February 7, 2005
by Jim Puplava & Frank Barbera
Financial Sense
Storm Genesis
A Fundamental Review by Jim Puplava
In their benign state they are referred to as tropical cyclones. These minor tropical depressions may turn out to be nothing more than a brief burst of wind that develops as a result of unstable atmospheric conditions. Their genesis is the result of significant temperature differences in various parts of the atmosphere as you go aloft. When they become menacing, the weather bureau gives them a name. They become hurricanes and typhoons. These storms get their own name when their wind speed exceeds 64 knots. A mature hurricane or typhoon is a formidable force of nature that can pack winds reaching as high as 150-200 knots. They represent one of the greatest natural hazards known to man.
Major debates persist among storm forecasters regarding the ingredients necessary to turn a tropical cyclone or an arctic high pressure system into a major storm. Most weather forecasters will tell you that climatological models have a poor track record of predicting nor’easters, hurricanes or typhoons. Nor’easters occur in the eastern United States between October and April when moisture and cold air are plentiful. They are known for dumping large amounts of rain and snow and are capable of producing hurricane force winds. Hurricanes form in tropical regions between June and November where there is warm water, moist air and converging equatorial winds.
What we do know about storms is where and when they are likely to occur. We even know what causes them. The only difficulty is forecasting them. Tropical depressions don’t always turn into a hurricane nor do artic high pressure systems form into nor’easters. It is only when unstable atmospheric conditions persist long enough that they form the genesis of a storm.
Forecasting The Perfect Financial Storm
Like the weather the financial markets and the economy are periodically ravaged by storm fronts. They are known as recessions, depressions and bear markets. Benign financial storms are similar to tropical depressions. They may be nothing more than a correction in the markets or a minor recession. The hurricane and nor’easter types turn into bear markets and depressions. Like climatological models financial models have a poor track record of forecasting financial storms. The majority of economists can’t tell you we’re in a recession until well after it has begun. Wall Street analysts suffer from a similar myopia. Most analysts see nothing but sunshine and fair weather in the financial markets. Seldom is a storm cloud ever discovered until well after the downpour.
Bear-o-Metric Pressure Dropping
It should come as no surprise that even as the financial barometer is dropping with each Fed rate hike, economists and analysts are once again forecasting clear and sunny skies. Record trade deficits, rising government deficits, leveraged financial markets, ravaged consumer balance sheets, corporate malfeasance and a climate of speculation concern no one. Our financial forecasters are once again predicting perfect financial weather rather than the perfect financial storm.
Instability in the International Monetary System
Meanwhile the financial jet stream—otherwise known as the international monetary system—is becoming increasingly unstable. Barometric pressure is dropping steadily in the world’s credit markets as central banks pump hundreds of billions of dollars into the world’s monetary system. Instead of targeting credit, central banks are targeting interest rates. The result is that money is plentiful whether for economic need or for speculation.
Washington and Peking Storm Fronts
On the horizon two simultaneous storm fronts are developing; one in Washington and one in Peking. Central bankers in the U.S. and central planners in China are attempting to slow down their respective economies. Both economies are awash with money and credit—the financial atmospherics that produce storms. In the U.S., credit is being used to finance consumption and asset bubbles. In China, credit is being used to finance an industrial boom. The U.S. is in the process of hollowing out its manufacturing base, while China is in the process of transforming itself into a manufacturing powerhouse. One country is in denial, while the other is in ascendancy. We are witnessing the greatest wealth transfer in history—one that may eventually lead to war as an inflationary hurricane in the U.S. confronts a deflationary typhoon out of China.
Inflationary Warning Signs and More of the Same
Financial forecasters are keen to point out the deflationary dangers emerging out of China, but ignore the inflationary warnings at home. Here in the U.S. the CPI has risen by 3.3% over the last year and that number is understated by hedonics. Asset bubbles continue to inflate in the stock and bond markets, mortgage markets and real estate. Consumers continue to borrow and consume. Investors are high on speculation chasing IPOs, bidding up shares of high beta stocks, standing in line or camping overnight to bid on a new home or condo. Corporations are back playing the merger game instead of building new plants or buying equipment. Wall Street is pitching IPOs in a feverish pitch and bubblehead financial anchors urge the crowds to play on.
Interest Rate Hikes Seeding Storm Clouds
Financial atmospherics meanwhile are turning combustible. Rather than targeting the money supply—the only way to keep a bubble from inflating and prevent inflation—the Fed is seeding the storm clouds with interest rate hikes. By not controlling money and credit, the Fed is providing the heat and energy that will turn a financial cyclone into a full fledged storm. If the Fed persists in raising interest rates, it could unleash another perfect financial storm. This next financial storm could end up producing violent winds, incredible waves, torrential rains and floods that devastate the financial markets and cripple the economy.
The Fed has never been good at forecasting, especially storms of its own making. I have a vision of Mr. Greenspan as Captain Edward John Smith at the helm of the Titanic. Knowing he is surrounded by icebergs, he steams ahead without caution believing his ship to be invincible.
There is a double message here—one that the financial markets and the Fed are ignoring. The Fed seems oblivious to the myriad asset bubbles it has created. In fact it admits it has no way of telling when the financial markets are in a bubble until well after it has deflated. Perhaps that is why the Fed’s moves are measured?
The "Carry Trade" Continues
The Fed remains oblivious to asset bubbles and the financial markets are more than happy to keep perpetuating them. Greenspan’s warning in Germany and recent Fed minutes from the December FOMC meeting indicate that the Fed is getting serious. It faces rising inflation rates here at home, global financial imbalances, especially in the U.S., and excessive signs of risk taking and speculation in the financial markets. The Fed’s frustration stems from the fact that no one is taking the Fed seriously. The excessive risk-taking the Fed cites in its December minutes (such as the increase in IPO activity, the increasing number of mergers, and narrow credit spreads) persists. Despite rising short-term interest rates, the “carry trade “as yet to unwind.
The “carry trade” has become far too profitable to the financial economy. Despite ample warnings from the Fed, hedge funds, regional banks, industrial corporations and speculators continue to borrow short and invest and lend long. Many financial institutions are digging in and refusing to unwind. An example is U.S. Bancorp, which sits on a large portfolio of mortgage bonds. It realizes 19% of its earnings from its mortgage bonds, while its lending margins have narrowed to 4.2%. Rising interest rates are cutting into the returns on its bond portfolio. So far the bank is holding, on hoping that profits from corporate lending will offset the losses it realizes on its bonds.[1] That is getting harder to do has the fed funds rate keeps climbing.
As the Fed continues to raise short-term interest rates, the yield curve will eventually flatten. This removes the profit margin for financial institutions and narrows the spread for making money at hedge funds. It isn’t just banks and hedge funds that are affected by rising interest rates. Industrial corporations are dependent on the "carry trade” to finance trade and shore up profits margins. Company profit margins are shrinking as a result of rising energy, healthcare and raw material costs. To compensate for shrinking profit margins, companies are relying on yield spreads to maintain profitability.
This loss in profitability has broader implications for the stock market. Financial services make up 23% of the S&P 500 and more than 30% of its profits. Financial companies aren’t the only ones that are affected by rising interest rates. Major manufacturing firms are increasingly relying on their financial units for profits. In some cases, the financial unit is the company’s main source of profits as is the case with Ford, GM, and GE.
"Manufacturing" Profitability
Percent of net income these companies earned
from their financing units in the third quarter.
Ford 157%1
General Motors 125%
General Electric 55%
Deere 25%2
Caterpillar 21%
Harley-Davidson 14%3
1Pretax income 2Fourth quarter ended Oct. 31, 2004
3Income before interest and taxes
Source: "Fool's Paradise," Forbes, February 14, 2005.
The “carry trade” permeates the manufacturing sector from GE to GM and from Caterpillar to Pitney Bowes. Playing the “carry trade’ is crucial to maintaining manufacturing profitability.
The problem is that cheap money has become an addiction. Companies and speculators are finding it difficult to give up the habit, so they continue to play the game. Last year 53% of all corporate bonds issued were floating rate. In order to unwind these positions many large financial institutions would have to take losses on their portfolios. If everybody unwinds at the same time, long-term interest rates would rise and bond prices would plunge. For leveraged players, such as hedge funds, that presents a problem. They are too highly geared to absorb the losses from a major bond market convulsion.
Bond Tsunami Looms Ahead
If the spec community unwinds long–term rates rise, it would impact all asset classes of bonds from junk bonds and emerging market debt to mortgage back securities. Hedge funds have emerged as major players in the junk bond markets. They make up 82% of the trading volume in distressed U.S. debt and 30% of the volume in below-investment grade bonds and credit derivatives. That is giving poorer quality companies an extended lease on life, a lease that lasts only as long as the bond market holds up. Currently bonds rated Caa or lower make up 20% of the outstanding supply of speculative bonds. That is twice the level reached in 1998 when the Asian financial crisis and Russian debt default ended the reign of LTCM. According to Moody’s, the percentage of risky debt is unprecedented. Moody’s believes that default rates are set to rise again as low-quality bonds age.
Meanwhile spreads have narrowed considerably, but not enough to endanger the costs of rising rates, defaults, or falling prices. With increasing amounts of leverage you can still arbitrage and make a nickel. In effect, the Fed has engineered the largest one-way bet in history. Everyone assumes that long-term rates will remain low for eternity. Hedge funds crave yield spreads and have very little fear of risk. Like tourists on the beaches of Puket, they are oblivious to the bond tsunami that is on its way.
Real Estate Bubble Continues
Even worse is the deterioration of underwriting standards in the mortgage markets. According to one underwriter “when money chases deals underwriting standards suffer." Last year interest only loans skyrocketed to make up more than 39% of all loans. That is up from 10% in 2002. Interest only loans are fine as long as real estate prices continue to rise or stay firm. Problems begin to surface in the way of defaults once home prices head south.
Meanwhile homeowners remain distracted and unaware of risk mesmerized by the returns made on real estate. Last year in San Diego housing prices rose 21.1%, the ninth consecutive year of gains. That figure is just an average. In the suburbs, price appreciation has been much higher. It has been 48% on the coast and as high as 39% in the tony parts of town. The median price San Diego home is now $500,000. San Diego is leading the state in lending trends. Buyers of homes are resorting to adjustable rate mortgages and interest only loans. In San Diego County in 2004 adjustable-rate mortgages represented 80% of all new purchases last year.
With housing inflation making most homes unaffordable, buyers here are relying on creative financing. Adjustable-rate mortgages, interest rate only, and negative amortization loans have become the new trend. It’s the only way buyers can qualify and make ends meet. Homebuyers are using savings and drawing down investments in order to buy. Salaries and wages just don’t cut it anymore when median price homes in the suburbs start at $700,000-$750,000. The new California definition of a millionaire is a homeowner. You have to be one to live here anymore.
California isn’t the only city to be taken over by the gold rush mentality sweeping over the real estate markets. From Miami to New York and from Orlando to San Diego, buyers are lining up, camping out overnight in front of sales offices to be the next in line to buy a new condo. With homes becoming unaffordable, buyers are rushing in to buy condos. Some are first-time buyers, some are looking for a second home, while others are just speculating hoping to make a quick buck by flipping the property. Buyers are oblivious to risk and believe that home prices can only go up. The Center for Economic Policy Research believes that a one percent rise in borrowing rates could start driving home prices lower. The fact that housing prices could decline may come as a shock to homeowners. Especially if they own an adjustable-rate, negative amortization, or interest only loan.
Addicted Consumers
Even worse is the shock that falling real estate prices could have on consumption. Last year U.S. consumers spent a record $4 trillion taking advantage of cut rate prices for cars and discounts from retailers. Total sales for 2004 were up 8% from 2003 to $4.06 trillion. The consumer is back at the mall buying everything from new cars to furniture and home entertainment systems. Funding this spending orgy is home equity extraction, which is now averaging close to $300 billion a year. What happens to consumption when consumers’ ATM machines—their homes—stops appreciating? Add this to rising interest rate costs and ballooning property taxes and it isn’t hard to see that a home budget squeeze is in the making.
Inflation-Deflation-Stagflation
At the moment consumers, hedge funds, banks, and industrial companies can breathe a sigh of relief; the long end of the bond market is holding up and hasn’t collapsed. But the spreads between what it costs to borrow and what a lender or investor can earn on his money is getting razor thin with each new Fed rate hike. By the looks of things the Fed has no intention of stopping. What lies in wait for investors sometime this year is a nasty popping of the bond bubble. Why? Because credit spreads are too narrow, yields are too low, and bond prices are too high and inflation rates are rising.
At the moment the endgame is causing investors and speculators to rush into bonds fearing an economic decline. Talk of deflation is everywhere, so the first reaction is to buy bonds. You can see the results of this in Frank’s charts of the bond market and the dollar further below.
The deflation scare will provide the cover for the next leg of the “Great Inflation.” As a result of economic weakness and a stagnating asset market, the Fed will begin another round of liquidity injection. The next credit boom will go increasingly into speculation and will do very little to reignite the economy. Stagflation is what lies directly in front of us.
Corporate America Braces for High Winds
Another trend along with rising interest rates that will slow down the economy is corporate mergers. As the pace of mergers quickens, corporate layoffs will shortly follow. The first piece of news accompanying the SBC and AT&T takeover was another round of job cuts. SBC will eliminate 13,000 jobs after its planned purchase of AT&T. These are all high paying jobs; 5,100 from sales and business operations, 2,600 from administrative, and another 5,100 from engineering. More layoffs are planned for 2009. The new layoffs follow over 20,000 jobs eliminated at AT&T over the last two years. U.S. telecomm companies have fired 300,000 workers since March of 2001, a 22% reduction in the telecomm labor force. People talk about good times, but they ignore the fact the manufacturing sector is in the midst of a depression. Over 3 million jobs have been lost in this sector since 2000.
What is lost here from a macroeconomic perspective is that cost cutting and mergers contribute to economic contraction. If only one firm cuts its costs, greater profits are realized. However when whole industries downsize, they end up cutting each other’s revenues. When firms cut expenses by slashing payrolls, they end up cutting the purchasing power of their customers. A fired worker loses his ability to consume. As the pace of mergers accelerate with companies using their cash hoard to buy out the competition, job growth should decelerate.
History has a way of repeating itself perhaps never in the same pattern but following similar paths. It has been five years since the Dow Industrials reached their peak. Investors have incurred horrendous losses in the markets between 2000 and 2002. A Nasdaq decline of 76 %, a loss of over 40% on the S&P 500 and close to 28% losses on the Dow have failed to dissuade investors from speculating. Speculation is back and is evident everywhere from IPOs to high beta momentum stocks and everybody’s new favorite—real estate. Real estate speculation has replaced the dot-com bubble. According to recent public opinion investor polls, investors ranked real estate as their best investment. It has become the latest can’t lose investment.
What it shows is that investors have short-term memories. Apparently they have learned nothing from the bursting of the stock market bubble. Like sheep surrounded by wolves, they are about to get sheered again. The day traders are back. They have unquestionable faith in their black boxes. John Q. has traded in his dot-com for a condo and granny is invested in junk bonds. This is the moral hazard at its finest display. Confidence has returned once again to the markets. Volatility readings haven’t been this low since December of 1993—a short time before the bond bear market of 1994 was to begin. What we have now is the lull before the approaching storm. It is time to put on the foul weather gear.
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