Fragile Equilibrium?

BCA Research | Fragile Equilibrium

Last week’s income, consumption and inflation data suggest that the U.S. economy continues to muddle through, but the most interesting stories may be found beneath the headlines.

The rush of high-impact economic data likely did nothing to change consensus views of the U.S. economy. As last week’s consumption data reiterated, American households continue to eke out decent income advances and spend at a rate that is supportive of real GDP growth somewhere above 2%. But as our Bank Credit Analyst pointed out in its November edition, households have become increasingly reliant on government transfers to maintain trend-level spending even while they boost savings to repair their balance sheets. Beneath the more celebrated recent data, the slump in the employment cost index (ECI) may provide some insight into the profit margin sustainability. The momentum that appeared to be building in the ECI over the first half of this year was choked off in the third quarter, suggesting that profit margins may yet have some life in them. If inflation pressures abate as we expect they will, margins could even expand from their already robust levels. The trouble is that there’s a limit to how long corporations can keep thriving as pressure on consumers continues to accumulate, especially if the federal government attempts to withdraw some of its support of households.

Bottom line: Just a few months after the debt ceiling debate fiasco, a fractious Congress may be preparing to return to center stage. Investors should keep track of which way the wind is blowing inside the Capitol.

Winners In A Low Growth World

 

BCA Research, Winners In A Low Growth World

U.S. spread products will be the big winners in the medium to long term.

Our U.S. Investment Strategy service expects the investment backdrop to eventually evolve from one dominated by fears of U.S. recession, a hard landing in China and a European financial meltdown, to one in which U.S. growth remains sluggish but the downside risks are more moderate. The expansion will be held back by the combination of ongoing private sector deleveraging and fiscal consolidation in the developed markets (DM). This combination will require monetary policy in the developed markets to support growth via low rates, potentially for years. Combined with plentiful savings in the emerging markets (China in particular), the deleveraging backdrop in the DM means that the global savings glut will remain a key feature for some time. Several fixed income asset classes stand out as being potential winners in this environment. Investors will favor income over the potential for capital gains. Spreads could narrow to extremely tight levels as the “search for yield” intensifies, similar to what occurred in Japan. The environment will also push investors toward carry trades. Among the U.S. spread product, agency MBS and municipal bonds offer good value. Corporates tend to outperform stocks in a low, but positive growth environment. Corporate credit quality is strong and corporate bonds currently provide a sizable yield advantage relative to competing asset classes, and will benefit in a world where growth is slow enough to keep policy rates low but not slow enough to cause a recession.

This economic backdrop implies minimal interest rate risk and only moderate credit risk.

U.S. Households And Fiscal Support

BCA Research, U.S. Households And Fiscal Support

Absent net fiscal social benefits, the U.S. household savings rate is even more negative than it was at the peak of the housing boom.

Social spending is deeply entwined with household income and has become part and parcel of consumers’ savings decisions as its share of household income has steadily risen. According to our Bank Credit Analyst service, after adjusting to remove the effect of social benefits, the saving rate as a share of disposable income is negative 7%. This rapid aggregate dissaving is being driven by two fundamental factors. First, higher commodity price pressures have sapped household purchasing power. Second, disposable income growth has been stagnant for the better part of four years. With social benefits already comprising a big part of household income and playing a critical role in forming future expectations, any uncertainty surrounding benefit flows risks driving consumers to ramp up the savings rate in an attempt to protect or rebuild their cushions. Recessions are always associated with rising thrift and politicians must therefore tread very carefully on social benefit reforms, especially at a time when global economic conditions are fragile.

Occupy Wall Street: Just Noise?

BCA Research, Occupy Wall Street

According to a Global Investment Strategy Special Report, the Occupy Wall Street movement symbolizes the fact that political extremism is rapidly becoming mainstream.

The Occupy Wall Street movement is rooted in the secular decline of the American middle class. Judging from the GINI coefficient, the distribution of income is more unequal in the U.S. than OECD countries in general. Moreover, real wage growth in the U.S. has stagnated since 2000, while education and healthcare costs have soared. High education costs have serious social repercussions since they are a strong drag on upward class mobility. While it is currently impossible to boil down the Occupy Wall Street movement to a single issue, it is a symptom of deepening social strife, political polarization and spreading discontent in the U.S. These are ingredients that, if left unchecked, can lead to potentially radical shifts in policy made to score political points with the extremes, rather than to address underlying economic problems. Both the extreme right and left of the political spectrum will be energized by genuine social discontent – which can nonetheless translate into completely opposing policy preferences – leading to further political polarization. If the clash between left and right intensifies, policy making will become even more difficult. This would mean a heightened political and policy risk premium on equity prices among all G7 markets.

Recapitalizing European Banks

BCA Research, Recapitalizing European Banks

The tangible common equity to total assets measure of bank solvency suggests that French and German banking sectors are most in need of capital.

To measure the solvency of a bank in times of stress, it is vital to only count the simplest form of capital that can absorb losses – tangible common equity. In other words, goodwill and complex forms of capital should be excluded from the numerator of any capital adequacy ratio. Also, when Europe is experiencing a sovereign debt crisis it is ludicrous to treat government bonds held by a bank as zero-risk assets (as the Core Tier 1 Capital ratio does). In other words, government bonds should be included at full weight in the denominator of the solvency ratio. On this basis, it is easy to identify which individual banks and national banking sectors need the most capital. In addition to Dexia, which has a tangible common equity to total assets ratio of 1%, French and German banks stand out as the ones most in need of capital injections. Other euro area banking sectors are better capitalized, but have more exposure to their own distressed bond markets. Importantly, irrespective of how banks raise common equity, whether from the private sector, their governments or from the EFSF bailout fund, it is dilutive to existing shareholders and a drag on their share prices. Meanwhile, U.K. banks do not have such a domestic bond problem and are relatively well capitalized. What is more, they started raising capital over two years ago. Therefore, our European Investment Strategy continues to overweight U.K. bank stocks relative to their euro area peers.