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Five Things You Need to Know: Everybody, Back Into the Woods! Back Into the Woods!


The coming age of voluntary thrift will redefine what Americans view as "means" and "luxury."


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Everybody, Back Into the Woods! Back Into the Woods!

There was very little about this morning's release of the Institute for Supply Management's Non-Manufacturing Index that wasn't a fiasco.

First, the report was released about an hour early "due to a possible breach of information." Second, the plunge in the index headline composite index number, from 53.9 to 44.6 stunned even the most grim-faced bears. Third, a recently announced change in the composition of the index mistakenly led a few "We're Out of the Woods" optimists to conclude that perhaps the numbers aren't' as bad as they seem. Well, everyone can run back into the woods, because they are as bad as they seem.

First, what is this index and why do we care? The ISM surveys purchasing managers and supply executives across the country and asks them a series of questions about their views on business conditions, costs, employment plans and the economy.

The survey is a bit like a Zagat's survey, but for the service sector. Frequently included are responses from some of the executives surveyed, such as this one today from a respondent in the Finance & Insurance Industry: "Recession fears taking hold as cost containment strategies have been dusted off from 2002."

Like a Zagat's restaurant review, nuggets from respondents are sprinkled throughout the report so you get a narrative that reads like below:

"Employment activity in the non-manufacturing sector decreased in January for the first time in five months... Comments from respondents include: "Did not replace some positions"; "Reduced headcounts with hiring freezes in place"; and "Layoffs."

Let's get the change in the index composition out of the way. All that was revised was the weighted formula for the overall headline composite index number. The previous weighted formula of the Purchasing Managers Index was scrapped in favor of an equal-weighted formula because, according to the ISM, to more closely predict GDP. An identical change was made to the NMI composite. What does that gibberish mean?

There are four categories that make up the overall composite index reading. They are:

1) Business Activity Index
2) New Orders Index
3) Employment Index
4) Supplier Deliveries Index

These categories are now weighted equally at 25% each. So while the overall composite reading of 44.6 may not compare easily to the January weighted composite of 53.9, the measurements of the components themselves are unchanged, and the component index readings are most important.

Therefore, when one sees the Business Activity Index plunge from 54.4 to 41.9 or the New Orders Index decline from 53.9 to 43.5, the Employment Index slip from 51.8 to 43.9 and the Supplier Deliveries Index fall from 52.5 to 49, the weakness is apparent. remember, any reading below 50 signals contraction.

Bottom Line: Service industries make up more than three-quarters of the economy. This is a very weak report. Some of the internals are at 2001 levels reached during post-9/11 stress and ahead of the 2002 deflationary scarer. Everyone out of the woods should now run back into the woods for cover.

2. Credit Standards Tightening, Credit Demand Weakening

Now that we're all safely ensconced back in the woods, it's safe to look at the Federal Reserve's first quarter Senior Loan Office Survey. What is this, and why do we care?

What is it? Every quarter dating back to 1966 the Federal Reserve publishes its Senior Loan Officer Opinion Survey where, as one would expect, senior loan officers at banks are asked about lending conditions in U.S. credit markets. Included in the current report are responses from 56 domestic banks and 23 foreign banks.

Ok, why do we care? Senior loan officers are on the front lines of the Federal Reserve's war against credit contraction. They are not pawns in the battle, but more like majors leading the charge. Not only do these majors observe first hand the demand for credit among businesses and households, they also are many times involved directly in decision-making that impacts credit availability to businesses and households.

The net of the survey is a clear pattern of a combined tightening of credit standards and weakening loan demand spread across a wide range of loan types. If there was a lingering perception that credit issues are contained to real estate, specifically subprime, then this report should end any doubts.

About 55 percent of domestic respondents indicated that they had tightened their lending standards on prime mortgages, up from about 40 percent in the October survey.

Concerning residential real estate loans, between about 70 percent and 80 percent of domestic respondents expect the quality of their prime, nontraditional, and subprime residential mortgage loans, as well as of their revolving home equity loans, to deteriorate in 2008.

The bottom line is that credit issues are widespread and infecting both business and household loan demand as well as lending standards.

3. The Fed's Dilemma, in Pictures

Credit in the economy is contracting rapidly. It's as simple as that. The charts below show commercial and residential standards tightening to near unprecedented levels as demand clearly falls to recessionary levels. This is a central banker's worst nightmare... a tightening of credit standards and, more importantly, a weakening of credit demand. It is the velocity of money that moves this economy and the pictures below show that velocity clearly slowing.

Net Percentage of Domestic Respondents Tightening Standards for Residential Mortgage Loans
Note the breakdown on the far right of the chart showing credit standards tightening for not just subprime and nontraditional but prime as well.

Net Percentage of Domestic Respondents Reporting Stronger Demand for Residential Mortgage Loans

Net Percentage of Domestic Respondents Tightening Standards for Commercial Real Estate Loans

Net Percentage of Domestic Respondents Reporting Stronger Demand for Commercial Real Estate Loans

But credit tightening is also showing up in consumer loans...

Net Percentage of Domestic Respondents Tightening Standards for Consumer Loans

... and the Fed's worst fear... plummeting demand for consumer loans...

Net Percentage of Domestic Respondents Reporting Stronger Demand for Consumer Loans

4. Rise of the Deflationistas

Having recently been labeled a "Deflationista," we want to reiterate something we believe is very important to understand in this economic cycle: inflation does not cause more inflation. This is a consumer-led recession. Consequently, all that "commodities demand" that Inflationistas point to as evidence of still more inflation ahead of us will recede with stunning swiftness once the slowdown in the velocity of money in our economy becomes truly apparent.

Clorox (CLX) yesterday in the company's earnings conference call provided what might seem like ready-made fuel for the Inflationista fire on the surface - they are raising prices an average of 7% on glad trash bags and Gladware disposable containers - but the reality requires seeing through to the other side.

As CLX Chief Operating Officer Lawrence Peiros pointed out, "We are closely attuned to concerns about the U.S. economy and consumer spending. However, we do not believe that our categories will be dramatically impacted, as people tend to buy bleach and household staples even in difficult times."

True enough. In weak versions of the recession we experienced in 2001, consumer spending actually increased. That will not be the case this time around because the single largest factor influencing consumer perceptions of financial safety and wealth - the price of their homes - is deflating.

But what about all that demand for raw materials from China and India? Surely that will pressure prices. And in fact, some central banks, such as the Reserve Bank of Australia, are raising rates. What gives?

There is no question that demand for raw materials in some emerging markets has created the feeling there is a floor under certain commodities markets, but we'll simply out that those countries are still far more dependent on U.S. consumption that the Inflationistas would have us believe.

American consumers spent more than $9.5 trillion last year. China's booming domestic economy accounted for about $1 trillion in consumer spending. India's was $650 billion. Our largest bank (by market cap), Bank of America (BAC), may be a close second place to the Industrial & Commercial Bank of China, but our consumers are dominant. They still need us.

At any rate, we'll add the Deflationista label to our growing T-Shirt collection:

Deflationistas do it for less.

I survived a Global Repricing of Risk and all I got was this stupid t-shirt

Don't worry. It's well contained.

5. Pay As You Go

Major media outlets continue to pick up on our theme of consumer cutbacks. The New York Times this morning looks at the rise of consumer "Pay As You Go" strategies in the face of economic weakness.

The article looks at what they term "involuntary thrift":

"With the number of jobs shrinking, housing prices falling and debt levels swelling, the same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: more Americans must live within their means."

And also noted is the cultural nature of the shift:

"The shift under way feels to some analysts like a cultural inflection point, one with huge implications for an economy driven overwhelmingly by consumer spending."

Indeed. It's not just the economy.

The most important takeaway from this evolving shift in social mood is this: it is not about "living within one's means," it's about redefining what those means are, adjusting the boundaries lower and embracing voluntary thrift.

In our current economic structure, involuntary thrift pales in comparison to voluntary thrift. The coming age of voluntary thrift will redefine what Americans view as "means" and "luxury."

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