The Impact of Deleveraging
The economy is still a mess and structural problems will act as a brake on economic growth.
We are in the “belt-tightening” form of recovery (No. 1). GDP averages are negative to low growth for the first one to three years, with growth resuming thereafter in years four to six.
The research by Carmen Reinhart and Kenneth Rogoff I mentioned above measures business cycle timelines on a worldwide basis over an average of six years:
It appears we have another 12 to 24 months of deleveraging of bank and household debt if you believe history will repeat itself.
CRE deleveraging will commence in earnest this year. There is about $3 trillion of CRE debt to private borrowers. Here is a CRE refi chart done by IREI:
If the default rate tops out at 6 percent this year, then expect $15 billion of defaults this year increasing to about $20 billion in each of the next three years. There is a great deal of capital waiting for CRE to collapse and that will set a floor on prices competing for foreclosed projects. This will prop up the market and help the deleveraging process.
There are too many “ifs” to put a date on this period, but as shown in the historical data above, this could last two to three years. I often say that this cycle is unprecedented and past history is not necessarily a good gauge of the future, so take that into consideration.
There is a question of the FHA continuing its easy credit because of its financial exposure to the mortgage market. The FHA is facing calls from some in Congress to continue to ease credit standards and others who demand fiscal responsibility. On the other hand, Fannie and Freddie are loosening loan standards. If credit tightens, then prices will fall. Regardless, residential real estate lenders will continue deleveraging.
Assuming easy federally induced credit, residential real estate prices will slowly stabilize despite supply from the shadow market.
Deleveraging points to continuing deflation. On the face of it, CPI, less energy, is starting to rise:
What the CPI doesn’t measure is real estate: deflation will occur in commercial real estate, and to some extent, residential real estate. The deleveraging process will continue to restrict credit, which in turn will suppress M1. When the banks become healthy, then “excess” reserves become a problem.
The Fed now believes it has saved the world and that the economy is in recovery and Fed officials are starting to talk about their “exit” strategy. That would involve paying interest on “excess” reserves as an attempt to sop them up.
If you believe the Fed that we are in full recovery mode, then why aren’t banks lending? Why is credit continuing to collapse? If you believe we aren’t in full recovery mode, then you know why banks aren’t lending. In either case, the banks have no incentive to give up their reserves until they have deleveraged sufficiently to believe they have weathered the storm.
Even if we assume a recovery is well on its way, and the banks believe this, then why would banks not lend to their customers? One could argue that they would rather service customers and rebuild their commercial loan business than receive interest from the Fed on reserves. After all, that is what banks do to make money.
Recovery: Yes or No?
The Fed is in a quandary. Too much tightening and the economy could, in its view, collapse (the dreaded “double dip”). Too little and we could see substantial inflation.
The economy is in recovery but not for the reasons the Fed and the Obama administration believe. I have been saying for some time that all economies repair themselves unless the government interferes with the process. Bankruptcies, unemployment, management’s drive for more efficiency, and debt reduction are all part of the process that goes on despite the government’s policies to prevent it.
But policies of the Fed and the government miss the most important thing necessary for a recovery: deleveraging.
They have been trying to re-inflate the housing market, prop up banks with bad loans, pump massive amounts of credit into the system, bail out financial companies, and spend tomorrow’s wealth on wasteful stimulus projects. When the stimulus spending wears off, the economic effect wears off as well. Their pursuit of these Keynesian fallacies has accomplished nothing other than to increase federal debt and bail out their Wall Street cronies who should have failed. It appears, fortunately, that there is not much political appetite for more stimulus spending other than as proposed in the administration’s jobs bill.
Almost all of the improvements in the economy are the result of the normal organic business cycle repair process. We see margins improve as companies strive for efficiency and lower costs, but sales have declined as well, putting pressure on earnings. For example, Coca-Cola’s growth comes from foreign sales (79 percent) whereas U.S. sales are down (4 percent). Ditto Levi Strauss, Tyson, Burger King, Kellogg’s, Sara Lee, etc. Many companies (financials, for example) are seeing improvement from better margins, not sales growth. This is more of a one-time event in the business cycle: how much more can they cut? The future will depend on sales growth.
The good news is that deleveraging will continue and the government can’t stop it. But it can delay it, which would be bad for recovery.
What is most likely to happen in 2010:
» Personal consumption expenditures will remain constrained.
» The household savings rate will remain high.
» GDP will, on a real inflation-adjusted basis, decline to near zero by Q3 or Q4.
» Deflation will continue in real estate, especially commercial real estate, as banks repair their balance sheets and deleverage.
» Inflation will remain low.
» Unemployment will stay high, probably above 9 percent for the year.
» The fear of sovereign defaults will support the dollar.
» The Treasury will have no problem selling debt to U.S. investors (rising savings) and foreign investors (seeking safety).
» China, Japan and the United Kingdom (the Big 3 creditors) will continue to buy U.S. treasuries.
» Interest rates will remain low.
» Any attempts by the Fed to tighten credit will be abruptly reversed as economic weakness is seen.
» Exports will be sluggish as the world’s economies struggle.
» Taxes will increase modestly this year (an election year).
» A VAT-type tax will be formally proposed next year.
» China’s credit tightening will burst their new real estate bubble and harm domestic consumer demand.
The problem with any kind of economic forecasting is that the world has a tendency to do things economists don’t see coming. I am humble enough to recognize that. Here are some things to think about that could change my scenario:
» The government panics (again). Stagnation is not something Fed chairman Ben Bernanke foresees happening. He’s hoping for a straight-line recovery. I am aware that he always covers his Delphic statements with caveats, but I think he; Larry Summers, director of the White House National Economic Council; and Treasury Secretary Tim Geithner think “We did it! We saved the world.” When the double-dip hits, it is hard to predict what they’ll do. In their Keynesian-Monetarist world view, they will be compelled to do something.
» A taxpayer rebellion alters the power structure in Congress. Mind you, I don’t have much faith in either party, but if a Tea Party backlash shows up at the polls in November, it could slow down some of the social legislation the Democrats propose. It makes more likely the possibility of tax cuts instead of more spending. Less legislation equals less change, which creates more certainty in the minds of business people about their future.
» I find that I have very little insight into what drives the market from day to day, so I’m not giving stock market advice. Of course I’m not alone. I think most stock market analysis is mere guesswork. For what it’s worth, the rally starting last March is a faith-based rally. I think most traders believe in the conventional wisdom on government intervention in the economy. I would buy David Rosenberg’s view that the market has been overpriced. If you want market advice go elsewhere.
» Catastrophe. The bad Black Swan. It’s always out there: an EU credit collapse, stock market crash, al-Qaeda, Iranian nukes, Israeli-Iranian war, massive earthquake in California, Pakistan falls to the Taliban. Use your imagination here.
I am very aware that it is easy to always be negative or positive because of one’s view of the world. It is quite difficult for me as a free-market advocate to be positive. I try to fight my tendencies and be wary of this trap. I try to see things as they are, not as I would wish them to be. So I want to end this survey on a positive note.
I believe the United States is still the world’s most dynamic, entrepreneurial country. Our capital and financial markets still give big rewards to successful companies. Every day I see people come up with new ideas for businesses and they risk everything for their dreams of success. These are the people who will rescue us. Now, if only the government would get the hell out of their way and let them do their thing.
— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.