The Artificial Recovery

David Rosenberg:

Indeed, this 2009-2011 recovery and cyclical bull market has been as artificial as the 2003-07 expansion. That last one was fuelled by financial engineering in the financial sector. This one is being underpinned by unprecedented government intrusion in the credit markets. As of this quarter, your government has replaced the private sector as the largest source of outstanding mortgage market and consumer-related credit (see front page of the Investor’s Business Daily). So not only is the U.S.A. turning Japanese in many respects, it is also now resembling China where the government also redirects the flow of private sector credit.

When we said capitalism went on a sabbatical three years ago, we didn’t expect this to be a permanent vacation. In the past five years, private sector loans have deflated by $1.9 trillion, while public sector assisted credit has surged a similar amount. Roughly nine in 10 dollars of mortgage flow is being dominated by the Federal government — Fannie Mae, Ginnie Mae, Freddie Mac, and the FHA. That is amazing, and these entities have actually been tightening their scorecards to avoid political taxpayer backlash.

Be that as it may, in this new era of socialized credit, the private sector now accounts for 42% of outstanding residential mortgages, down from nearly 60% at the bubble peak in 2006. The only reason why consumer credit has not shown a complete implosion is because in the past three years, federally- assisted student loans have soared by $250 billion.

But not even the government can prevent credit from retrenching — the best it can do is cushion the blow. The front page of the weekend WSJ runs with an article on the aftershocks of the credit collapse — Tighter Lending Crimps Housing. Credit applications are still being rejected at a rapid rate.

About 20% of new home loan applications have been refused this year, up from 18% in 2010; 27% of refinancing requests have been turned down, up from 24%. And if you need any proof as to how this is playing out in the consumer space, have a look at Property Investors Face Losing Their Shirts with Strip Malls on page C14 of the WSJ. The low-income consumer that tends to shop at strip centers has been completely hobbled by weak job market conditions and punishingly high food and gas prices this cycle. Somehow the benefits from QE1 and QE2 bypassed the $50,000 and lower income club, and this group represents half of the U.S. consumer spending pie, for all the talk of Coach, Tiffany’s, and Saks for much of the past 24 months.

The WSJ emphasizes the implications of the on-going deleveraging cycle on the front page of today’s paper — Debit Hamstrings Recovery. It is so obvious that as much as the government tries to slow the process, it cannot prevent the private sector from healing itself after decades of tremendous credit excess. U.S. consumers have 30% more credit card and other revolving debt on their balance sheet than they did just a decade ago. While outstandings are down 6% from the peak, there is still considerable contractions to go before household debt levels revert to the mean relative to both income and assets. At the same time, an estimated 23% of mortgages are “underwater” and it is against this backdrop that home-equity and credit lines have almost completely dried up. The necessity of climbing out from under this unprecedented amount of debt-related stress means that interest rates are very likely going to remain near the floor for a very long time. Ben Bernanke may publicly state that “extended period” means over the next few FOMC meetings, but anyone with a sense of history knows that they will stay close to zero for years to come.

And whoever thought we’d be seeing headlines like this, four years after the initial detonation in the U.S. housing market — Lennar Profit Slides 65% on page B8 of the weekend WSJ. Incredible. Revenues are down 6.1% YoY, margins are still compressing and order books are flat.