Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth

April 16, 2018

Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth

A majority of my readers (two) have asked me to update the discussion about the behavior of thin-air credit or a variant thereof, namely the sum of commercial bank credit (loans and securities) and the monetary base (bank reserves at the Fed and currency). To paraphrase the motto of the former iconic Chicago department store, Marshall Field’s, give the customers what they want. To give the “customers” a preview of what they are going to get, let me state that thin-air credit growth has slowed to a rate that is low both from a long-run and short-run perspective. The slowing growth in nominal thin-air credit in conjunction with the acceleration in consumer price inflation has negative implications for growth in real U.S. aggregate domestic demand in 2018. In turn, if growth in real aggregate domestic demand “surprises” on the downside in 2018, then the Fed is unlikely to hike the federal funds rate the full 50 basis points this year that the market currently expects. Alternatively, if the Fed is hell-bent on raising the federal funds rate 50 basis points or more over the remainder of 2018, it would be sowing the seeds of a 2019 recession unless there is an acceleration in the growth of nominal and real thin-air credit. An acceleration in the growth of thin-air credit would be unlikely in the face of a rising federal funds rate.

As shown in Chart 1, year-over-year growth in thin-air credit has trended lower from its 9+ percent observations from Q4:2013 through Q3:2014. As of Q1:2018, year-over-year growth in thin-air credit was 2.7% -- low growth in terms both of a long-run and short-run historical perspectives.

Chart 1

Plotted in Chart 2 are the year-over-year percent changes in the quarterly observations of, again, thin-air credit (the sum of commercial bank credit and the monetary base) along with the percent changes in each of its major components – commercial bank credit and the monetary base – by themselves. The slowing growth in thin-air credit (the red line) in 2015 and 2016 was primarily due to the Fed’s cessation of quantitative easing (QE), i.e., large outright purchases of government securities and quasi-government mortgage-backed securities, which resulted in the year-over-year contractions in the monetary base (the green bars). Surprisingly, at least so to me, was the rebound in year-over-year growth in the monetary base in the past three quarters inasmuch as the Fed had started to reduce, albeit marginally, its outright holdings of securities and the Fed had been hiking the federal funds rate. Starting in 2017 and continuing through the first quarter of 2018, growth in commercial bank credit the blue line) has been trending lower, which has restrained the growth in thin-air credit.

Chart 2

Not only has growth in nominal thin-air credit slowed, but so, too, has growth in real thin-air credit, i.e., nominal thin-air credit deflated by the Consumer Price Index (CPI). In Q1:2018, the year-over-year percent change in real thin-air credit was just 0.5%. The importance of this is that there is a relatively high correlation between the year-over-year growth in real thin-air credit and real final sales to domestic purchasers. Starting in Q1:2011, the correlation coefficient between the year-over-year percent changes in real final sales to domestic purchasers and the year-over-year percent changes in real thin-air credit, advanced two quarters, is 0.68 out of maximum possible 1.00. This is shown in Chart 3.

Chart 3

As one of my readers (the other one?) has correctly pointed out, correlation does not necessarily imply causation. However, when I tested the lead-lag relationships between these two series, I found that the correlation coefficient was highest when thin-air credit growth leads growth in real final sales to domestic purchasers by two quarters. When growth in real final sales to domestic purchasers leads growth in real thin-air credit, the correlation coefficient declines. This does not prove that growth in thin-air credit causes growth in real final sales to domestic purchasers, but it sure does support the hypothesis.

In sum, the slowing in the growth of both nominal and real thin-air credit augurs poorly for the growth in aggregate domestic demand in 2018. But wait, won’t this year’s federal tax cuts stimulate demand? Not unless the resulting increased deficits are financed with the creation of thin-air credit. (See my January 22, 2018 blog post “No Sugar High from Tax Cut Unless the Fed and the Banking System Provide the Sugar” for an explanation of this). And, so far, at least, growth in thin-air credit has slowed, not accelerated. The market currently expects the Fed to hike the federal funds rate at least another 50 basis points this year. If I am right that growth in domestic demand slows this year, a further 50 basis point increase in federal funds rate might be sowing the seeds of 2019 recession. Available data, such as annualized growth in Q1:2018 nominal retail sales of 0.8% vs. 10.4% in Q4:2017, suggest a slowing in the growth of Q1:2018 final sales. Rumor has it that the Fed believes this slowing in aggregate demand growth is mainly due to “faulty” seasonal adjustment factors. The Fed ought to take a look at the behavior of thin-air credit growth before dismissing the weakness in first quarter final sales growth.

Paul L. Kasriel, Founder, Econtrarian, LLC

The Econtrarian

Senior Economic and Investment Advisor

Legacy Private Trust Co., Neenah, WI

econtrarian@gmail.com

1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swart                                            ∆ + 6 = A Good Life

As of this Past Fourth Quarter, the S&P 500 Remained Relatively Cheap

April 2, 2018

As of this Past Fourth Quarter, the S&P 500 Remained Relatively Cheap

Now that the first quarter of 2018 has just ended, what could be more fitting than to look back at the relative valuation of the S&P 500 stock index as of last year’s fourth quarter? After all, isn’t that what we economists do best, look back? This commentary is an update to my November 29, 2017 commentary, “The S&P 500 Is Not Expensive According to the Kasriel Valuation Model”. Before reviewing my methodology for estimating the over/under valuation of the S&P 500 stock market index, let me give you the Q4:2017 results upfront. According to my methodology, the S&P 500 index in Q4:2017 was overvalued by 7.4% compared with a revised 4.1% overvaluation in Q3:2017. Given that the median value of over/under valuation of my methodology in the period Q1:1964 through Q4:2017 was 35.5% overvaluation, the 7.4% overvaluation of the S&P 500 in Q4:2017 seems trivial. The continued low level of the corporate bond yield is the principal factor keeping the S&P 500 from being more materially overvalued.  Now for the important disclaimer. My relative valuation methodology involves only three observable variables – smoothed annualized reported earnings of corporations included in the S&P 500 equity index, the level of the corporate BAA/A-BBB bond yield and the actual market capitalization of the S&P 500. My methodology does not take into consideration expectations of corporate earnings or of bond yields. Nor does it take into consideration exogenous “shocks” including but not restricted to the likelihood of changes in the U.S. tax code, of geopolitical conflicts or of the imposition of U.S. trade protectionist policies. Of course, if I had a high degree of certainty about these exceptions to my “model”, I would be an extremely wealthy person and would not be inclined to share my “wisdom” with you!

To refresh your memory about my methodology, I calculate a quarterly theoretical market capitalization for the S&P 500 by discounting (dividing) smoothed annualized reported earnings of S&P 500 corporations by the yield on the lowest-rate investment-grade corporate bonds (BAA/A-BBB). I then compare my calculated theoretical market capitalization value with the actual market capitalization value. The percent of over/under value for the S&P 500 is calculated as follows:

((Actual Market Cap/Theoretical Market Cap)-1)*100

The technique I use to smooth reported corporate earnings is some high-falutin’ econometric technique called the Hodrick-Prescott filter. (Edward Prescott is a Nobel Prize winner in economics.) This smoothing technique is designed to remove the cyclical variation from a trending series. Another economics Nobel Prize winner, Robert Shiller, uses a 10-year moving average to smooth the S&P 500 price-to-earnings ratio in his stock market valuation research. He calls this the cyclically-adjusted P/E. It seems to me that a 10-year moving average is an arbitrary tool to use to remove the cyclical component from a time series. Why not use a technique specifically designed to remove cyclicality? While I’m on the subject of the Shiller cyclically-adjusted P/E, aside from the arbitrariness of using a 10-year moving average, a P/E in isolation tells you nothing about the stock market’s over/under valuation without taking into consideration the level of bond yields. A low P/E could be an indication of an overvalued stock market if the bond yield is relatively high. Conversely, a high P/E could be an indication of an undervalued stock market if the bond yield were relatively low, as has been the case for several years now.

Let’s go to the data. Plotted in the chart below are the quarterly observations of the percent over(+)/under(-) valuation of the S&P 500 calculated with my methodology discussed above. Also plotted in the chart are quarterly observations of the year-over-year percent change in the S&P 500 equity index. If my methodology has any legitimacy, there should be a negative correlation between the over/under valuation variable and the year-over-year percent change in the S&P 500 index. That is, if the S&P 500 is overvalued as calculated by methodology, then I would expect the S&P 500 equity index to be increasing at a slower rate or even declining. I found that the highest absolute value of a negative correlation coefficient, minus 0.20, is obtained when the over/under valuation is advanced by five quarters in relation to the year-over-year percent change in the S&P 500 index.  (With the low value of the correlation coefficient at minus 0.20, there obviously is a lot missing from this “model” in terms of explaining the behavior of the stock market, as I admitted at the outset.) So, the last data point plotted in the chart for the over/under valuation variable at Q1:2019 is actually the observation for Q4:2017 (advanced five quarters). The median value of over/under valuation is 35.5%. So, interpreting whether the S&P 500 is over or undervalued, it is better to look at the percent over/under valued in terms of 35.5% rather than zero.

As of Q4:2017, then,  my “model” indicated that the S&P 500 was overvalued by 7.4% -- a relatively low reading in comparison to the 35.5% median value for over/under valuation during the entire sample period. The yield on the BAAA-BBB corporate bond yield appears to have averaged about 4.45% in Q1:2018, up about 18 basis points from its Q4:2017 level. The market cap of the S&P 500 was about $22.5 trillion. If annualized smoothed S&P 500 reported earnings remained at their Q4:2017 level of $906.7 billion, then the S&P 500 would be 10.4% overvalued in Q1:2018 – still well below the median overvaluation of 35.5%. What if the BAA corporate bond yield had risen 100 basis points in Q1:2018 to a level of 5.27% and annualized smoothed reported S&P 500 earnings remained the same as they were in Q4:2017. In this case, in relation to the actual S&P market cap in Q1:2018, the S&P 500 would have been 31% overvalued. Of course, if the bond yield had risen by 100 basis point in Q1:2017, it is likely the actual S&P 500 market cap would have been significantly lower, and thus, the overvaluation of the market would also have been lower.

In sum, given S&P 500 annualized smoothed reported earnings and the current level of corporate bond yields, the S&P 500 stock market does not appear to be excessively overvalued. The continued low level of corporate bond yields is the principal reason that the overvaluation of the S&P 500 remains low in an historical context. Corporate earnings are growing, but at a subdued pace. In full disclosure, my portfolio is devoid of equities even though I do not believe that the S&P 500 is grossly overvalued.  Why? Because of those other factors that I mentioned earlier in this commentary. As evidenced by the quote I put at the end of my commentaries -- for most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal – I am congenitally risk averse. The S&P 500 equity index exhibited increased volatility in Q1:2018. I believe that this increased volatility was due primarily to exogenous “shocks” mentioned earlier in this commentary rather than the behavior of corporate earnings and/or corporate bond yields.

Paul L. Kasriel

Founder, Econtrarian, LLC

The Econtrarian

Senior Economic and Investment Advisor

Legacy Private Trust Co., Neenah, WI

econtrarian@gmail.com

1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte

∆ + 6 = A Good Life