Excerpt from http://www.contraryinvestor.com/mo.htm
Dear Prudence, Won't You Come Out To Play?
Dear Prudence, Won't You Come Out To Play?...For years now, we have been focused on the macro theme of the credit cycle in all its wonderful glory quite intently. For those reading our work over the years, you’d probably characterize it as focused “to a fault”. Again and again during the current decade we asked, is it a business cycle or a credit cycle? Of course after the events of the last few years, it sure seems that question has been answered in spades. At the moment, we believe our little credit cycle obsession is still the key focal point for what may lie ahead in terms of real economy and financial market outcomes. In this discussion we want to have a brief look at components of credit cycle character that as of today simply have no precedent over the last six decades of recorded Fed data. After looking at these data points, we want you to ask yourself, should we really be expecting a “typical” economic recovery? Secondly, we want to briefly have a look at historical patterns of consumption in prior recessionary cycles and what experience of the moment may be telling us relative to behavioral patterns of the past. Let’s get right to it.
When it comes to the macro credit and conjoined economic cycle, we suggest an important item to keep in mind is that historically; US economic recoveries of the last half-century have had similar “fingerprints”. Those being pent up demand for auto’s, housing and accelerating credit usage by the private sector. Every single one. They all look the same. But what we are seeing at the current time that is completely different than anything seen over the last six decades is net private sector credit contraction. The following chart could not be more clear on the issue. Remember, the private sector is made up of households and corporations (including the financial sector).
As you can see in the chart, even at the depths of any recession of the last half-century plus, year over year credit demand by the private sector has always been in positive territory. We’re currently breaking new ground. And this new ground begs the question, is Fed monetary policy impotent? Here we have the lowest Fed funds rate of a generation, and credit is contracting. Completely the opposite of what we have experienced in prior cycles. It could not be clearer. We are convinced this key fact is simply not getting the attention it deserves. Moreover, we need to remember that government stimulus efforts have been focused on reviving credit demand as of late. C4C (cash for clunker) and the tax credit for home buying was the sheep’s clothing used in an attempt to spark credit reacceleration. Crazily enough, despite the success of C4C in August, non-revolving (largely car loans) consumer credit balances actually shrank in the month! Not even C4C could offset the power of household balance sheet reconciliation. That’s a very loud message.
We know we are going to sound like pessimists and doom and gloomers with a few of these comments. We also know that we risk looking like idiots down the road by suggesting we buck the longstanding Street truism of “do not bet against the US consumer”. But every dog has its day, and we believe the consumer/household dog is barking, and loudly. Is it the end of the world? Of course not, but we believe changing patterns of behavior at the household level will have very meaningful consequence for investment outcomes ahead. As it applies to US households, two themes emerge from the numbers. First, we are currently in the beginning stages of a household balance sheet reconciliation cycle that we feel will be of a magnitude greater than anything we have seen in the post War era. Secondly, and we’re still early in this, household behavior regarding consumption is likewise in the midst of necessarily important change directly linked to the balance sheet reconciliation phenomenon. Lastly, we believe these two forces will be greater in magnitude than Wall Street may be discounting and will play out over a longer time period than the consensus now expects. Let’s get to the numbers and trends relative to historical precedent.
It should be no surprise to anyone that household debt outstanding fell again in 2Q (the latest Fed Flow of Funds data), making this now three quarters in a row of household net debt contraction. The important character fingerprint in the 2Q period being that debt contraction at the household level accelerated. Over the last three quarters through 2Q, US household debt balances have fallen 1.4%. In nominal dollars that’s a contraction of $199 billion. Admittedly pocket change set against the totality of household balance sheets, but from a thematic perspective, this contraction was a diversion from consumption. As we’ll see in a minute, consumption patterns in the current cycle are very different from prior cycles. Balance sheet reconciliation does not happen in isolation, and that should be key to our investment thinking ahead. The combo chart below chronicles close to six decades of the quarter over quarter change in household credit balances. The anomaly that is the past three quarters is clearly noticeable and nothing short of a dramatic contrast to experience of the current decade through middle 2008. Very quickly, although official Fed numbers are not yet available, anecdotal monthly data such as consumer credit suggests strongly the contraction in household credit balances continued in 3Q.
Very quickly, although official Fed numbers are not yet available, anecdotal monthly data such as consumer credit suggests strongly the contraction in household credit balances continued in 3Q.
Certainly contributing to the net US private sector credit contraction highlighted above. If this is not the very picture of changing US consumer behavior, we just don’t know what is. Household sector credit contraction is a first in post War history.
And given yet still current levels of household debt relative to GDP, it seems a very easy bet that there is plenty more to come in this reconciliation cycle. Although it may sound a bit confusing to hear this, the household debt to GDP ratio depicted in the following chart has actually been quite healthy over the last few quarters. The ratio fell just a bit in the current quarter, but the positive is this ratio fell in a period where GDP also fell. That’s the picture of a household sector determined to restructure its balance sheet. Very healthy from a longer-term standpoint. And you probably thought you'd never see the day, right? In the spirit of non-linearity, that day has arrived.