The economic data has taken on a more positive tone recently, at least in some areas, and with an FOMC meeting and Janet Yellen press conference on the schedule this week, the bulls pulled in their horns last week. It seems that, for now anyway, good news is bad news for markets as any indication that the US economy is escaping its long lethargy produces angst about the pace of monetary normalization. The Fed is still the life of this party but with the punch bowl running low, people are starting to wonder how big the hangover will be and whether their portfolio will be coyote ugly in the harsh light of day.
The US economy has certainly accelerated since the cold of winter and last week’s data was positive enough to push down both stocks and bonds. Consumer credit expanded rapidly, up $26 billion in July, with credit cards and auto loans leading the way. The US consumer isn’t going down without a fight. Small business optimism was also on the rise although the report had a slew of contradictions – job openings are rising but intent to hire is not. The JOLTS report was basically unchanged from the previous month but job openings are on the rise; whether companies can find suitable candidates to fill those jobs is another question. Jobless claims were higher on the week but still show no stress around the 300k level. Retail sales were up strong in August; ex-autos and gas by 0.5%. All those positives stoked fears that the Fed will be forced to hike rates sooner than expected.
There were still some negatives as well. Mortgage applications continue to fall with both the purchase and refi indexes falling on the week. And that after only a minor uptick in interest rates. The quarterly services survey showed a drop off in the growth of information revenue to just 0.8% in the quarter, down from 1.3% in the first quarter. Inventory growth was weaker than expected raising some suspicions about the outlook.
I suppose it is possible that the US economy will decouple from a global economy that is decidedly less upbeat. We are surely doing better than the rest of the world right now, something reflected in the rising value of the US Dollar. But I do wonder about the foundation of this recovery which has been built on the same monetary sand as the previous expansion. In the last cycle, it was anyone who could fog a mirror getting a mortgage; this time it is any company with a business plan and access to public debt markets that has gotten credit where it isn’t due. Back in 2007, covenant lite loans, those with fewer creditor protections, represented about 1/4 of new deals. Today that number is 62%. In the junk bond market, 72% of new issues were for companies rated single B. Back in the late, great 90s the share was about 1/3. (hat tip: Evergreen/GaveKal).
A not insignificant percentage of those loans have been going to companies in the business of fracking for oil and natural gas. Oil and gas exploration capital spending in the US has roughly doubled as a percentage of the total and now accounts for nearly a third of all capital spending. Total borrowing by oil and gas companies globally has risen by over $100 billion in the last year. Unfortunately, revenues have been basically stagnant since 2011 and the difference between cash earnings and dividends, capex and stock buybacks was even higher at roughly $110 billion based on a recent EIA study.
The fracking boom has had an outsized impact on the US economy with “tight” oil production up over 3 million barrels/day since 2009 and gas production up ten fold. It is hard to exactly quantify the effect on employment but non farm payrolls in just three states in the middle of the boom – Texas, Colorado and North Dakota – represent nearly 20% of the total jobs added in the entire country since the nadir of the recession. When one considers the breadth of the boom across so many states, the total impact of fracking is considerable. It appears we have built our economic recovery on the back of high oil prices, something that should worry everyone now that the dollar is rising and oil prices are falling.
So, yes, the US economy is doing better than the rest of the world but it isn’t as if we’ve actually solved any of the problems that led to the last crisis. We’ve still got a debt problem – private debt in the US is still over 150% of GDP down only slightly since 2008 – and speculation still drives growth, this time in an industry where boom and bust is the norm rather than an historic outlier. It is hard to remember but the last time we had a strong dollar – and the current version doesn’t qualify for that moniker yet – oil prices fell to low double digits. Very low double digits; West Texas Intermediate was trading for as low as $10.65/barrel in 1999. And the previous period of a strong dollar in the 80s had a similar effect with prices falling to the $10 area in 1986. I know things have changed a lot since then but who would have thought prices could fall that low in the midst of a boom in the late 90s?
And that brings us back to those fears over a tightening Fed. I have my doubts as to whether the Fed can or will want to tighten policy anytime soon. If the policy divide between the US, Europe and Japan continues to drive the dollar higher and oil prices lower, the effect on the US economy may not allow the Fed to do anything but rejoin the global beggar thy neighbor policy game. There are obviously positives to lower oil prices some of which we are seeing now in the form of lower gas prices. And a strong dollar, in the long run, is certainly in the best interests of the US and will help to solve some of our problems. But the short term may be a different story as the transition from “investing” in energy production to something more durable is unlikely to be smooth.
The current angst about future Fed policy could go on for a while longer but for now, I see no reason to expect tighter monetary policy. Growth expectations have risen slightly recently but inflation expectations haven’t budged. And if the dollar keeps rising both expectations and actual inflation should fall. It seems likely the Fed will take that as license to keep rates low for longer no matter how they change what they are telling the public via their open mouth operations. On the growth side, even if the fracking boom doesn’t come a cropper, we are not an island and the growth challenges of the rest of the world will have an impact, particularly on S&P 500 companies where over 40% of revenue comes from outside the US.
Good times, bad times, boom and bust. That’s been the story of the US economy for nearly 20 years and since we are doing nothing different in this cycle than the last two, it is hard to foresee a different outcome. Maybe the positives of lower oil prices will more than offset the negatives of another bust, one boom replacing another. That happened to some degree after the dot com boom was replaced by the housing boom but we got a recession anyway, albeit a minor one. The transition from the housing boom to the fracking boom did not go as well despite unprecedented stimulus. What will replace the fracking boom? If the Fed is truly determined to normalize policy and that continues to push the dollar higher, we better hope the Fed has an answer to that question. I sure don’t.
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