the likes of department stores, automakers, home depot, and other firms that extend their own credit lines to their customers - something that is definitely not good for consumer spending (I will go into more later in this email). The third largest contributor, which represents 33% of total credit outstanding, decreased by 180bps from a double digit annual rate of 10.8% to 9.0%. The deceleration in mtg. debt growth subtracted 60 basis points from total nonfinancial debt growth. Finally, the two segments that saw increases were consumer credit (8% of total credit) and state and local gov't credit (7%) - the two smallest segments of nonfinancial credit. Consumer credit increased 410 basis points from 2.5% to 6.6%, while this is a major increase it is also a small chunk and the worst kind of credit as the rates on this debt are the highest of all forms of credit - THINK Credit Cards, Cash Advances, etc. Local gov't debt edged up by 310 basis points. The two respectively increased the total nonfinancial credit growth rate by 35bps and 21bps respectively.

In a credit driven economy, like the US economy, spending is directly tied to credit availability, especially in our economy since jobs/income growth have been the worst in this expansion of all post WWII expansions. I show this analytically through regression analysis. I attempted to explain the delta in GDP and PCE, which each were used as dependent variables in different regressions, w/ various credit deltas (total nonfinancial credit growth, household debt growth, a multivariate w/ consumer credit and mtg and business - which attempted to exclude the gov't portion), and came up with some decent results. However, the major takeaway was not a forecasting model but a higher level of conviction that our economy is on a credit cycle with booms coming when credit flows, like prior to the real estate and internet bubbles, and busts coming when the credit spigots dry up, like in the case of the great depression, the Japan deflation, the post-internet bubble, and the mess that we have in front of us shortly. The relationship between credit growth and output/spending growth is illustrated clearly in the graph that plots the 3year moving average of total nonfinancial credit growth and pce/gdp growth. The other thing I took away is that the Betas on the regressions for the credit explanatory variables were like anywhere from +2.3 to +3.7, which makes sense given that the US is levered by 3.5x gdp. Essentially, this means that if credit rises by 1% we are going to see output / spending increase by 2 % to 3%, which is great, and clearly evident, in times like the mid to late 90s, the 1920s, Japan's big boom when they were all buying up US assets, and the last couple years in the US, but terrible when credit decreases. The problem with leverage is that it works both ways, like those poor boys from Amaranth Advisors that lost $4.5 billion (50% of equity) when Nat. Gas went the other way on their levered position. Essentially that is what the betas tell me; that America is levered to credit growth and if it goes the other way things will get ugly. Currently, our country is levered (total financial and nonfinancial credit / gdp) at a ratio of roughly 3.5x (350% of annual output). To put it into perspective, that is more than one year's real gdp. So right now we are adding roughly $4.80 of debt to get an incremental $1 of real GDP; its worse on a nominal basis where we are adding roughly $8 of debt for every incremental $1 of GDP. Essentially, we are in bad shape if we really look at the situation.
Given our credit leverage, I think that is very interesting that credit decelerated quite a bit in Q206 according to the Fed's Flow of Funds report, and therein lies the problem of the credit cycle economy. Remember that 30 countries in the world have raised rates in the last 2 months, which equates to a global credit crunch. I mean in the last five years the total incremental credit addition surpassed real gdp by $12 trillion roughly. This is why I have pounded the table for buying gold, selling dollars and buying Canadian and Australian Dollars, and have called for significantly higher inflation. While some may say that inflation hasn't picked up and point me to CPI, I will argue to the death that it has completely and discuss CPI lastly. First, look at the price of oil - the commodity, like gold used to, now backs the dollar. I don't see higher oil as so much of a supply and demand issue as demand has yet to exceed supply (even though I know that refining capacity is close to 100% it still hasn't fell short), as a weaker dollar issue. The huge Eurodollar reserves that many foreign banks hold, which are sometimes referred to as petrodollars, are usually to buy oil from one of the three exchanges where you can only buy oil using Us dollars. The result of this is the same as the 2 Breton Woods agreements - essentially that there is an artificially high demand/bid under the dollar, which is why we haven't had a currency crisis given that our CA deficit is 6.6% of GDP - a level that is higher than that of all of the countries that have currency crisis in the last 30 or so years. Another point to this is that the Fed stopped disseminating the M3 statistic in March, which is shady in itself, but was probably to hide what was going on in the Eurodollar market due to threats of a euro-currency based oil bourse opening up in the middle east. Anyways, look at the price of all assets, there are no risk premiums anywhere and no cheap assets anywhere. The earnings yield on the S&P 500 is like only 75bps above cash, credit spreads are near historic lows, real estate and commodities are at historic prices, etc. I call this asset price inflation, which according to Benjamin Strong, John M. Keynes, the World Bank, and the IMF (note I didn't put Alan Greenspan in this list) should be treated exactly like consumer price inflation. Asset price inflation is a product of the massive credit expansion; it was the direct cause of the ponzi-esque scheme in the 1920s and is the cause now. Another place I see massive inflation is in our trade deficit, which is ballooning. Money flowing to Asia has two effects. First it can't be recycled in the economy and let the multiplier effect take hold, and second it is causing enormous wage deflation, which is what is keeping the prices of goods and services from going sky high like it did in the 70s when there was much less trade with China/India. One last point on CPI, the series has been recalculated two different times in the last 14 years in order to decrease entitlement payments, decrease Treasury Inflation Protected Security coupon payments, to keep wage inflation at bay as most employees / unions wages are adjusted by the CPI, to make politicians / central bankers look better and not let everyone onto their neo-Keynesian credit scam, and finally to make the country look more solvent than it is in reality. Remember Alan Greenspan has testified in front of Congress seven different times to decrease the calculation of the benefits equation (aka CPI). If you are interested in this let me know as I subscribe to an economist named John William's website where he uses the footnotes of the gov't releases to calculate the CPI in the pre-Clinton method. Let me tell you that the series is currently running at 10% if we calculate it the way that the US did only 14 years ago.

Finally, looking at the most recent data to come out shows that credit slowed significantly in the major nonfinancial categories, increases were in the smaller segments as mentioned above. When on a credit cycle you look for downturns the same way you look for bad jobs/income data in an economic cycle. So the fact that our economy is so levered to credit and credit decelerated by 310 bps makes me think that Q406 is going to be bad. I think Q3 will come across good as people eek out one last quarter, there is easy comps from last year due to the high level of hurricane damage last year, and the fact that energy prices have decreased recently should be a boost to consumption. However, I don't see anything that will drive consumption, which sadly drives our economy, in the future.
Think about the consumer from a Sources/Uses of funds perspective.

SOURCES:
Jobs - Worst post-WWII expansion job numbers. In addition, the jobs created are asymmetrical with an estimated 4/10 being created in the closely tied construction and housing sectors. The other jobs are of the low paying variety at places like Home Depot, Target, Wal-Mart, restaurants, and other service related employers.

Income - Real income growth is flat and nominal is up slightly. Disposable income is ugly and getting uglier as taxes continue to rise.

Savings - Personal savings rate is negative. People have to start saving again, which will mean less money spent.

Asset Sales / Price Appreciation - Housing market needs no discussion as we all know what is going on there. Cap gains are always a taxed source, but asset prices are so expensive due to the credit expansion that you must take on a lot of risk to make money. I see this category of cash out refis etc. being a major problem.

Uses
Energy - Forget about the short term dip, the dollar is going down and the S&D is out of line - meaning in intermediate term there is only one direction for energy prices to go. Thus, gas, utilities, etc. are rising by a greater % than incomes, which inherently means wealth erosion - #1 cause of less spending.

Taxes - Have gone up recently and will probably continue that way as the gov't is broke and needs money.

Food and Metals - Price increases in these areas are derivatives of energy bull, but also have bad S&D situation. With prices being passed on across the economy at a higher % than income growth there is wealth erosion here as well.

Debt Service - The Fed didn't even publish this number last time till a Wall St. economist called complained. The reason they gave is probably different than the real reason, which is that debt service as a % of gdp / income is the highest its ever been (15% roughly). To make matters worse, the resets in the mtg. ARMs of $700billion in 2006 and $1.2 trillion in 2008 will work to only increase this ratio. Plus, interest is an exponential function, which means if you only pay the minimum on your debt b/c its all you can afford due to higher basic needs costs and less wealth growth for all of the reasons discussed above.

My Thesis:
These effects will combine with the credit deceleration to destroy spending demand. Units aren't moving right now. I mean all I hear in talking to these mgt. teams is that revenues are comprised of a much higher % of price taking than volume increases. Restaurants, for example, are actually decreasing prices for the first time across the country to drive demand. This is what happens with excess debt - it is by definition deflationary and pushes out consumption and investment growth. So if people are struggling to make basic needs payments and have to decided between buying stuff they don't need / eating out at a restaurant and heating their home and paying their debt, which they all have as $12k is the avg. debt per person in America, we all know what will happen.

So if credit is the key and it is decelerating, I believe that the economy will decelerate quickly and Helicopter Ben and the boys at the privately owned Federal Reserve will come to the rescue and drop rates. And when the Fed drops rates they do it fast. A good primer for this would be reading the Fed Minutes from like 1999 to 2001. The economy was chugging along, the last rate hike was in May to 6.50%, which is where it sat until January. If you read closely you can see the language / economy detiorate the rest of the year. Inventories climbed, sentiment dropped, credit dropped, and the economy followed suit. The Fed figured it out and called an emergency meeting that probably went something like this:

Greenspan: Hello?

The US Economy: Easy AL, we need help. You have choked off our lifeline (credit) by keeping rates so high for so long, we need a fix or else the inventories are going to keep climbing and the market is going to keep dropping.

Greenspan: No problem, I will call an emergency meeting of the FOMC and drop rates by 50bps to 6.00%. And in our regular meeting at the end of January (01) we will drop it another 50bps for you. In fact, I will tell you two things. First, buy bonds or if you’re a little more savvy go long Eurodollars. Second, I promise I will keep dropping rates until you have all the credit you need; I will even take rates down to 1.0% if necessary.

The US Economy: 1%!!! No way, that means we can all refinance our homes and buy 2nd homes or additions or other stuff that we don't have right now. You’re the best Central Banker an economy could have AL. We'll never forget you; in fact, we will support an $8million book sale when you retire. Thanks again.


Sorry, but that definitely means I am a finance nerd as I really had fun with this email. So the investments that I see coming out of this are to buy gold, go really long interest rates - options are preferred method and pack the most leverage and are actually the cheapest options available on futures markets, buying foreign currencies, especially Canadian and Australian dollars, and buying general commodity indices - Rogers is best probably - are all great ways to participate.