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Different Markets Discounting a Similar Conclusion: A Slowdown in Growth


Are we on the verge of an inventory-led recession?

Well that was an interesting quarter. On the surface you wouldn't think the Fed backing out of the market has had much impact, but looking under the hood, many trends that persisted under QE have exhibited signs of reversing.
With the S&P 500 Index (INDEXSP:.INX) virtually unchanged for the first Q1 since 2008, bonds will have outperformed stocks. Within that outperformance, the yield curve is actually bull-flattening as long-term yields fall, which is contrary to the consensus belief of how the Fed's purchase program impacts interest rates. At the same time we have high-beta growth equities that have been leading the market rally beginning to underperform low-beta equities. Consistent with the rotation from high to low beta, you are seeing the smart money -- as measured by the Bloomberg Smart Money Flow Index -- clearly reducing exposure.
Russell 2000/S&P 500 Ratio Vs. 5-Year/10-Year Spread

Smart Money Flow Index Vs. Dow Jones Industrial Average

On the currency front, the US dollar has been strengthening and the Chinese yuan (CNY) is weakening.  At the same time, since the Fed announced tapering at its December 18, 2013 FOMC meeting, FX reserves held in custody accounts at the Federal Reserve have collapsed. Is this a cause-and-effect relationship? Maybe, maybe not, but the two events are not unrelated.
CNY Vs. FX Reserves

As I covered in Weakness in Chinese Yuan May Portend Global Paradigm Shift, the CNY has been a one-way trade for the better part of the past decade. From the time China entered the WTO, the US current account deficit, which was a product of a consumption bubble, fed the Chinese economy up until the financial crisis adjusted this imbalance. As the US current account deficit narrowed, the Fed's QE program either explicitly or implicitly subsidized these flows into China.
With the US current account continuing to narrow, and as the Fed has pulled back, it's conceivable that the reason China has weakened its currency was to maintain its export advantage. With fewer flows into China, however, there have been fewer dollar reserves to get parked at the Fed.

If the corporations and other investors behind speculative long CNY flows were now to believe that an inevitable weakening was coming, they might pull money out, in effect weakening the CNY. The negative-feedback loop of capital flows would then be set in motion, and the central bank would need to sell dollar reserves to offset the capital flight.

Is this what's happening? Maybe, maybe not -- but, again, the narrowing of the US current account and weakness in the yuan are not unrelated.
In the commodity complex, two of the main consumer staples -- natural gas used to heat homes and generate electricity, and food prices -- spiked from multi-year lows. The natural gas rally was no doubt a function of the harsh winter hitting at time when the gas glut had much of the country's supply in the ground. While utility costs were high in December of last year and January, Friday's PCE report showed some easing in prices month-over-month. Food prices, on the other hand, showed a 0.3% rise, which was the largest monthly increase in the past six months.
CRB Food Vs. Natural Gas

In the real estate market, both home sales and mortgage originations have dropped significantly. February existing home sales dropped to a $4.6 million seasonally adjusted annual rate (SAAR) which was a year-over-year (YoY) decline of 7% after a January decline of 5%. In July of 2013, right after interest rates spiked on the taper negative-convexity blowout, home sales were growing at 17% YoY. Not surprisingly, mortgage purchase applications have shown a similar slide over the same time frame; they remain at the lows of the recovery and near levels not seen since the mid-1990s.
Existing Home Sales Vs. Purchase Applications

However, there has been a notable rise in bank commercial and industrial (C&I) lending to companies. C&I lending is non-real estate floating-rate asset-based lending, typically used for operating expenses and inventory. Fed H.8 data released on Friday showed C&I lending soared in February by a 26.4% annualized rate after growing 6.5% in January and 10.8% in December 2013. The following was reported by Bloomberg on Friday:
Banks eased their lending policies for C&I loans to companies of all sizes as demand increased, according to the Fed's last senior loan officer opinion survey on lending practices in January. The lowering of standards included cutting spreads on C&I loan rates, reducing the cost of credit lines, decreasing the use of interest rate floors and easing covenants, the survey showed.
C&I Growth Annualized

That can't be right. Banks don't ease lending standards when the demand for credit is strong. That's counterintuitive. Banks ease standards when the demand for credit is weak. But even in a strong-credit-demand environment, this type of spike in C&I lending is not normal.

On the surface one might assume this increase in C&I loans is a function of companies investing in cash-flow growth. However, in previous spikes in 1998, 2007, and 2008, this was a sign of cash-flow stress. With the credit markets tightening up, companies that might have been tapping the commercial-paper market for operating cash were turning to their bank lines of credit.  In times of stress, companies draw down on the whole line for fear that money won't be there in the future, causing spikes in growth. Thus it's no surprise that previous spikes in growth also preceded severe contractions.

With the new-issue credit markets freely flowing, it is unlikely there is any perceived stress from corporate managers, and they likely wouldn't need to tap bank lines to finance capital expenditures. The weakness in capex has been well-documented as companies are content with buying back stock and financing operating expenses out of existing cash flow.

But recall the better-than-expected Q4 GDP growth was primarily on the back of an inventory build. With the weather-related sales and consumption slowdown, it's quite possible companies are sitting on a lot of unsold stock that must be financed with credit because cash flows are slowing. Otherwise why would companies massively increase exposure to floating-rate debt at the very time the Fed is poised to increase the cost of this debt? This is a very different interpretation but it's entirely plausible and should not be dismissed. 

As we wind down the quarter, there have been some clear trends that have changed direction. The question for Q2 is whether these are changes in trend or countertrend adjustments. The economy is emerging from a weather-related slowdown but a slowdown nonetheless. While there may be some pent-up demand ready to be unleashed, there is also a lot of inventory that must get worked off. Will companies increase hiring and, more importantly, wages at a time where they are increasing credit lines to finance unsold inventory? If the demand is there they will. If not, then the stage is set for a double dip.

It's been a while since we had an inventory-led recession, but we may be on the verge. There are a lot of metrics that, when analyzed separately, look benign, but when analyzed together, indicate trouble ahead. The weaker CNY, bull-flattening yield curve, and money rotating out of high-beta into low-beta equities are all moves you would expect amidst a deceleration in growth. When analyzed in the context of spiking C&I loans potentially used to finance unsold inventory that will need to get liquidated, you have the recipe for a contraction.  No one is forecasting a recession, but this is exactly how recessions happen. Perhaps by the time the Fed finally begins to raise interest rates it will be time to lower them.

Twitter: @exantefactor
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