Almost to the Bottom
I find it helpful to compare everything we’re seeing to the Great Financial Crisis. Most everyone reading this remembers it well, and it stands as the worst economic calamity of most people’s lives until now. As you see, 5 months in, we are almost to the nadir of the GFC, which did not come until the 8th month in that crisis.
Personal consumption expenditures (PCE) is the largest, and most important part of GDP, accounting for 68% of 2019 real GDP and 75% of growth. It also drives the second most important part of GDP, investment.
So the key to recovery is getting that green line back to 100, and the rest will follow.
But in the meanwhile, firms piled up very large revenue losses in Q2, now extending into Q3 for some. In general, there is a huge dichotomy between goods, which are recovering well, and services, which are not. Unfortunately, services PCE is about twice the size of goods.
In the income data, we see the same patterns as before. Income loss is substantial, but that has been more than made up for by government benefits. Combine that with reduced consumption, lower taxes and interest payments, and we see over a trillion dollars in excess household savings. The personal savings rate remains at record levels:
But this is only one of several cash bubbles out there. Commercial banks:
We don’t know exactly how much cash nonfinancial corporations are holding on to right now, but they did raise $954 billion in new debt and equity from March to July. For comparison, nonfinancial corporations raised $969 billion in all of 2019. And that does not include all the private placements.
So, the money supply has ballooned.
But the M2 velocity hit the lowest level ever in Q2 (quarterly only).
Velocity of M2 measures how many times the average dollar was used to make a purchase in a quarter. That is by far the lowest reading ever, though it only takes us through the Q2 average, and April and May were pretty much the worst months ever.
So, what happens to all this cash just sitting around remains the key issue going forward.
We see it all over: the data quality is extremely poor right now, and large revisions are becoming common. So, in the first place, remember that all this will undergo multiple rounds of revisions, and even in normal times, these can be large, especially in prices and deflated real numbers.
But these are not normal times, and agencies are struggling just to get the nominal numbers right, on top of trying to figure what is happening with fast-moving prices. So, we will look at nominal consumption and prices separately, and I encourage you to look at the prices especially as close approximations of reality.
Income and Savings
To me, this is the most remarkable thing that has happened. Cumulatively since March versus the February TTM average, households:
- Earned $248 billion less…
- … but received additional $794 billion in benefits, a difference of $546 billion.
- They consumed $504 billion less…
- … and paid $75 billion less in taxes and interest…
- consequently saving $1.1 trillion.
Here’s what that all looks like on a chart
Through June, households had also paid off over $100 billion in credit card debt from that giant green savings block. Just looking at commercial banks, their cardholders shaved another $9 billion off their card balances from the end of June through August 19. So, at least in that subset of consumer cards, the repayments have slowed down considerably but are still going.
So, minus the debt repayments, households have held on to about a trillion dollars – about half from stuff not purchased, and half from excess government benefits. Pretty staggering numbers all around.
The corporate income numbers are behind the personal income numbers by a couple of months and are only quarterly. We don’t get the detailed splits until next month, but Q2 corporate income, roughly equivalent to revenue, was down 13% QoQ and 12% YoY.
Before tax profits, roughly equivalent to EBT, got hit even harder:
And the nonfinancials were down almost 30%.
Yet, the stock market went up every month in Q2.
Remember, these are nominal dollars, just like public companies report in.
This is undoubtedly the fastest and largest shift in consumer preferences ever, and the general trend is against the sweep of the last 74 years. In that period, we went from an economy very much fixed around producing and consuming goods to one dominated by services.
Services were 47% of GDP in 2019 and 69% of all consumption. But the pandemic trend we are seeing goes against that. Many of the services people purchase are closed or unsafe, so they have taken the brunt of the storm.
But people are also stuck in their homes and bored, and seeing every flaw their home has every waking moment. So, they have taken the large savings from all those services not purchased and put it into their homes – new furniture, appliances, electronics, building materials and garden supplies. And, of course, more food and household supplies to substitute for all the meals not eaten out in the past 5 months.
So, this is what that looks like month by month:
Services are still down over 9% in July from February levels, but the goods economy has made more than a full recovery and is up 6%. The net effect is that goods, 31% of consumption in 2019, made for 34% of consumption in July. It took 11 years to go from 34% to 31% and 5 months to go back.
But services are still much bigger, so the accumulated revenue losses for firms keep piling up.
We are looking at this via cumulative losses versus the February TTM average. Goods losses were much smaller to begin with and peaked in May, now down to less than half May’s level. If goods consumption stayed flat in August, these businesses will have collectively wiped out all the large losses of April and May, which is pretty extraordinary.
Digging down a bit, we start to see the household goods come into play. Starting with durables, vehicles are the biggest part of this, and have recovered somewhat, but the household categories – furniture, appliances, electronics, building and garden – have now almost made up for all accumulated losses.
That’s pretty remarkable. Vehicles are always a very important category, and we see a continuation of incoming trend: people are preferring used to new:
Used vehicle dealers have made up almost all of pandemic losses. When we look at public transportation, we will see why. The nondurables home categories have been strong all along:
The biggest home category is, of course, food – one of the three large nondurable categories along with gas and clothing. Those other two are the only sour notes for goods:
So, overall, the goods economy is in pretty decent shape if you’re not selling gas or clothes. One last thing from the goods table:
But services are much larger, and that’s where the problems are. We start with the Big Dogs – housing and health care. These categories are so large, they can move the whole report by themselves. Health care is doing much worse than I would have expected at this point, and, at least through July, housing is acting as if nothing is happening.
That’s a pretty normal-looking curve on housing. I really expected health care to be cutting into those large losses by now, but instead, it put on another $10 billion in July. The whole category is still down 7% since February, with dental and nursing homes doing particularly poorly. The only up category is labs.
But there are group of services with high fixed costs that make up for it with density and volume and peak demand times – transportation, recreation, food, accommodations, and smaller services grouped under “Other”. Together, these were 23% of consumption in 2019. They were only 18% of consumption in July.
The accumulated losses in these businesses were at $407 billion through July.
These are by far the worst large categories in the report.
Starting with food and accommodations, we see that the split between fast food and full service is real. Fast food restaurants have turned it around and have started eating into their March through May losses. Q2 looks like a pretty good quarter for them.
Full service restaurants and bars are still losing about $10 billion a month in revenue, while fast food is moving the other way. Comparing groceries to food service, we see losses in the latter are outstripping grocery gains substantially.
Households have saved a cumulative $38 billion from not eating out as much since March. That’s about $23 a month for every man, woman, and child.
Also note the food hoarding in March.
Looking at the two student categories, they are really in the dumps. Remember, these are seasonally adjusted in these highly seasonal categories, so this is compared to what a “normal” spring and summer might look like.
This is one of the reasons universities are opening against all logic. The large recent increases in tuition and fees have not been to pay for education (faculty salaries are stable), but rather for amenities like food and housing. If students are only paying for education via remote learning and not the amenities, universities operate at a loss.
Anyway, it will be interesting to watch these categories as they play out in August and the Fall as schools open up.
Finally, in this category, we have hotels, which added another $5 billion in losses in July.
Moving on to transportation, these were some of the hardest-hit categories in March through May, and recovery has been slow compared to their plunge.
I consider these categories bellwethers. The recession doesn’t begin to end until people are willing to get on a crowded plane, bus, or subway again. Air carriers added another $4 billion in losses in July, for $32 billion total. They also missed out on their summer surge.
Recreation services is where the worst-hit categories are:
Audio and video services includes streaming services like Netflix (NFLX) and Spotify (SPOT), so that is buoying that category, even though the rest of it, especially photo studios, are still doing poorly. Cable and satellite TV are continuing their slow slide as if nothing is happening.
Let’s check in on some of the subcategories here, because it’s pretty striking.
Look at casino gambling in June and July. Vice is nice in pandemic life. Weirdly, though, lottery purchases remain down. I would have thought gamblers would substitute large lottery ticket purchases for casino and sports gambling not available. I guess they have the stock market, which, at this point, should be switched from financial services to recreation services.
Looking at the losses in the broader subcategories:
Most of the really bad services from the previous chart sit in that far right-hand side group, and you can see they added another $12 billion in losses in July, for a total of $62 billion now.
“Other Services” is pretty dense, with 52 sub-categories and sub-sub-categories.
Communications is the largest of the sub-groups, but only 15% of Other, and mobile and home internet are most of that. This has been a flat line across this whole time, though that hides some large variation
The two digital services for mobile and home are very flat, but we see a huge divergence between first class mail and other delivery services, now up 28% since February. First class mail is a whole article unto itself, so you will have to forgive me if I skip it.
But the rest of the Others are doing poorly, with most of the accumulated revenue losses coming in the clothing and personal care category.
That is almost entirely personal care, $45 billion out of the $47 billion total accumulated losses. $25 billion of that was for salons, which is only a $7 billion per month business in the first place. In July, salons were still down 81% since February.
Professional and business services is one of the categories that worries me the most, here and also in the jobs numbers. Legal and accounting are starting to get back up. But the rest are down then flat, and funeral services are, if you will forgive the expression, dying.
The rest of Other:
- Education services losses are spread out amongst the subcategories. But again, these are pretty seasonal right now, so we’ll see where that goes in the August and September numbers.
- 67% of the cumulative losses in social and religious services is child care.
- 62% of the cumulative losses in household maintenance is domestic services.
There are two sort of accounting anomalies that are also having an unusual effect on the top line PCE number. The first is foreign travel. PCE is calculated by who spends the money for the good or service, so counterintuitively, spending by US residents abroad is added to PCE, but spending by foreigners in the US is subtracted. The result, “net foreign travel”, is added to PCE. Since both foreign travel categories are way down, they cancel each other out in the top line of PCE. But that is masking these declines:
The other accounting anomaly is nonprofits. Here, and in many other government data, households and nonprofits are reported together. But nonprofits are both consumers and also sellers of goods and services to households. In order to not double-count the latter, nonprofit sales to households are subtracted from their gross output, and that net consumption, aka “Final consumption expenditures of nonprofit institutions serving households”, is added to PCE.
What happened was that in March through June, nonprofit sales fell much more than their gross output, which also fell. The net result was a cumulative boost to PCE of $49 billion over those months because of this accounting. As you see, that has evened out in July, and all three are down 6-7% from February.
- This is the fastest shift in consumer preferences ever.
- Consumers are substituting household goods for services they cannot enjoy.
- Even if it remains flat in August, the goods economy will make up all the accumulated losses of April and May.
- But services are still twice as large, and are doing much more poorly.
- Health care remains terrible.
- The other very large service category, housing, is acting like nothing is happening.
- The group of high-density services in transportation, recreation, food, accommodations, and personal care were the worst hit and remain the worst off.
- There has been over $100 billion not spent on foreign travel to and from the US.
Prices and Inflation
Again, this is where we are likely to see the largest revisions over time, so treat these as approximations.
PCE-chained price indexes attempt to measure the prices of what people are actually buying, unlike the fixed basket of goods of CPI. So, importantly, we are going to see the results of large substitution effects. Normally, this is when the price of something goes up, so people substitute something else. In this case, it is more that many services people used to buy are not available or unsafe, and they are substituting goods in the home.
But especially in services where the shifts have been the largest, we also see large formula effects. The most extreme example is spectator sports. This is a category that is still down 99.9% in July, but with prices inflating at 6.2% YoY. What that means is, whatever is left out there (and I have no idea what that 0.1% of sports is), is relatively expensive. But unlike CPI, almost none of that winds up in the top line numbers.
So, given all those well-deserved caveats, let’s get to it. In the first place, despite all that cash flooding the system I told you about, inflation remain muted at 1%.
This is not to say it has done nothing; we would probably be deflating right now otherwise.
But like with consumption, we are seeing a small reversal of the historical trends of goods and services:
Services inflation runs a little hot, above the 2% Fed target, whereas goods price inflation is much lower and often negative. Zooming in on 2020:
We see that services inflation dipped down below 2% and has stayed very flat since. But goods prices, which had bounced in January and February, collapsed sharply in March-May, but have also recovered pretty sharply. That curve is hiding two things, in particular, underneath.
In the first place, food and energy goods have had a huge effect on that curve, but they are more or less cancelling each other out.
In July, the inflation rate for the combined line was -0.9%, but that’s come back from -3%, boosting the goods top line somewhat. But if we pull out food and energy, the chart looks pretty similar to the one with them still in there, just with slightly higher levels in goods.
So, what’s happening? Outside of recovering energy prices, it’s almost entirely due to vehicles, and really, used vehicles.
I’m accustomed to used vehicles having an inordinate influence on the report, but this is amazing. This is another one of those goods-for-services substitutions:
So, demand has spiked, and even though inventories are very high right now, dealers are taking advantage and raising the stickers. Their margins are skyrocketing as a result:
The used truck margin has doubled since April. So, to sum up:
- Services, two-thirds of consumption, are seeing reduced inflation that has been flat for 4 months now.
- But goods are on a bit of a wild ride, driven almost entirely by energy prices and used vehicles.
- The net effect is 1% inflation, well below the Fed’s target.
The Fed’s Inflation Targeting Announcement Ultimately Means Nothing
The Fed’s announcement that they would begin to use average inflation targeting and allow inflation to get hot for a while to make up for lower periods sent equities rallying again and the long end of the Treasury curve up. I took the opportunity to buy some 20- and 30-year bonds.
But the Fed saying that they will tolerate brief periods of high inflation does not mean there will be inflation. They are bankers, not gods.
In the first place, they had already told us they were not raising rates for years, so this has zero effect on the short and medium term. It is merely recognition that our problem no longer is keeping a lid on inflation, but rather, stopping deflation. That chart in the Twitter screenshot above is core PCE inflation, what the Fed targets, over the longest expansion in history. That period includes near-zero rates for 6 years, 3 rounds of QE totaling about $2 trillion dollars, TARP, and a giant tax cut in 2018 that finally pushed inflation over 2% for 2 quarters in that year.
Note that what finally pushed it over was fiscal policy, not monetary policy. They are bankers, not gods. So, what is happening? For that, we need to back up 50 years.
For anyone who live through the 1970s, it was a formative experience. We all have “Inflation Bad” tattooed on our frontal lobes. A thriving middle class, a rising Boomer generation, and women entering the workforce pushed demand high. Add in a couple of oil shocks, and you get this:
Prices and rates were high because there was a high demand for capital to meet consumer demand, but not enough savings to fund that capital. The neutral rate, the magic rate at which savings equals investment and 2% inflation meets full employment, was very high.
The Fed controls only overnight rates, and the further out you go on the curve, the less control they have. Right now, the 1-3 month bills are all inverted with the overnight rates. They can’t even control that.
The narrowing spreads and inversions we saw through 2018-2019 was the bond market telling the Fed that short-term rates were too high. Powell’s pivot in December 2018 was a reaction to this and credit conditions tightening, not the President.
But back to the 1980s. In response to the neutral rate skyrocketing, the GOP devised a variety of supply-side policies to create more savings at lower interest rates – to raise the marginal propensity to save:
- Lower marginal tax rates on high earners, who save more of their income
- Tax-advantaged retirement and other savings
- Capital gains tax rates
So, this sets the stage for our current problems, which are the opposite of the problems of 1980, when there was too much consumption and not enough savings. Now, there is not enough consumption:
- Red line – Annualized real PCE growth 1970-2000, 3.5%
- Green – 2000-2019, 2.3%
The reasons given by economists, generally:
- Demographics – Workers work the same number of years but are retired for much longer, so they must self-insure against running out of money in their 80s. There is a good chance you are here at Seeking Alpha for this exact reason.
- Inequality 0 High earners have a lower propensity to consume, and they are getting a larger share of income.
But the supply-side policies are still in effect. They were created to solve problems from 1980, and both helped create that inequality and continue to reinforce it. Those policies are now working against us.
I would add a third, psychological, reason – which is that the experience of the last recession was indelible, and it highlighted to everyone the tenuous nature of our incomes in a globalized world.
Rates are a price for money. Like all prices, they are controlled by supply and demand. When the price for money was high in 1980, it was telling us there was not enough capital to meet demand. We needed more supply. Now rates are telling us that there is not enough demand for capital to meet supply.
We see that reduced demand for capital in fixed investment.
- Red line – Annualized real fixed investment growth 1970-2000, 4.7%
- Green – 2000-2019, 2.1%
Inflation similarly sits at the nexus of supply and demand. It’s no big mystery why inflation is low. Scroll back up and look at the real PCE chart. Consumption growth has slowed; demand is low, and the system is awash with capital with no place to go. They are literally giving it to blank-check SPACs now, because there is no other place for it to go. So, the Fed can say whatever they want, and the inflation bugs can come crawling out of the woodwork. They can’t make people want to consume more.
Unless we deal with those root problems of inequality and income insecurity for seniors, demand will remain low, and so will inflation, no matter how many digital dollars the Fed prints.
The Numbers That Really Matter
I’ve been quoting this extensively since he said it, because it frames our situation particularly well. During the Q2 earnings call, Citigroup (C) CEO Mike Corbat finished up his scripted remarks with this:
We are in a completely unpredictable environment which no models, no cycles to point to. The pandemic has a grip on the economy and it doesn’t seem likely to loosen until vaccines are widely available.
When asked to elaborate later in the call, he said:
I think of this going through four stages, containment, stabilization, normalization and ultimately a return to growth… I would describe right now that broadly in the world we are somewhere between containment and stabilization, right? Containment is that we can bend the curve in terms of the transmission of cases. Stabilization is that as we remove or start to take down some of the barriers or actions that were put in place… And when you get to the third phase around normalization – and simply put, normalization to me is: Am I willing to get on the airliner? Am I willing to get in a subway? Am I willing to go into a crowded venue to watch a sporting event or a concert or what it may be? And I think realistically when we get to that third bucket, I just don’t see that coming and I would say many don’t see that coming until we feel like there’s an anti-virus vaccine that’s available for the mass population around that. And so I think one of the things that people struggle with today is the disconnect in some ways between where the market is in some ways and actually where we are in terms of this health pandemic… So I don’t want to be pessimistic in there. I want to be a realist and I just think that in order to truly normalize, that’s what’s necessary to do that. [emphasis added]
Let’s break down the key points:
- The pandemic caused the recession, not the shutdowns. This is at root a public health problem, not a political or economic one.
- We cannot get out of containment.
- We will not get to normalization until there is a safe, effective vaccine. The recession only begins to end then.
- There is a huge disconnect between the market and the economy right now.
So, how’s that going? In the first place, we are no longer the worst in the world, as Spain has snatched that title from us.
But as you can see, the case rate has stopped coming down in the last week. This is different from that pause earlier in August, which was just California clearing backlog. So, this is where we stand today:
As you can see, the Dakotas are the worst states in the country right now, but we are seeing flare-ups throughout the Midwest. Even Maine is seeing their case rate go up from a single wedding, which now infected 65 people, several whom did not even attend. One of the non-attendees has died.
But the biggest spikes have been in Iowa and Alabama:
Why? They reopened the universities, and those counties now have sky-high case rates:
And it’s not just there:
So, it looks like we are maybe at another inflection, which would be the sixth by my count. Stay tuned, COVID-19 is not going anywhere.
Adding It Up
There’s a lot here, but the big issue remains over $3 trillion in cash that is just sitting around waiting. Households have about $1 trillion, banks another trillion, and Treasury another trillion. In addition to that, there is another $4 trillion in T-bills that have been auctioned since April 1. They have a weighted average term of 135 days and a weighted average rate of 0.14%. The demand for this $4 trillion in bills earning a negative real return was 192% higher than the issues, with $14 trillion tendered.
Just last week, Treasury sold another $300 billion in bills with a weighted average term of 102 days and a weighted average rate of 0.10%, the same as the overnight rate, for 102 days. There was $888 billion tendered, 196% more than the offerings. That’s almost $900 billion chasing 10 basis points for 102 days.
That’s about $7 trillion earning little or no return. The system is awash with capital, and there is no place for it to go. Real rates will remain negative because the real neutral rate is negative. Right now, the 10-year TIPS is -1.09%. Does that sound like an inflationary environment to you?
So, the big question remains: will this cash just sit on the sidelines like it has been, or will banks, corporations, and households put it to work?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.