Report on Europe and US credit froth despite poor wage growth

Today’s post is a potpourri of events I am seeing from around the world that impinge on macro.

Europe. As expected, European consumer price inflation came in at 0.5% following the unexpected dip in German inflation. I believe the ECB will act on this, but not just via an interest rate cut but also with some other non-traditional form of easing. We will know on Thursday.

The big news out of Europe, however, was the drop in the unemployment rate to a 17-month low of 11.7%. At first blush, this seems to support the European recovery story. But Ambrose Evans-Pritchard believes the drop is largely due to workers dropping out of the labor force rather than an increase in employment. He notes that Italy lost 68,000 jobs in April and that France also saw a 14,800 rise in its key jobless figure. These are the two biggest economies in the periphery. And so the jobless fall is not as positive as the headline figure suggests. We have seen this in the US too. Read this article from CNN on the long-term unemployed to see how this is reflected in personal, human terms.

Note, however, that Spain is an outlier here. The economy created 198,000 jobs in April, the best month since 2005. I remain bullish on the Spanish economy and believe that growth will pick up further as 2014 progresses.

Emerging Europe. Now, in the emerging European countries, we see Slovenia on an upward trajectory. Slovenia saw GDP grow 1.5% in Q1. This is a country that was being touted as the next Cyprus and looked almost certain to need a Troika program. But now, Slovenia is getting a 2% net export boost and domestic demand is also rising, with household expenditure growing in Q1 for the first time in over two years.

On the other side of the coin in the former Yugoslavia is Croatia. Croatia’s economy hasn’t grown since 2008 and it shrank in the first quarter by 0.4%, following a 1.2% contraction in Q4 2013. Croatia has been in recession now for 10 quarters. Domestic demand is low due to austerity, stagnant wages and consumer deleveraging.

United States. In the US, after two corrections, the ISM finally got its figures right, releasing a manufacturing index figure of 55.4% for May 2014. Key subindex figures saw the Production Index at 61.0%, up 5.3% from April’s reading of 55.7%. Employment was only 52.8% however – and that was a decline of 1.9% from April’s 54.7% figure. Goldman Sachs has raised its US Q2 2014 GDP estimate by 0.1% to 3.8% because of “stronger than expected inventory accumulation”. And this ISM report confirms why. Employment for manufacturing is actually down but output is at a very high 61.0%, suggesting inventory accumulation is building again.

Note, however, that Doug Short had a note out earlier showing US real median household income at a level 7.6% below the January 2008 high. Month on month wages were down 0.42% according to Sentier Research. Expectations of GDP growth in the absence of median wage growth are predicated on an unsustainable increase in debt accumulation or on increased income inequality or both. None of this speaks to a durable multi-cycle recovery dynamic and reinforces my worry that deleveraging will begin in earnest again once the US economy turns down.

Mortgages. On that note, it is interesting to note that households are about to see a home equity line-of-credit payment reset that will reduce disposable income. According to the Wall Street Journal, a bevy of interest-only helocs that were sold at the height of the housing boom are about to end their 10-year interest only period. This covers 817,000 borrowers nationwide. And according to the Office of the Comptroller of the Currency, approximately $50 billion in loans will reset in each of the next three years. We should expect this to have a negative impact on consumer spending given the lack of wage growth.

Autos. What has replaced mortgages as the new subprime is the auto sector. And that sector is still going strong, bolstering GDP. Monthly sales came out for May and they were up 17% year-on-year. Chrysler now projects auto industry-wide sales for May at a seasonally-adjusted annual rate of 16.9 million, which would be the best year since 2006.

So we have wages and mortgage resets holding GDP down but inventory building and car loans bolstering GDP.

Credit markets. In terms of US credit markets, I have two tracks of note. First, according to the FT, residences whose rental payments are bundled into new rental securitization bonds go for 6% less rent on average than similar houses that are not securitized. While it is unclear why there is this discrepancy, I believe this differential is a data point that should worry investors of these products, especially to the degree they receive high bond ratings. Investors are starved for yield by the low-rate environment and are likely to overlook these signs of risk in these new instruments. But when the economy turns down, we are likely to find out just why these homes are renting at a discount.

The second story of risk in credit markets comes via high yield. Bloomberg notes that more than half of this year’s loans for issuers backed by PE firms allow the borrower to boost earnings by an unlimited amount through projected cost savings from acquisitions and “any other action contemplated by the borrower”. Think of this as pro-forma non-GAAP earnings – something we see plaguing the tech sector again as companies IPO.

The dodgy accounting here is due to increased stringency in regulatory guidelines. The Fed and the Office of the Comptroller of the Currency have increased pressure on lenders to to keep high underwriting standards due to their concern that the market is getting frothy. Remember, this is a sector of the market that is seeing higher EBITDA multiples and lower covenant restrictions. We can add dodgy accounting to the mi, as a sign that market froth is well advanced.

Bottom line: the US is in the frothy part of the economic cycle in which credit conditions have loosened considerably. At the same time, we are still not seeing any wage growth. It’s not clear how much longer we can see this combination without visible signs of economic weakness. But I expect a good jobs report. And Q2 GDP growth is likely to be well over 3%. For now, the US economy is doing just fine. But I question the sustainability of the roots of this recovery.

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