January 28, 2011

Released by the BEA this morning: the advance reading of real GDP came in at 3.2% for the 4Q of 2010 (actually, it was 3.17%, but who’s counting?) versus expectations of 3.5%. There was a lot of internal noise, with large positive contributions from personal consumption and net exports, offset by negative contributions from inventories and government spending. However, the line item that jumped off the page was the GDP deflator, the measure of inflation that turns nominal GDP into real GDP.

The GDP deflator was very light at only 0.3%. If it had come in as estimated (1.6% according to Bloomberg), and all other inputs remained constant, real GDP growth would have been cut in half. A smaller deflator pads real growth by subtracting a smaller number from nominal growth. We read one possible explanation for the light deflator: oil is an import, and imports subtract from GDP, therefore higher oil prices subtracted from the GDP price index. What we do know is that the core PCE price index (a preferred Fed measure of inflation) also declined, and the GDP deflator tends to track Core PCE over time despite the quirkiness of GDP accounting. The current level of Core PCE, 0.4%, is the lowest on record since 1959.

As mentioned above, low and falling inflation has the effect of padding real GDP growth. The chart below shows the recent trend in real GDP growth.

However, remember our small and shrinking deflator? The one that we said seemed to be skewing real GDP higher? Take a historical look at nominal GDP growth, and the recent economic activity looks different.

Average nominal growth since the late 1940s is about 6.8%, which included the inflationary 1970s and early 1980s, but this doesn’t seem way off. During expansions in the past 30 years, growth has averaged about 6.4%. Current nominal growth is at 3.4% and has been trending down throughout 2010. Considering that we are 6 quarters into an expansion with plenty of unusual stimulus to boot (+$2 trillion Fed balance sheet, +$1 trillion federal deficit), this low level of nominal growth and inflation is surprising.

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January 25, 2011

Lost in the headlines over the state of the expense side of municipal finances is the fact that tax revenues are rising at the state and local level.

The U.S. Census Bureau tracks the various line items of receipts for governments, and the news is that in the third quarter of 2010 on a year-over-year basis total tax receipts were up 5.2%, from $270.2 billion to $284.3 billion. As the graph below shows, clearly there is seasonality to these numbers, but municipal revenues in the third quarter 2010 are just below the record for any third quarter, set in 2008.

To better understand the drivers of those tax revenue increases, let’s look at the line items. As the graph below shows, the proportions have been roughly constant in recent history (we have smoothed out the seasonality by using a four-quarter average). To be precise, here are the latest contributions of the various revenue sectors: Individual income taxes (21%), corporate net income taxes (3%), property taxes (32%), general sales receipts (25%) and other (18%), including tobacco product sales tax, alcoholic beverage sales tax and motor vehicle and operator’s licenses. Since 1988, individual income taxes have ranged from a low contribution of 16% (4Q09) to a high of 31% (2Q01), property taxes have ranged from a low contribution of 21% (2Q00) to a high of 49% (4Q09), and sales tax receipts have ranged from a low contribution of 19% (4Q09) to 28% (3Q06). Corporate tax receipts have never been above 8%.

Currently individual income taxes, property taxes and sales receipts account for 78% of all state and local government tax receipts. And guess what? According to the graph below, those three line items (as well as other tax receipts) are growing on a year-over-year basis. We wouldn’t want to jump to any conclusions based on a couple of quarters of data, particularly a couple of quarters of massive stimulus and monetary accommodation. Indeed, the other half of the municipal ledger—the expense side—still holds many significant challenges, but the revenue side of the municipal ledger, at least, is showing positive growth.

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January 21, 2011

This was a relatively data-filled week for the housing market. We’ll start with the good news.

The National Association of Realtors (NAR) reported that existing home sales rose more than expected in December 2010, to a seasonally adjusted annual rate (SAAR) of 5.28 million homes. Also reported was the level of existing home inventories for the month, which aren’t seasonally adjusted.

Dividing inventories by sales, the enterprising housing analyst can calculate the months of supply, which is currently 8.1 months (but it’s also reported in the NAR press release, so no enterprise is necessary). However, inventories are not seasonally adjusted, which typically creates a decline in months of supply during the winter months. As you can see in the chart, existing home sales have jumped back to more “normal” pre-bubble levels of a decade ago. Inventories, while improving over the past 3 years, are probably still near double the levels of a decade ago. This oversupply is having a predictable effect on prices, which fell 1% year-over-year. Another explanation was offered by Lawrence Yun, chief economist for the NAR:

“The modest rise in distressed sales, which typically are discounted 10 to 15 percent relative to traditional homes, dampened the median price in December, but the flat price trend continues,”

Distressed sales accounted for 36% of all sales, up from the previous month (33%) and from the year ago month (32%).

On Monday the National Association of Homebuilders (NAHB) released their home builder sentiment index. The reading for January was stagnant at 16, and has basically been bumping along a 3 year bottom. Why, with existing home sales at more normal levels, are the builders still so dire? The following day, we got the answer. On Tuesday the US Census Bureau released data on new housing starts.

It’s no wonder the builders’ confidence has yet to recover; there’s no building to be done. It appears that the oversupply of existing housing is dampening something else besides home prices. Typically the homebuilding sector supplies a natural tailwind coming out of a recession, as evidenced by the many V-shaped bottoms over the previous 50 years. To date, residential construction activity has not enjoyed any recovery to speak of. Building a new house adds to economic activity, while the effect of the sale of an existing home has a much more minute effect.

Next week we will be on the lookout for home price data from S&P Case-Shiller and the FHFA, as well as an update on pending and new home sales. The initial read on 4^th quarter 2010 GDP will be released on Friday, and the expected 3.5% growth likely doesn’t contain much help from the residential housing sector. Justifiably so, it seems.

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January 18, 2011

Senator Rand Paul is on the tape promising to unveil a budget with $500 billion in expense cuts in one year, and that he will not spare any government program or agency from his scythe, including the Defense Department, the Education Department (he would eliminate it altogether) and entitlement programs. As he told POLITICO, “These are not without ambition.”

Ambition is what is needed in order to sufficiently tackle the structural budget problems facing our country, but ambition is a curious thing on Capitol Hill. Solo ambition is a virtual non-starter, and likewise there are no guarantees on the ambitions of small, bipartisan groups. Witness the abbreviated life of the National Commission on Fiscal Responsibility and Reform’s report, “The Moment of Truth,” which ambitiously set forth a plan to achieve nearly $4 trillion in cumulative deficit reduction through 2020. The report wasn't even passed by its own authors.

One of these days, Congress will hopefully get around to living up to its deficit-cutting ambitions. The problem is clear enough. The graph below shows the rolling 12-month Federal deficit, which shows how big the hole is (over $1.3 trillion for the 12 months ended December 2010). We almost feel guilty for not showing the federal debt graph at the same time, because those deficits only get funded through borrowings. The deficits and the resulting rise in outstanding debt is the main item referenced whenever the ratings agencies start talking about downgrades (most recently by S&P and Moody’s just last week).

On a monthly basis, the graph below shows that the US hasn’t had a positive budget month since September 2008, a 27-month stretch, which is the longest stretch since at least 1954, which is as far back as we’ve seen the data. Also, since September 2008, there have been nine months where the monthly deficit exceeded $150 billion, which is more than the average annual deficit from 1980 to 2007.

Clearly, the states and cities are well ahead of the federal government in taking the politically difficult steps to rein in structural deficits. In 2009 and 2010, budget problems at the state level prompted legislators to close more than $250 billion in deficits. There is still a lot more wood to chop, but it sounds like the states have gotten Rand Paul’s memo. As the New York Times reported on January 17, over two dozen inaugural addresses by governors included variations on the same theme for fixing the problem: “Slash spending. Avoid tax increases. Tear up regulations that might drive away business and jobs. Shrink government, even if it means tackling the thorny issues of public employees and their pensions.”

With regard to taking the direct approach to dealing with public pension fund shortfalls, the Pew Center on the States reports that through the first 10 months of 2010, 18 states took action to reduce their pension liabilities—either through reducing benefits, increasing employee contributions or both. “It took years for states to get into their current pension predicaments,” reported the Pew Center, “and it will take years for reforms and fiscal discipline to get them out.”

Reforms and fiscal discipline. Ambitious indeed.

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January 14, 2011

Earnings season is upon us and there will be the usual scrutiny attending each release. At a time like this in the business cycle, investors will be poring over the financial results to try and get a sense of whether or not we are at an inflection point in the recovery, one way or the other. Are the cyclicals on the upswing? How is the tech sector faring? Consumer staples? Financials? The actual numbers can help to give some context for the latest economic data and the information in the Beige Book, and it is particularly critical now that the Federal Reserve is about one-third of the way through QE2.

If we are looking for evidence of trends and cycle markers, however, we have to also remember to listen to what they say, not just what they report. Case in point is the earnings release of JP Morgan Chase this morning. As it relates to the housing market, CEO Jamie Dimon called it “terrible” although better than it had been, and that the bank reserved another $2.1 billion for its WaMu loans and another $1.5 billion for litigation expenses to fight against private-label mortgage put-backs. On a call with analysts, Dimon said this is a long-term issue. “We will be talking about this for every quarter over the next three years,” he said.

The informed mind makes many mental leaps when reflecting on this fact pattern. There are the obvious connections, such as the potential economic ramifications of a subdued housing market and the ongoing costs—including management distraction—of the put-back issue for large banks. And there are the not-so-obvious ones, such as the shape of regulation and implementation under the Dodd-Frank Act—for example, disclosure and reps & warranties requirements for asset-backed securities, or the definition of Qualified Residential Mortgages—and the future of housing finance reform in the United States.

But sometimes the connection is simply back to the root of what got us here in the first place: the deterioration of underwriting standards for residential mortgages during the boom and the resulting woeful credit performance. The graph below sets forth the serious delinquency performance of conforming mortgages—with a maximum LTV of 80%, good credit, under the loan size limit and fully documented—and non-conforming prime mortgages since the beginning of 2008. Before 2008, they used to be on top of each other, but since that time they have diverged widely, with Fannie Mae reporting serious delinquencies of 4.5% in its conforming pools, and CoreLogic data showing 90-day plus delinquency rates of over 15%. (Subprime mortgages, needless to say, have performed even worse: the Mortgage Bankers Association subprime index now has a 26.2% delinquency rate.) As policymakers consider the future of housing finance, it is worth recalling that the conforming mortgage—which is wrapped by the government guarantee—has performed far better than other sectors of the market.

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January 11, 2011

An interesting recent piece by Reuven Glick and Kevin J. Lansing of the San Francisco Fed looks to explain changes in the savings rate over time. On an aggregate level, the authors point out that the savings rate is mostly a function of:

1. Wealth – if I’m already wealthy, I don’t need to save as much

2. Credit availability – if I can borrow to spend, I don’t need to save as much

First, they compare wealth, measured by household net worth as a percentage of disposable income, and the personal savings rate.

You can see very clearly the two asset booms on the right side of the graph, first equities and then housing. Both of these were clearly bubbles in retrospect, and therefore not repeatable. This also tells us that the corresponding savings rate in the 2%-4% range isn’t sustainable.

Second, they look at credit availability as measured by household debt to disposable income.

What’s the right level of debt? As we’ve said before, we don’t know, but it appears that 130% in 2007 was too high. This also tells us, again, that the corresponding 2-4% savings rate was likely too low. In the short run, a rising savings rate reduces GDP because personal consumption is still 70% of GDP. The rise in the household savings rate from below 2% in 2007 to above 6% recently coincided with a painful reduction in consumer spending and economic activity. Much of the stimulus, including 0% interest rates from the Fed and a slew of spending incentives from the fiscal authorities (Cash for Clunkers and the homebuyer tax credits), was aimed at stimulating spending at the expense of savings, to break the paradox of thrift endangering the economy.

The real paradox of the savings rate is touched on by John Hussman in his most recent weekly commentary, entitled “Illusory Prosperity – Ludwig Von Mises on Monetary Policy.” Hussman discusses the relationship between savings and investment: “The amount of real physical investment in the economy is, and must be, precisely equal to the amount of output not allocated to consumption but instead to savings.”

The conundrum of central bankers: savings is needed to fund investment. Lower savings may boost current economic growth, but at the expense of longer term economic well being.

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January 07, 2011

The next voice to be heard in the debate on the future of housing finance in the United States will be that of the Treasury Department, which is slated to release its report on the subject sometime this month. Given the sensitive political and economic nature of the topic, the complexity of the problem and the current tenuousness of the housing market, we imagine that Treasury’s contribution will be not so much a shout, more like a polite throat-clearing.

Mortgage-Backed Securities (MBS) investors are an important constituency in the housing finance debate, because since the advent of securitization it is the MBS investor—in particular the Agency MBS investor both here and around the world—who has provided the majority of the capital to the $11 trillion US residential mortgage market. Roughly 70% of American residential mortgages are pooled and held in securitized form by investors of all kinds. When various constituencies discuss how the market will look under the wide range of future potential housing finance paradigms, the MBS investor needs to be at the table, because we are the ones who will price out the MBS relative to competing opportunities in the market, which ultimately drives the pricing of primary mortgage rates.

The core of the debate over housing finance reform is the government’s role in the mortgage market. Right now, that role is significant, largely through the credit guarantee that is wrapped around Agency MBS. Fannie Mae and Freddie Mac, of course, are the most prolific providers of this guarantee (although Ginnie Mae is catching up thanks to the credit crisis), because most of the borrowers in the United States are of the conforming variety. The discussion over the government’s role is often conflated with the history, performance and expense-to-taxpayers of Fannie and Freddie. We can all agree that Fannie and Freddie as business models were seriously flawed—private companies with a public charter, poor incentives for management, excess leverage for their book of credit risk, and so forth—and they are rightly being effigized for it. The former operating models of Fannie and Freddie, particularly their retained portfolios, will likely not survive this exercise (although the effective government backing of their MBS will).

But is government involvement necessary for the housing finance system in the United States? The short answer is no, but this is a complex issue without any short answers. Again, it all comes down to price. There would be consequences to a housing finance system that had no government involvement and, depending on how different the new system is from the current one, these consequences could be significant. In other words, if mortgage rates and house prices were not an issue, the government would never have been involved in housing finance in the first place.

To argue, however, that the US mortgage market doesn’t need government involvement because other countries without a Fannie/Freddie/Ginnie model have similar home-ownership rates and manageable mortgage costs misses some very significant points. First, the mortgage capital stack in the US is unique. Whereas securitization is the largest capital formation tool in housing credit in the US, in Europe bank balance sheets and covered bonds fund most mortgages. Not only isn’t there anywhere near enough bank capital in the US to supplant securitization, it is difficult to conceive that the universe of “rates” buyers will become mortgage credit buyers or move over to covered bonds (which default to the issuing bank’s credit ratings), at least not at the same price levels and in the same size.

Second, the government guarantee is such a powerful advantage for US homeowners looking to buy or refinance a primary residence. The current housing finance system, certainly the one that prevailed until underwriting standards started to slip around 2004, is the most efficient credit delivery system in the world. Securitization allows borrowers of similar creditworthiness using similar mortgage products to receive the benefits of scale in pricing, and the government guarantee to make timely payments of interest and principal scales the process even further. The to-be-announced market is the window through which much of this scale occurs; it levels the playing field for smaller loan originators and community banks and enables lenders to offer longer rate-locks for borrowers. It is what makes possible the very popular 30-year fixed-rate mortgage with a down payment that is manageable for a wide swath of creditworthy borrowers (20%, with or without primary mortgage insurance for a conforming borrower), but also maintains other underwriting standards as well.

Third, and we say this only half in jest, anyone who suggests that a money-center bank, European or otherwise, is not a government-sponsored enterprise hasn’t been reading the papers lately.

Aside from all this, and perhaps most importantly, the price and availability of credit and the value of our housing stock matter a great deal to current and prospective homeowners, the vast majority of whom pay their mortgages on time, take pride in their homes, form the basis of solid communities in America and have already seen their home values fall 25% or more. If one were to ask them to chime in on this issue, our guess is they would want to maintain the best aspects of the current system.

The message from the bond market is loud and clear: We are prepared to fund our neighbors’ homes, in size and at relatively attractive rates, particularly if there is a government wrap involved. Yes, protect the taxpayers by guaranteeing only soundly underwritten mortgages and charging appropriate guarantee fees, and allow for a vibrant and competitive private-label market by carefully defining the conforming box, implementing sensible risk retention rules and setting risk-priced guarantee fees. If policymakers, however, resolve to have no government involvement at all, the bond market will price it out for you, but the likely outcome is a residential mortgage market that is smaller, more expensive, and less liquid.

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January 05, 2011

Yesterday the Census Bureau released manufacturers’ new orders, which is usually seen as a leading indicator for the US economy. According to a Bloomberg article titled Orders to U.S. Factories Increase in Sign of Sustained Recovery: “The 0.7 percent increase in bookings topped the median forecast of economists surveyed….” The 0.7% increase mentioned is a month-over-month figure, which is how this metric is typically reported. Below is a historical chart showing the month-over-month change in new orders, seasonally adjusted.

New orders is a volatile data series, even seasonally-adjusted. Not a lot of utility in this number, and yet there are several variables that are usually presented in this way: construction spending, business inventories, existing home sales, durable goods, and more. Last month’s result was a 0.7% decline, so it’s hard to say that this month’s 0.7% gain is a sign of anything at all, much less a “sustained recovery.”

Viewed through the right prism, there is still much to be gleaned from the data. Here’s how we look at it: absolute level, year-over-year change, and drawdown from peak. In the graph below, one can see the absolute level of seasonally-adjusted new orders over the last decade. The drawdown from the 2007 peak was dramatic, and the initial pace of recovery off the 2009 bottom was impressive. That recovery has begun to slow somewhat, which is consistent with other data. At $423.8 billion, we are at 2006 levels and more than 12% below the previous peak.

Next, we take a look at year-over-year percentage change, and the graph below illustrates the historically large year-over-year decline in new orders, followed by the equally large recovery.

Despite the impressive bounce back in year-over-year percentage terms, the recovery has still not been enough to regain its previous peak, as the graph below sets forth. This is turning into a very sluggish recovery. (Hat, tip to Calculated Risk for giving us the idea for this framework, which is similar to that blog’s widely imitated nonfarm payroll chart.) Manufacturers’ new orders is an interesting data series, buffeted by large changes in volatile defense spending and auto production. It is also useful, but looking at month-over-month data will just get you lost in the weeds.

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December 28, 2010

Last week we noted that new home sales have not enjoyed the same kind of rebound that retail sales have experienced. Already this week we received a few more data points on the state of the housing market. On Monday Freddie Mac released their monthly volume summary for November which contained information on serious delinquencies (90 days or more delinquent), which rose for the 2^nd month in a row. As you can see below, this delinquency rate tends to move with unemployment, which crept back above 15 million people in November.

Delinquencies had been on an improving trend throughout 2010, and the recent reversal is worth watching.

Home price data for the month of October was released this morning, courtesy of the S&P/Case-Shiller. As you can see in the chart below, there has been a pronounced roll-over in pricing in recent months:

This marks the 4^th month in a row of falling home prices, and the first negative year-over-year reading since January of 2010.

The coming year could be an interesting one for the US housing market. 2010 began with an extended tax credit for homebuyers, and mortgage rates declined throughout most of the year. 2011 is likely to be relatively stimulus free, and although some are interpreting rising interest rates as a sign that the Fed’s asset purchase program (aka QE2) is working, higher mortgage rates aren’t likely to be welcomed with open arms by an already weak housing market. Stay tuned.

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December 23, 2010

Seasonally adjusted greetings to Annaly Salvos readers around the world!

In the commercial spirit of the season (and a day early for our blog post this week), we thought we’d go down a level from the headline retail sales numbers, which have been trending strongly of late. In November, retail sales rose 0.8%, and October and September were both revised upwards. Many economists are pointing to the relative strength of this three-month set to predict a decent 4^th quarter GDP number. Macroeconomic Advisors has raised its estimate to over 3%. “The report on retail sales through November,” they write, “was much stronger than expected, and even with offsets to our assumptions for imports and inventories, we revised up our current-quarter tracking forecast of GDP growth by four tenths on this report.”

The results for selected line items were consistent with the theme that Americans are starting to spend a little bit more on things that fall more into the “discretionary spending” category, while cutting back on most purchases related to buying new houses. So to begin at the top, total retail sales (less food and autos) were approximately $338 billion at a seasonally adjusted rate in November, up 8.1% from a year ago and within shouting distance of the cyclical peak of $342 billion in November 2007. (All retail sales data are through November 2010.)

Sales at furniture and home furnishing stores, which rose along with the strong housing market, are still languishing below the cyclical peak and bumping along the cyclical trough.

Likewise, sales at electronic and appliance stores, which we would put in the same general “new home sales” category as furniture, are also skittering along the cyclical bottom.

In contrast, building materials, garden equipment and supply dealers, more reflective of the do-it-yourself category of housing-related consumption, are registering double-digit year-over-year sales growth. After the collapse in this category’s sales over the last two years, and with prospects for the housing market still weak, perhaps people have capitulated on maintenance and upgrades.

Recreational purchases are rising faster than the cohort. Sporting goods, hobby, book and music stores are rising impressively on a year-over-year basis, perhaps reflecting the trend towards staycations and the tentative beginnings of the resumption of discretionary spending.

Likewise for the “miscellaneous” category of retail sales, which encompasses stationery, gift, novelty, souvenir and used merchandise stores. They are rising at a double-digit year-over-year pace.

The lump of coal in the sales stockings is new home sales, which are still at generational lows after the mid-decade top. The population of the United States has about doubled since the 1960s, and yet new home sales are less than the run rate of that era. Moreover, it is the first time that new home sales have continued to decline after the official end of a recession. The question before the market is whether or not we can have a sustainable recovery without the important contribution of the housing sector.

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