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Generational Dynamics Web Log for 6-Feb-08
Both consumer and commercial credit is disappearing as deflationary spiral accelerates

Web Log - February, 2008

Both consumer and commercial credit is disappearing as deflationary spiral accelerates

Wall Street markets plummet 3% on Tuesday, as service sector contracts sharply.

A bad omen occurred around 8:45 am on Tuesday. The Institute for Supply Management (ISM) was supposed to release a report at 10 am. But suddenly they announced that they would release it at 8:55 am instead, because it had leaked. Even before the report was released, investors seemed to know that it would be bad news, and market futures began to fall.

ISM non-manufacturing business activity index

The report was worse than anyone expected. The "Non-manufacturing business activity index" was 41.9, much lower than the value 53, which is what economists had predicted.

Non-manufacturing busines activity refers to what is otherwise called the "service sector." It consists of everything from restaurants and banks to contractors, travel agencies and airlines.

(To add to the confusion, the ISM is introducing a brand new index with this report, the "Non-Manufacturing Index," or NMI. If you look at the the actual report, then you see NMI = 44.6% headlined. But economists are interested in only one component, the index they've been working with for a long time, the Non-Manufacturing Business Activity Index, which was at 41.9% in January.)

According to the actual report:

Business Activity

"ISM's Non-Manufacturing Business Activity Index in January registered 41.9 percent, indicating a significant contraction in business activity in January from the seasonally adjusted 54.4 percent registered in December. This is the first contraction in the non-manufacturing sector since March 2003, when the index registered 46.3 percent, and the lowest Business Activity Index since registering 40 percent in October 2001. Two industries reported increased business activity, and 14 industries reported decreased activity for the month of January. Two industries reported no change from December. Comments from respondents include: "Pervasive economic weakness"; "Less customer demand, stiffer competition"; and "Fewer job orders, fewer inquiries about our capabilities."

The industries reporting growth of business activity in January are: Utilities and Educational Services. The industries reporting decreased business activity in January are: Arts, Entertainment & Recreation; Agriculture, Forestry, Fishing & Hunting; Accommodation & Food Services; Health Care & Social Assistance; Transportation & Warehousing; Real Estate, Rental & Leasing; Management of Companies and Support Services; Construction; Wholesale Trade; Finance & Insurance; Information; Retail Trade; Public Administration; and Professional, Scientific & Technical Services."

The report includes the following quotes from survey respondents:

"Recession fears taking hold as cost containment strategies have been dusted off from 2002." (Finance & Insurance)

"Business [is] slow as normal after holiday rush." (Management of Companies & Support Services)

"Oil increases affecting delivery costs and the costs of goods." (Retail Trade)

"Business is tough coming into Q1 after a very tough, unprofitable Q4. Competitive pricing is driving rates to unreasonable levels as competition is over fleeted." (Real Estate, Rental & Leasing)

"... business activity is currently lower than normal at this time." (Wholesale Trade)

Economists found the report devastating. According to one economist quoted by Bloomberg, "This is a stunning fall. If accurate, it's dire news on the economy."

Generational Dynamics and service sector

From the point of view of Generational Dynamics, this development is significant.

I've been predicting a deflationary environment since 2003, and the initial explanation I gave was from my book, called the "crusty old bureaucracy" theory. I came up with this name because I had read some newspaper column describing some company as having a "crusty old bureaucracy."

According to this concept, there's a generational cycle in businesses, where bureaucracy sets in, and the products become gradually obsolete, and that this happens on a national basis. In the extreme, once enough businesses are producing obsolete products, inflation can't increase because no one will want the products at any price. The only way to fix the problem is through massive business bankruptcies and a new set of businesses.

In the case of American business, practically all of the old businesses went bankrupt during the 1930s Great Depression, and those that survived completely renewed themselves so much that they were new "lean and mean" businesses again.

During the intervening years, every organization -- business, government, education, etc. -- began to develop a bureaucracy of people and departments that were no longer "lean and mean." By the 2000s, most businesses were bogged down with a very heavy bureaucracy. These organizations could only produce products that nobody really wanted anymore.

When I was writing about this in 2003, it was well known that tens or perhaps hundreds of thousands of manufacturing jobs had fled or were fleeing to China. I expected that trend to continue, and the economy to spiral downward.

That didn't happen, and what I hadn't anticipated was the "second bubble," the huge credit bubble that was created by financial engineering and structured credit. This huge bubble created an enormous amount of liquidity, and the US economy was able to generate a lot of new service sector jobs.

In most cases, service sector jobs can start up more cheaply than manufacturing jobs. Manufacturing jobs usually require someone to build a factory; service jobs use products that were manufactured by someone else, so you can hire someone without building anything in advance. So service jobs just require money, and there was plenty of that around, thanks to the credit bubble.

So in 2003 I didn't foresee the enormous growth of the service sector, but I was right about the manufacturing sector. Today, about 90% of all American jobs are service jobs. The manufacturing sector has effectively been destroyed, thanks to the development of the crusty old bureaucracy in many businesses.

Now that the credit bubble is leaking very quickly, we're beginning to see the deflationary spiral that I was expecting in 2003. I would expect service jobs to start disappearing fairly quickly in the months ahead.

The collapse of the credit bubble

The huge credit bubble that began growing in 2003 is now deflating, and appears to be deflating more and more quickly.

The result is that it's getting harder to get credit every day. There are many ways to measure this -- for example, banks are toughening up their lending standards.

This became startling a few days ago, when Citibank actually cancelled the credit cards of many customers of Egg, a UK online bank. Citibank had acquired Egg plc a year ago in order to expand into new markets.

But last week, Citibank sent out an unexpected warning to 161,000 of the 2.1 million Egg credit card users saying that it will end their agreements in 35 days time, because they have a "higher than acceptable risk profile."

A lot of people are really pissed off about this for several reasons, not least of which is the fact that many of the canceled customers had perfectly high credit ratings. Many of them, apparently, either didn't use the card much or else paid off their monthly bills in full, which meant that Citibank could not make much profit on them. If you want to get a feel for the anger of many customers, read the reader comments to this Times Online article on the subject.

An article in WSJ says that banks are making it much tougher to get and keep credit cards, and suggests the following for "How to avoid getting squeezed":

Boost your credit score, as issuers are raising minimum score requirements.

Aim to pay down balances and limit applications for new credit cards.

Maintain several cards with high limits, so if one issuer raises fees, you have other options.

Quite honestly, it's hard for me to see how much good this advice will do, given that Citibank canceled cards for people with perfectly good credit ratings.

Another sign that credit is disappearing is that the CDO market is almost frozen. These CDOs were the means by which banks expanded credit in the past. But with all the writedowns of CDOs, no one wants to buy them any more, so the market no longer exists, for all practical purposes.

On Tuesday morning, CNBC reporter David Faber gave a report on the credit markets as follows:

"Here it is February 5, and we're still talking about credit. It has been a lot of months, hasn't it? And it continues to be very similar in terms of news flow, and the conversation, and the concerns.

This morning, any number of different data points that you could cite as a reason why the markets are yet again focused on that area.

I will get to highly leveraged transactions in a moment, but it's like Sallie Mae getting downgraded by S&P to one notch above junk.

It's a report from Goldman Sachs - their institutional portal this morning saying "Credit is too tight to mention."

Specifically on the real estate side, the residential / commercial real estate markets painted by the report is unequivocally much bleaker -- both the demographics, the supply of real estate credit stand at their worst point since they started this series in the early 90s.

It is these kinds of small but significant data points that we get.

Europe credit blew out yet again today -- or at least is in the process of having a difficult time of things.

And then you get more specific kinds of reports about some of the deals out there.

For example, Harrahs, which had closed a couple of weeks ago -- the banks had hoped to sell as much as $14 billion in debt that financed the transaction -- they haven't been able to. That's not a surprise, of course, given the reluctance of the banks to really take significant hits on what are really likely to be money good deals -- but an unwillingness of people in the credit markets to pay anything near par for these names.

So you've got Harrahs sitting on the books of all these banks. That in turn of course has people concerned about the likes of ClearChannel communications, a company I've reported on many times. Why? Because of all the banks that are financing that huge "go-private." As I reported last week, the principals in the deal remain very positive on its prospects, but they are concerned that the banks are going to panic to such an extent that there is even the possibility that they might try any way they can to get out.

And if you're a bank, of course you're going to consider it. You don't want to fund any of these deals. Why would you? You know you're going to have to mark them down the minute they hit your books. You know that you're going to be unable to sell any of them.

The latest names also that is now going to be concerned about is BCE Inc. Some reports in the Canadian press late yesterday really just questioning how it is that the banks are going to be able to step up to finance a deal that they know they're going to have to keep on their books.

That of course the biggest leveraged buyout more or less of all time, I think topping TXU.

That's where we stand yet again, Erin. It's the same old story. Frankly it continues to worsen."

So this collapse of credit isn't just happening in one place, say real estate. It's happening to consumers, to small businesses, and to large businesses alike.

The collapse of corporate earnings

The fall in the growth rate of corporate earnings for the fourth quarter of last year has been enormous. The fall finally appears to be leveling off at -20% to -21%.

Here's the summary from Friday from CNBC Earnings Central:

"As of Friday, February 1st:

282 companies in the S&P 500 have reported earnings for Q4, 59% have beaten estimates, 14% were in-line, and 27% have missed.

The blended earnings growth rate for the S&P 500 in fourth-quarter 2007, combining actual numbers for companies that have reported, and estimates for companies yet to report, stands at -20.7%.

At the start of the quarter, the growth rate for Q4 was 11.5%. (Data provided by Thomson Financial)"

We can now update the table of the changes in fourth-quarter earnings estimates since the beginning of the fourth quarter, as follows:

  Date    4Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct  1:             +11.5%
  Dec  7:              -1.3%
  Dec 14:              -3.8%
  Dec 31:              -6.1%
  Jan  4:              -9.5%
  Jan 11:             -11.3%
  Jan 18:             -19.0%
  Jan 25:             -20.5%
  Feb  1:             -20.7%

In other words, at the beginning of 4Q, Thomson Financial was predicting that earnings would grow by 11.5%. That turned out to be a complete fantasy. As time went on, and actual results came in, the estimate fell sharply, now at a 20.7% loss.

The fantasy continues. According to a report on CNBC on Tuesday afternoon, Thomson Financial has provided its estimates for earnings growth in 2008. Here are the results:

  Period  Earnings growth estimate (Thomson Financial)
  ------- --------------------------------------------
  Q1 2008       2.6%
  Q2 2008       3.5%
  Q3 2008      20.0%
  Q4 2008      50.0%

This is so absurd that I don't even think many of the CNBC reporters believe it's possible, except for the Pollyannas.

The Pollyanna factor

Late Tuesday afternoon, Maria Bartiromo squawked, "What's going on? We've known all of this bad news for a long time!"

She was referring to the bad news, such as the ISM report and the earnings reports, that were evidently driving the market down. She was making the point that there had already been hints of reduced service sector activity and lower earnings. So why, she wondered, was the market falling now? Since it was old news, the bubble should be growing again.

The answer is that it's related to the old Aesop's fable about the boy who cried "wolf." The first time he cried "wolf" as a joke everyone ran to save him from the wolf. The same thing happened the second time he cried "wolf," But then one day a real wolf showed up. He cried "wolf," but nobody came to save him because they thought he was trying to fool them again. Aesop's moral is, "Nobody believes a liar, even when he's telling the truth."

Well, maybe that news was old news, but whenever bad news comes up on CNBC, the Pollyannas like Maria Bartiromo and Dennis Kneale simply say that it's irrelevant, a one-time thing that will disappear.

The first time Maria cries, "Ignore the bad news," people run to buy, because they believe her. The second time Maria cries, "Ignore the bad news," people run to buy, because they believe her. But the third time Maria says "Ignore the bad news," they think she's trying to fool them again, so they sell. You see, Maria, nobody believes a liar, even when she's telling the truth.

Even now, there are still airhead pundits saying that everything's OK. "It's beginning to feel like 1991 again," one of the them said.

Now, I don't care if it's an analyst, a journalist, a blogger, a pundit, a politician, a college professor, a Nobel prize winner, or anything else, but if someone says that the macro economy today is like 2001 or like 1991 or like 1982 or like l974 or like 1962, then I tell you, Dear Reader, that guy has his head up his a--.

What's going on today in the macro economy doesn't remotely resemble anything that's happened since 1929.

The market

The market rose last week, after the Fed's huge two-part interest rate cut, and after everyone became euphoric over the possible Microsoft leveraged buyout of Yahoo. It seemed like the punch bowl was back, and it was time to party on.

Instead, we're now resuming the downward trend that began in December.

Investors are hoping against hope that the Fed will save them -- by cutting interest rates again, so that liquidity will return and credit will return and leveraged buyouts will return, and so forth.

One thing that I didn't fully understand in 2003 that is fully apparent today is that the Fed has absolutely nothing to do with what's going on now.

The Fed can cut interest rates to zero, and it won't stop the deflationary spiral we're in. In fact, that's what Japan did in the 1990s -- interest rates were set literally to zero, and the deflationary spiral continued, and even today many prices are still falling.

In December, I posted an article called "Will hyper-inflation make the dollar worthless (like the Weimar republic)?" in which I explained why there will NOT be hyper-inflation, but rather deflation.

I've received many questions about that article, and I promised to write an update answering the questions, and it's still on my todo list, and I've even started it, but it isn't done yet, and I'm sorry, but it will get done.

In the meantime, let me address a point that several people asked. It was something like the following: "The Fed will print lots of money, and the dollar will become worthless."

First, the amount of currency in circulation is a very small part of the total money supply. It's so small that it's almost irrelevant. The Fed injects money into the financial system by creating credit by lowering interest rates.

What I didn't understand in 2003 is how little effect the Fed really has. The Fed can inject a few hundred billion dollars into the financial system, or maybe even a trillion or two.

But what really made me see the light was when I realized that there are some $700 trillion dollars of credit derivatives in the world today in various portfolios. Now, that's money too, in the sense that it can be used as collateral or to make investments.

The point is that the trillion or two that the Fed commands is almost nothing compared to the amount of money in the world. Alan Greenspan didn't cause the credit bubble; he had nothing to do with it. He couldn't have created it because the Fed can't control a $700 trillion total. Similarly, Ben Bernanke can't control it either.

The deflationary spiral we're in today is progressing and can't be stopped. Every day that $700 trillion comes down a little, as various securities get written down, or as companies or banks go bankrupt, or as credit cards get canceled. That's where the deflation is coming from, and it can't be stopped because it's too big to be stopped. As I always like to say, you can't stop a tsunami.

From the point of view of Generational Dynamics, we're headed to a new stock market panic and crash, triggering a new 1930s style Great Depression. It's impossible to predict the exact date, but unless the markets somehow reverse themselves quickly, the spiral will be reaching full speed before long. (6-Feb-08) Permanent Link
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Generational Dynamics Web Log for 6-Feb-08 Both consumer and commercial credit is disappearing as deflationary spiral accelerates