As promised, there will be more on inflation this week and maybe even next week.
For those of you who either flunked Money and Banking or never took economics in the first place, we live in a fractional reserve world, where banks are required to maintain a fraction of their liabilities in actual reserves to meet the demands of their customers. The rest of the money is available to be lent-out. So, if you’re a banker with $1,000,000,000 in deposits, you’d have to retain $100,000,000 in reserves if we had a 10% reserve requirement. Looked at another way, if the bank as $100,000,000 in capital, it can create $1,000,000,000 in assets. The bank can take the $100,000,000 of high-powered money and multiply it. This is the guts of the money creation machinery. But today, banks aren’t taking their high-powered money and creating even more money. If they did, the economy would be screaming, assuming the monetarist economists are right.
We have ranted in the past about the environment that the Fed has engineered to make the banking system incredibly profitable. Low short term rates give banks access to almost free money. Higher long-term rates give the banks a term spread when they make loans of several years duration. Besides that, the banks are also able to pick and choose their customers today as there are more people wanting credit than there are people willing to grant it. Several alternatives to a loan from the bank have been shut-down due to the problems in the capital markets (try issuing commercial paper today unless you’re a AAA/Aaa borrower). Plus, the banks have just gone through and eliminated a lot of dead wood (plus a certain volume of good, solid wood that just happened to be in the way) to keep their costs down. On top of that, they have exited a lot of businesses that were marginally profitable even during the boom times. The banks are making loads of money.
The banks could make even more if they put some of this high-powered money to work. And, they will once they come to believe that the environment is as good as the one we see.
From our discussion last week of the old MV=PQ formula, you may recall that a change in M (the supply of money) will lead to a change in one of the other elements of the equation. Today, the change we are seeing is that V (the velocity of money) is dropping rapidly because the banks are keeping all the high-powered money sitting in the vault. This can only be a temporary thing while the banks figure-out how to make money on that money. The area that looks the most promising is probably buying each other. But, sooner or later they will get around to making loans to people who are liable to pay them back. Then we’ll see the change in V reversed and we’ll see a change in either P or Q. This is one of the reasons we think we have some time before inflation really gets ramped-up. It is also why we think the economy will be slow to get going even when it stops falling.
What we have seen in the last thirty or forty years is that it takes several dollars of extra credit to create one extra dollar of GDP. With consumers unwilling to drastically increase their debt and businesses not needing to increase their liabilities all that much, there is little demand for lots of new credit. So, either we will see a change in the credit dynamic in the economy or we won’t see any growth. We will probably see something in-between, less growth and not much new credit. But, we will start borrowing again. Why? One reason is because all those young people out there need stuff and they are usually unwilling to wait for it.
All us old people can save quite a bit of our incomes because we already have most of the stuff we will ever need. We have houses, cars, refrigerators, microwave ovens, stereos and computers. But, young people don’t have that stuff and they want it now. They will be willing to borrow to get it and pay way too much for the privilege.
There was really no good news last week. Too bad.
Other Economic Numbers
S&P Case-Shiller reported that home prices are still falling in their sample of 20 large urban areas. Most of the cities saw a slowing in declines as the average price fell ‘only’ 0.6% in April from March. The decline over the latest 12-months was still 18.1%. Interestingly for those of us who live in one of the less-impacted real estate markets in the survey, these markets are just now showing record year-over-year declines a year or more later than some of the hotter markets. It will take several more months to see if this is indeed the first phase of stabilization. But, with foreclosures making up a larger share of sales and the volume of sales so much lower than several years ago, it seems that stabilization may be a ways off yet.
Consumer confidence, the Conference Board version, surprisingly fell in June from May. While most economists expected a very modest improvement in the number, confidence slipped to 49.3 from 54.8. Now, 54.8 isn’t anything to brag about, but 49.3 is still worse. We’ll watch this in the next couple of months to see if this is an aberration or a new downtrend in sentiment.
The employment report, always the high or low point of the monthly cycle of economic outpourings, was worse than expected but really not that bad. Were it not for the rather surprising report last month, this one would have been the best in nearly a year. Instead of the 600,000 jobs lost that we were seeing regularly over late 2008 and early 2009, we had only 467,000 jobs lost in June. Unfortunately, this is far worse than the 322,000 jobs that were lost in May. Pity, June gets to be Miss Congeniality or First Runner-Up to May’s Beauty Queen of a month.
This does follow a pattern as old as the hills and one that has daunted economists for centuries, data doesn’t often go in a straight line. Too often, data has major ebbs and flows that defy modeling. Look briefly at May and you will see that while most economists expected the month to show improvement, that improvement was expected to be fairly minor, guesses of 575,000 lost jobs rather than 625,000 from many recent months. But, we got a stunner of a month with somewhat more than half the job losses expected. To make matters even more amazing, May saw government jobs decline, which seldom happens.
Now, June doesn’t follow suit and show even further job ‘gains’. The June number is sort of a regression toward the mean, showing May to be nothing more than an outlier, a weird data point that just emphasizes how different it really was, not how the trend may have changed. June shows that the trend may have shifted a little, but we can’t say how much, because our data points aren’t consistent.
The calendar week from last Monday through Thursday wasn’t all that good for US markets. The gain we all enjoyed last Monday was more than offset by the debacle on Thursday. Our hoped-for, quarter-end window dressing largely failed to materialize. If that is what powered last Monday, it wasn’t enough. The bad news last week was largely that things haven’t changed enough for the economy, for the markets, for investors as we investors had been expecting.
The jobs report on Thursday shouldn’t have been a big surprise, but it was enough of a surprise to move investors to sell. So, you take a bunch of nervous bulls, give them data they weren’t expecting, and the next thing you know, the market is down for the week.
The new thing this week will be anticipation of the earnings reports that start later in the week. Earnings shouldn’t be all that bad as expectations have been driven down a lot by the last several quarters’ surprisingly difficult environment. This is the last even remotely tough comparison since once we get to the third quarter reports, the comparison will be to the first really awful quarter of earnings last year. The next four quarters will be very easy comparisons and we should see some benefit from that in the market’s behavior.
US stocks were down anywhere from not quite 2% to over 3%, mostly on Friday. Foreign stock markets were also down the EAFE down about 1%, but the emerging markets were actually up. More than all of the EM strength was from China as most other major emerging markets were down on the week. Remember that all other markets were open last Friday, only we celebrate July the 4th.
Bonds had a pretty good week with all the dire news and handwringing being a good environment for bond investors. Treasury bonds rode the surge in bad news to low yields we haven’t seen in a month. By and large, corporates and municipals followed suit, but high yield bent toward the equity market showing small losses overall. Gains were quite widespread around the world too. European rates dropped even without an expected ECB rate cut. Japan’s yields were also lower.
Real estate and commodities were both weaker on the reduced expectations for quick recovery.
There you have it, a short tally for a short week.
Hope you all had a safe and sane Holiday weekend. But, we do find it funny that we celebrate July 4th and not April 19th. That was the real start of the Revolutionary War when Massachusetts militia men (the Minutemen) fought with British regulars at Concord and Lexington. The “shot heard round the world” as immortalized by Ralph Waldo Emerson’s ‘Concord Hymn’ came at Concord on April 19, 1775 and started the fighting that wouldn’t end for eight years. Washington was already in command of the Continental Army that fall and the siege of Boston was already over with a major victory for the Americans.
After July 4th, the American side went on a series of defeats, first losing New York and then New Jersey and only a surprise victory over Hessian mercenaries at Trenton in December salvaged the year for the revolution.
From our vantage point today, it seems winning the revolution was a fairly straight-forward affair. All it took was a lot of British arrogance, some American pluck and occasional brilliance and time. To think that after August 1776 the British never lost control of New York and could attack virtually any part of the coast with impunity. They were able but not willing to wage war indefinitely. We won a political victory, not a military one. So why not celebrate September 3rd, the day the Treaty of Paris was first signed in 1783 which finally ended the Revolutionary War and granted America its independence?
But, we chose instead July 4, 1776. Why?
Have a really great week.
Schroeder Financial Services, Inc.