Commentary

On the juxtaposition of positve economic growth and market vulnerability

By Edward Harrison

Today’s commentary

It was interesting to see the US markets follow through yesterday to the upside after a monster rally in shares when the Fed tapered large scale asset purchases on Wednesday. But rather than seeing strength in this, I see vulnerability because the move to the upside is directly at odds with the news flow and the fundamentals.

My macro view is positive. I am concerned about the inventory building and the recent uptick in jobless claims. I believe these data points bear watching. But, on the whole I am positive on the real economy and believe that the inventory/jobs situation can be overcome. That said, this recovery is long, 52 months long to be precise. Rather than believing we are going from strength to strength and a long cyclical rebound lies ahead, we should understand that we are well into the business cycle and the peak in economic growth is probably behind us. None of this speaks to recession, more to moderate growth, less vulnerable to exogenous shocks.

In the links today, I noted however that the leading economic indicators were pointing to accelerating growth rather than moderate or moderating growth. So I think we are at a delicate moment in view of the fact that the Fed has just taken away the QE prop because of its expectation for accelerating growth. If this growth doesn’t come to pass, the markets will react negatively.

What are some of the problems I see in the data flow then?

First, there is China.

Six months ago, China’s desire to tamp down on asset price inflation caused a hiccup in the markets. Bearish analysts were warning that slowing growth was sure to come. But the PBoC stepped in with a massive injection of liquidity and eased conditions. The latest data from China points to growth in the 7.5% to 7.8% range. And so the bears were proven wrong. Now we are in a similar situation again.

Along the lines of what Jamie McGeever tweeted, Belgian newspaper De Standaard reports that Chinese officials have provided 200 billion yuan (24 billion euros) of liquidity to calm the situation down (link in Dutch). But markets are still convulsing. I tend to agree with George Magnus that the PBoC will step in again and calm the situation.

But let’s watch this one carefully. I also strongly recommend reading Michael Pettis’ take on monetary policy under financial repression because it is related to what we are seeing.

Second, there are the signs of stress in the auto market. In terms of stress on companies, not only are inventories at 8-year highs, but also capital investment plans for 2014 are larger on the back of the best post-crisis sales numbers. Ford is a best case here. They are hiring 11,000 people and investing more in the business. But we still have that inventory problem AND earnings guidance was weak. My biggest concern , however, is the credit situation.

The problem with this picture is that according to Reuters, the average loan-to-value on new cars rose to 110.6% in the latest quarter as credit standards loosen. That means people are borrowing more than the value of the car, an asset which depreciates quickly. These are not houses. On used cars, the numbers are even worse. LTV was up to 133.2%. And when these loans go bad, they go catastrophically bad. The average loss on bad loans was $7,770 in the third quarter, up from $7,026 a year earlier. Reuters also reported that “repossessions increased sharply, particularly for subprime borrowers.”

For me this paints a picture of loan growth and deteriorating credit standards into what is obviously a weakening picture regarding fundamentals on credit losses. It speaks to Sober Look’s point about what happens to banks’ balance sheets during a downturn. The balance sheets worsen significantly because credit standards worsen despite signs they should be tightening.

Third, the real economy data has been a tad weaker. I mentioned jobless claims and inventories as two concerns. But just yesterday during the rally, claims, existing home sales, and the Philly Fed numbers all missed – this, the day after the Fed tapered – and yet markets rallied. I see that kind of price action as a sign of weakness rather than strength because it points to a market that is impervious to real economy data and is trending higher on psychological and internal factors. This is the kind of market that can fall out of bed in a hurry.

The existing home sales were the most worrying here. November existing home sales dropped below year ago level for the first time in 29 months. The numbers were down 4.3% from October, and down 1.2% from a year ago. So we can’t call this something seasonal, it is something more, something that could accelerate if interest rates rise as a result of tapering. And note the progression of data points here is negative:

To wrap this up, earnings guidance is decidedly down as negative guidance is outstripping positive guidance 9-10 to 1. Even bellwether companies like Fedex and Ford are guiding down. And Ford is increasing capex and hiring in anticipation of continued economic success. I find this worrying. My sense is that if the economy holds through 2014 as I expect, the market should continue to rise. But it will not be a cheap market. It will be an expensive market, perhaps more expensive as time goes on, especially without a correction. And therein lies the vulnerability.

To be continued.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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