Thursday, August 21, 2014

Where Are We In The Credit Cycle?

  • The deleveraging process has ended, but overall credit growth remains low.
  • The culprits are the housing sector--and the Fed.
  • Low growth supports current bond and equity valuations.

The US economy has begun to dig out from the post-Lehman deleveraging process, but the current level of overall credit growth is anemic. (I am using the Fed’s flow of funds data series from FRED.)

Total Credit Growth
Total credit was growing at 10% before the Crash, contracted in 2009-10, and is now growing at 3.5%, which is low enough to be acting as a drag on money growth and the recovery. This is mainly due to the low level of activity in the mortgage sector.

Household credit was growing at 11-12% pre-crash and then contracted for four straight years: 2009-12. Only last year did the contraction end, and growth is now de minimis. The mortgage sector has not recovered from the collapse of the housing bubble. This is the main drag on growth today.

Corporate credit was growing at 14% before Lehman, contracted in 2009-10, and has since recovered to a healthy 9% growth rate. Business is not starved for credit. This is a major positive for overall growth.

Financial Sector
During the bubble, the financial sector was growing in the low teens, then contracted very sharply, and has not yet resumed growth. Like housing, the financial sector has not yet recovered from the crash.

Federal Government
Pre-crash, federal debt was growing at a modest 3%. During the crash, it grew very rapidly (2009). Following the Fiscal Cliff, federal debt growth has fallen to 6% which is neither contractionary nor stimulative. One could say that government finance has normalized at “neutral”.

I believe that the current low level of overall credit growth is acting as a drag on the Fed’s monetary policy by countering the Fed’s efforts to grow M2. Larry Summers has suggested that the US economy can only grow rapidly during credit bubbles. I don’t agree. I would reformulate that to say that the nominal economic growth rate will tend to grow at the nominal rate of aggregate credit growth. You can’t have economic growth without credit growth, but it need not become a bubble. We don’t need 12% household credit growth to achieve 6% NGDP growth; we can make by with household credit growth in the mid-single digits.

At present, aggregate credit growth is stalled at 3.5%. If it can accelerate (i.e., if housing and/or inflation can pick up) then I would expect to see the benefits of the quantity equation, resulting in higher nominal growth. Of course, that is almost a tautology. It would appear that everything hinges on the bugaboo of the bubble years: house price appreciation and the availability of mortgage credit.

I do not mean to contradict monetarism or to absolve the Fed of its unwillingness to accelerate money growth. I am only saying that by handcuffing itself the Fed is making the economy hostage to the housing market. The growth rate of the nominal economy is within the control of the Fed, if it is prepared to reflate. The Fed’s ongoing satisfaction with inadequate inflation means that we are swimming on our own. At present, neither the government nor the Fed are providing any stimulus.

Investment Implications
We are looking at an economic dashboard where almost every dial is on LOW: credit growth, money growth, velocity, inflation, nominal growth. This suggests to me that the outlook for inflation and bond yields remains low. This in turn supports current stock and bond valuations, and it explains why the bond market yawned when the FOMC minutes were published. The fact that the Fed is plotting to reverse QE is deflationary, not inflationary. In fact, I am reminded of the monetary fiasco of 1937-38, when the Fed hit the brakes much too soon. The FOMC continues to be “Austrian Lite”. Monetarism is nowhere to be found.

Bottom line: current bond and stock prices are supported by the low trajectory of credit and money growth.

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