The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.

The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.

This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.

Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.

My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.

The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.

The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.

Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.

If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.

Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.

It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.

JR

China’s energy supplies are heavily concentrated in coal, which is one reason so much effort is being expended to clean up the air and water and devise cleaner energy sources. The Chart below, taken from a McKinsey report, China’s green opportunity, suggests that China’s policies can do a lot to mitigate the problems in coming years. Very optimistic report.

Which reminds me. On Forbes on Fox tomorrow morning (10:20 EST) we have a spirited debate about the impact of green policies on the economy. I take the position that the proposed cap and trade legislation is a massive tax on working people and would have a very negative impact on growth. At the end of the day our living standard will be exactly as high as the amount of work that is performed int he economy. That includes work done by people, work done by current sunlight (agriculture and solar power), and work done by transforming stored solar energy (oil, gas, coal, uranium) into goods and services.

JR

The amount of currency people hold in their pockets and under their mattresses is the single best indicator of the level of fear on main street. Since last summer, when people first got the wind in their nostrils that banks might fail in big numbers, individual depositors have withdrawn roughly $90 billion from their bank accounts “just in case.”

To put that number in perspective, the total reserves of the U.S. banking system last summer before people got spooked was $85 billion.

In recent weeks, however, people have stopped taking $100 bills out of their bank accounts. Total currency held by the public was $849.4 billion on May 18, less that it was a month earlier ($850.1 billion on April 20.) I think it is a sign people are beginning to unclench their buttocks and become a little less afraid. That’s a great sign for spending. When people became frightened last August/September they slammed their wallets shut and stopped buying everything. That’s when the economy fell off the table, inventories spiked up and employers began laying off workers in a hurry.

When the public exhales and put their money back in the bank there will be a rebound in spending. There will also be a further $90 billion spike in bank reserves, which will eventually show up as lending. I don’t know about you, but I can’t wait to see this happen.

JR

The new U.S. Financial Data report out today from the St. Louis Fed shows that bank loans to business are still falling. This fits what we hear from entrepreneurs, that large banks have been systematically reducing availability of working capital loans for small companies—likely an unintended consequence of the Treasury bailout programs that make it bad business to make any loans that are not salable to the government.

The chart above shows that the lion’s share of the more than $100 billion (left scale) cut in total bank business loans since last fall is attributable to large banks (right scale). Small banks that do not have full access to the Treasury programs are still making loans.

Banks lend money to small companies, not big ones. Job gains (and losses) come from small companies, not big ones. That’s why this chart tells us we are going to see another lousy job report next week. I think we still have several months of job losses ahead of us before employment turns up again.

JR

As you know from my recent posts, I spend a lot more time thinking about balance sheets and a lot less thinking about GDP, than most economists. In this post I want to look at the balance sheet of the household sector. The most recent data from the Fed’s Flow of Funds report show that at the end of Q4/2008 (12/31/08) households (including nonprofit organizations) owned the following mix of assets.

Households hold 62% of their assets ($40.8 trillion) as financial assets like deposits, T-bills, bonds, stocks and mutual funds. They keep 31% ($20.5 trillion) in real estate assets, and they hold 7% ($4.4 trillion) in the form of consumer durable goods like used cars, old washing machines and computers (in all 38%, or $24.9 trillion in tangible assets). As I have written for years, these percentages represent portfolio choice decisions for people based on their perceptions of return and risk for each asset class. These portfolio decisions are exquisitely sensitive to changes in tax rates and monetary policy.

The table above shows the history of household balance sheet composition. The first thing to notice is the household balance sheet numbers are huge when compared with GDP (roughly $14 trillion per year) or its components like consumption, investment, net exports and government spending. At the end of 2008, people owned $65.7 trillion worth of total assets, made up of $24.9 trillion of tangible assets and $40.8 trillion in financial assets.

The tangible assets, in turn, can be divided into $20.5 trillion in real estate assets and $4.4 trillion in consumer durable goods. It makes sense that the assets on our balance sheet are so big. They represent all the economic activity that has ever happened–all the buildings we have built, all the cars and washing machines we have ever made–less the ones that are no longer in service. In the case of autos, for example, there are more than 15 used cars and trucks on the road and in the driveways for every one that will be produced (i.e., that will appear in the GDP accounts) in the U.S. this year.

In spite of what you read in the headlines, total household liabilities, including mortgages, installment credit and credit cards, add up to just $14.2 trillion. Net worth is a whopping $51.5 trillion–more than 3.6 times total debt and almost five times disposable personal income of $10.6 trillion.

So where is the financial crisis we read about? It is in the behavior of asset values over time. Our net worth of $51.5 trillion is $12.9 trillion (20%) lower than it was just 6 quarters earlier in Q2/2007. That puts our net worth roughly where it was at the end of 2004 ($51.9 trillion) but still much higher than it was a decade ago in 1997 when it was $33.3 trillion.

You can also see from the figures when the trouble started. Tangible asset values peaked in Q1/2007 at $28.4 trillion; since then they have declined by $3.5 trillion or 12.3%. Financial assets peaked 2 quarters later in Q3/2007 (when the leveraged loan and asset-backed securities markets froze up) at $50.5 trillion but have declined by $9.7 trillion or 19.2% since then. Essentially all the adjustment in both types of assets was due to price decline; the physical stocks of tangible and financial assets did not materially change during this period.

When asset values change abruptly, as they did over the past two years, it is always a demand story. That’s because over a short period asset supplies can’t change by much because new asset creation and retirement are small compared with the stock of outstanding assets. In this case it was the sudden drop in demand when investors pushed away from the asset-backed securities market a year and a half ago.

JR

California’s budget mess is front page news. Some are trying to figure out whether they can (or will) cut spending enough to live within their means. Others are looking for new revenue enhancers–we don’t call them taxes anymore or people will vote them down in elections. Both are missing the point. It’s not only the budget, but the balance sheet that needs attention.

California does not only have a tax and spend problem; it has a balance sheet problem. There are too many promises of future cash flow to pay for pensions and the like. California needs a balance sheet solution. Not the one that failed in last week’s election—borrowing more money and accounting with mirrors. California needs to sell assets and shrink liabilities in order to regain financial health. When a person or a company declares bankruptcy the judge takes your house, your car, your toys and your other ‘stuff.’ Although state governments cannot, formally, declare bankruptcy, the same medicine will work for them as well. Easier said than done.

Yesterday I wrote about the strange accounting practices for government entities used by the Federal Reserve Board in preparing their quarterly Z1: Flow of Funds of the United States reports. They provide detailed information about cash receipts and cash disbursements for federal, state and local governments, consolidated on p. 110 for all levels of government. They include the information on current receipts (tax collections) and current expenditures as well as information on government purchases and sales of all sorts of assets including spending to buy fixed assets (buildings etc., $513.1 billion annual rate in Q4/08). But in the consolidated balance sheet, which I have reproduced above, they conveniently forget to mention that governments own real assets.

According to the table, All levels of government owned $3280.4 billion in financial assets and had total liabilities of $10,171.3 billion on 12/31/08, which seems to imply that governments had a negative net worth position of nearly 7 trillion dollars (-$6,890.9 billion). But where are the $513.1 billion in fixed assets they reported governments buying in the flow of funds table? Indeed, where are all the other tangible assets–the land, the buildings, the machines, the trucks and buses) the governments purchased in all the previous periods? If they had included government holdings of tangible assets the statements would look much different. Indeed, they would reveal the immense stockpile of real assets on government balance sheets that are available for sale to meet the government obligations everyone is writing about. The federal government, for example, owns more than 700 million acres of land (not reported on their balance sheet either). These assets can be sold outright or they can be sold and leased-back. Either way the cash is available to pay obligations. Either way we would have more honest financial statements.

JR

I recently wrote about the fact that the forces impacting the U.S. economy’s balance sheet, at about $200 trillion, dominate those affecting GDP (just over $14 trillion) when thinking about interest rates and stock prices. A blog reader wrote to ask me where the $200 trillion figure comes from.

First, I want to point out that it is revealing that we have to ask the question. Why is it that people know so much about something so small (GDP) but so little about something so big (total assets)? I think it is because since the 1930′s macroeconomics has developed into a discipline concerned almost exclusively with who is spending how much money. Very little attention is paid to the capital base, or balance sheet, that makes it possible to produce the goods and services measured as GDP. A glance at a newspaper or any list of data produced by the government will convince you this is the case.

The best source of asset market, or balance sheet, information we have today is the document Z1: Flow of Funds of the United States produced after the end of each quarter by the army of economists working at the Federal Reserve Board.

The most recent (116 page!) flow of funds document, publish March 12, contains information about the balance sheet of the U.S. Economy on 12/31/08. I will warn you that you will have to dig for it–most of the 116 pages are devoted to measuring “flows of funds”, roughly the amount added and subtracted from balance sheets during the quarter. But you can find most of what you need if you hunt for it.

So what about the $200 trillion? I have constructed the table, above, by pulling figures from the report. The report reports balance sheets for some sectors of the economy but not others (which I find a little strange). They report balance sheets for 1) Households and Nonprofit Organizations, 2) Nonfarm Corporate Business (big companies), and 3) Nonfarm Noncorporate Business (small companies). These balance sheets show that at the end of 2008 housseholds and nonprofits owned $40,814 billion in financial assets like stocks and bonds and $24,905 billion in tangible assets like houses and cars, which adds up to $65,719 billion in total assets. Against that total, households and nonprofits owed debts, or liabilities, of $14,242 billion, which means they had net worth of $51,477. (These last numbers are in the document on p. 102 but not in the chart.)

Adding the three sectors together (Subtotal in row 4) produces a balance sheet with $104,049 in total assets divided between $58,639 in financial assets, and $46,301 in tangible assets.

Now it gets trickier. The Fed does not report complete balance sheets for the other sectors (farms, financial sectors, federal government, state & local governments, or rest of world (foreign owners). Instead, they report statements of financial assets, financial assets and financial liabilities. In other words, they leave out the fact that all these other sectors own tangible stuff like land, buildings, cars and computers, in addition to securities. I think that is a big mistake, reflecting the analytical bias in the macroeconomics community that somehow people consciously manage their portfolios of stocks and bonds but are passive owners of more than $46 trillion of real stuff.

We can use the Fed’s measures of financial assets held by all the sectors to get a pretty good figure for total financial assets in the balance sheet. Adding in farms, financials, governments and foreign owners brings the total financial asset figure up to $141,512 billion, which is reported on p. 115. (I say a pretty good figure because the document reports a $4,922 billion statistical discrepancy in getting to that figure themselves.) They do not report figures for tangible assets held by those “other” sectors, which is unfortunate because the “other” sectors are actually bigger than the ones they report.

That leaves us in an awkward position in trying to derive a total asset figure than makes sense for the overall U.S. economy’s balance sheet. One way to do it is to add up the numbers that we do know. I have done so in line 13. We know there are $141,512 billion in financial assets. We know that just three of those sectors own $46,301 billion in tangible assets. Adding those two numbers together produces a (reported) total asset number of $187,813 billion, pretty close to the $200 trillion number I wrote about at the top of the story. (The number would have been much closer 2 years ago before the recent drop in asset values.) Unfortunately, I have no idea what to call this number because it leaves out so many huge question marks.

If I weren’t so lazy I could dig up numbers to at least approximate the values of some of the question marks in the table. Farms own land and tractors, banks own buildings and ATM machines, governments own all sorts of crap including nearly a billion acres of land and all those cars you see on the highway that don’t have to buy license plates like you and me. And foreigners own a ton of stuff too. For today’s purposes all we have to know is that these things would add up to a very big number. And plugging these figures into the missing cells in the table would produce a total assets number far in excess of $200 trillion.

OK, that’s enough arithmetic. Why does this matter? It is to show you that the balance sheets are so big that almost any analysis of the economy that focuses on spending or saving or budget deficits alone, to the exclusion of the balance sheet, is almost certain to be wrong because balance sheet changes are so big. For example, household financial asset holdings fell from $50.5 trillion in Q3/07 to $40.8 trillion on 12/31/08 due to the collapse of stock and bond prices. And the value of their tangible assets fell by another $3.5 trillion due to falling home prices. Does anyone really think that the impact of this roughly $13 trillion drop in household net worth can be fixed by sending people checks for $700?

The most relevant application of this thinking today is how to understand the impact of the massive bailout programs on the economy and to say something meaningful about the impact of government borrowing on interest rates and stock prices. I will write more on these questions later.

You can read an analysis of budget deficits and interest rates using this approach in Chapter 4 of my new book, Lessons from a Road Warrior. You can get it from Amazon or get a signed copy directly from the John’s Book section of our website.

JR

I wrote a few days ago that the amount of currency held by the public is a very good measure of the public’s level of fear about the stability of the banks and financial system. The numbers are produced weekly by the Research Department of the Federal Reserve Bank of St. Louis.

The chart above shows that the level of fear is still very high. People have taken about $90 billion of $20 and $100 bills out of their bank accounts to keep at home under the mattress.

 

The increase in currency holdings appears to be abating, however, as you can see in the chart above, which measures the increase over month earlier levels. Withdrawals, which had been running $10-$15 billion per month, have now decelerated to less than $5 billion in April.

These numbers bear watching. Whenever people conclude that the all-clear whistle has blown and banks are not going to fail there is going to be a flood of money being re-deposited into banks. That will make bank reserves swell even higher. It will give banks an additional $90 billion of zero cost deposits and the resulting $5-$10 billion of increased earnings, And it will be the signal for the next round of bank stock price increases.

I am heavily invested in financial stocks today for these reasons.

JR

Ran across an interesting research paper tonight in the Business and Politics journal. The paper, “Corporate Lobbying Revisited”, by Jin-Hyuk Kim of Cornell University,  attempts to measure the return on corporate spending on lobbyist services. You can see the paper by clicking here.

Kim’s conclusion, is that money spent on lobbying Congress appears to have a return higher than the firm’s cost of capital. Doubling expenditures on lobbying increases the firm’s equity returns by 2.5 percent unadjusted, 2.4 percent relative to the market, and 1.3 percent relative to the industry. While the results do not appear to be very robust (the estimates move around when he changes the specification of the model) this is an important question that merits more work.

JR

Yesterday I posted a piece about inflation and interest rates arguing that although recent inflation numbers have been very tame, the tsunami of bank reserves (=800%) released by the Fed is beginning to show up in inflation expectations, which is why long Treasury yields are rising. I ended with a warning that long-term bonds, not stocks, are the riskiest assets in our portfolios today.

A good friend asked me to review some of the logic in more detail. I will do so below:

1) The link between rising interest rates is not just a theory that might or might not be true. It is the definition of an interest rate, or yield. 

For example, In the chart below, if you pay pay $95.24 to buy a bond (really just an IOU) that promises to pay you $100 in one year then we would calculate its yield as r = ($100-$95.24)/$95.24 = $4.76/$95.24 = 5.0%.

If something changes in the marketplace and people lose interest in owning bonds so that their price falls to $90.91 then we would calculate their yield to be r = ($100-$90.91)/$90.91 = $9.09/$90.91 = 10.0%.

SO, SAYING THAT INTEREST RATES GO UP FROM 5% TO 10% IS THE SAME EXACT STATEMENT AS SAYING THAT BOND PRICES ARE FALLING.

2) the interest rate, or yield, (which is just a calculation we make by dividing a contractual interest payment by the price we pay for the security) on all sorts of securities rises and falls with inflation (actually expected inflation. Bet way to understand this is to think of the inflation rate as the “interest” you receive from owning a tangible asset like a house or a bar of gold. If you buy it for $100 this year and its prices goes up to $110 in one year (10% inflation) then the “yield” on the asset is $10/$100 = 10% (the increase in value divided by what you paid.) 

The logic is; inflation goes up => “yield” on real goods goes up => that makes the yield on real goods high compared with the yield on bonds and other securities => that makes people sell bonds to buy more houses and other hard assets => that pushes hard asset prices up and bond prices down => Falling bond prices increases the yield. => SO YOU DON’T WANT TO OWN BONDS WHEN THEIR PRICES ARE FALLING.

3) Over long periods the price level will be roughly proportional to the money supply. The money supply is roughly proportional to bank reserves. The Fed has increased bank reserves by +800% since last September. Together these mean that there is a big increase in the price level, hence inflation, baked into the recent Fed policy. When the economy starts to look a little more normal again (it is starting to do this already) people are going to worry about inflation unless the Fed does something to reverse their actions over the past 6 months.

Moral of the story–you don’t want to own bonds when people start worrying that inflation, hence interest rates, will go up.

JR