It’s Official – Demand Is Slowing

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Summary

  • Banks are reporting weaker demand across nearly every major loan category.
  • Loan growth is decelerating rapidly across most loan categories.
  • With bank loan growth continuing to slow at an accelerating pace, the money supply growth will continue to weaken and put further downward pressure on core inflation.
  • Major banks such as JPMorgan and Citi are seeing rising delinquency rates and are raising their provisions for losses on loans.
  • Core inflation is likely to fall below 1% by February 2018 due to the contraction in loan growth and increasingly difficult ‘comp’ effects.

Overview

I recently penned a brief update in my Marketplace service, EPB Macro Research, on the demand and lending standards reported by the banks (XLF) to the Federal Reserve in their survey on bank lending (You can find the report here). The results were ominous, to say the least, as banks reported weakening demand and looser lending standards. In this report, I want to expand on the results of that survey and detail what that means for future loan growth, inflation, bank profitability and economic growth.

Each quarter, the Federal Reserve publishes the results of their survey of senior loan officials at domestically chartered banks. The respondents’ answers provide information that is critical to the Federal Reserve’s monitoring of bank lending practices and credit markets.

The primary information gathered in the Federal Reserve Senior Loan Survey is whether banks are claiming they are tightening standards on loans, making credit less available, or loosening standards on loans, making credit more available. The banks also provide information as to the change in demand for new loans. This is an important read into the initial demand of the private sector. If banks are seeing a drop in demand for new loans, that can foreshadow weaker economic growth. The survey breaks down these two metrics across the size of bank and type of loan (credit card, real estate, automobile, etc.),

On balance, banks reported to the Federal Reserve that standards on loans have loosened and demand has weakened across most major lending categories.

Federal Reserve Senior Loan Survey:

Source: Federal Reserve Board of Governors

The yellow highlighted section is directly from the report that details a weakening of demand for loans across all critical lending categories.

To put context around the decline in demand below is a graph from the report that shows the trends in the changes in demand. The past two economic recessions showed a reporting of declining demand from banks (KRE) that is very similar to today’s declines and the number of banks reporting weaker demand for loans is at recessionary levels.

Number of Banks Seeing Increased Demand:

Source: Federal Reserve Board of Governors

Both of the past declines in economic activity (2001, 2008) were preceded by a report of declining demand from the Federal Reserve Senior Loan Survey. The results of the survey on trends in demand are at precisely the same level as they were at the start of the past two recessions making a case for a possible decline in economic activity in 2018.

The fact that banks are seeing a decrease in demand for loans corroborates the slowdown in all of the economic data that I have been tracking and publishing over the past several months. Asset prices should follow, with a lag, the change in demand for loans on those assets.

What is interesting, however, is that typically economic expansions end with banks tightening loan standards and that in part, contributes to the declines in demand for new loans. As the standards are less attractive, borrowers demand less credit. Currently, banks are loosening their standards on loans, and they still see weakening demand as pictured above.

The Number of Banks Tightening Standards on Loans:

Source: Federal Reserve Board of Governors

The simple fact that banks are reporting a decrease in demand at a time when lending standards are easing speaks volumes about the real demand for new loans or new investment projects in the economy. With the demand for loans appearing very weak, bank loan growth will continue to contract, as it has been quite significantly, and this, in turn, will continue to reduce the growth rate in the money supply, lowering overall growth and inflation. These data points substantially strengthen the thesis that growth and inflation will be lower in 2018 than in 2017; therefore long-term interest rates should fall in 2018, and the most significant position in the portfolio should rise (Position exclusive to subscribers).

Bank Loan Growth Already Contracting Substantially:

Source: Federal Reserve Board of Governors

Money Supply Growth Contracting:

Source: Federal Reserve Board of Governors

Before moving on to the various sub-components to the report, I want to answer some criticism I received on some recent analysis. Most of the data that I track is in ‘rate of change’ terms. In other words, I am looking to see if the growth rate of various metrics is getting better or getting worse. When the growth rate of a metric drops from 10% to 3%, that is a very derogatory mark in my models. The critics have responded to this and have said that although the growth rate is slowing, it is still positive and positive growth is a good thing.

I aggressively push back on this critique. If you wait until growth rates officially turn negative, well, the recession is already upon you. If you have any desire to forecast economic slowdowns and recessions before them occurring, the reduction in growth rate from positive to less positive is a vital piece of information.

Housing prices peaked, in growth rate terms, at the end of 2005 and decelerated until 2007 in some cities. If you waited until 2007 when the growth rate went negative, it was far too late. There were nearly two years of growth deceleration that occurred before the recession in home prices so the rate of change or deceleration in positive growth would have helped forecast this crisis. Those who rejected the deceleration and waited until growth rates turned negative were punished in their investments.

Moreover, when looking at the growth rate in bank loans, negative rates of growth typically occur after the recession. The deceleration or ‘pulling back’ of loans is what is most important. Below is a chart with highlights of when banking loan growth turned negative, and it can be seen that waiting for negative rates of growth is a poor way of analyzing data.

Bank Loan Growth Turns Negative After Recessions:

Source: Federal Reserve

The total rate of bank loan growth has been contracting violently, falling from 12% in January 2015 all the way down to the 1% region today. Flipping over to the sub-components of bank loan growth shows a decrease in demand across all the major lending categories, again, in the face of more relaxed lending standards.

Banks have reported a substantial drop in the demand for commercial real estate loans.

Demand For Commercial Real Estate Loans:

Source: Federal Reserve Board of Governors

Below are a series of excerpts from the Federal Reserve Senior Loan survey, highlighted in yellow, which detail the change in lending standards and demand across various lending categories.

Federal Reserve Senior Loan Survey- All Real Estate Loans:

Source: Federal Reserve Board of Governors

Banks are reporting decreases in demand across all forms of commercial real estate loans as well as a reduction in demand for residential household loans.

The details of this report are translating into contractions in loan growth in the commercial real estate space. Below are two charts of the loan growth in commercial real estate, one dating back as far as there is data, and the second graph a more zoomed in view.

Commercial Real Estate Loan Growth Decelerating:

Source: Federal Reserve

In both charts, the deceleration can be seen quite clearly. For those who again, do not understand the merit in ‘rate of change’ analysis, the prices of commercial real estate peaked in growth rate terms (excluding 2010) within one year of the peak in loan growth in commercial real estate. Also, the price growth in commercial real estate is already negative which should be quite alarming given the boom and corresponding debt increase associated with the commercial real estate space.

Commercial Real Estate Price Year over Year Growth:

Source: Green Street Advisors

To summarize, loan growth in the commercial real estate sector is slowing substantially, dropping from over 10% growth in 2016 to around 5% growth today; banks are reporting weaker demand for commercial real estate loans and the year over year growth rate in commercial real estate prices is negative. Those factors, stacked together, certainly paint a picture of weakening demand and a red flag for banks (IYF) who are exposed to this sector.

Commercial real estate is not the only category of loans that is troubling the banking sector. Consumer loan delinquencies are starting to rise, and banks such as JPMorgan Chase & Co (JPM) and Citigroup Inc. (C) are responding accordingly by increasing the provisions for losses on consumer loans and tightening standards on credit card loans, the only category of bank loans experiencing tightening lending standards.

Delinquencies on Consumer Loans Rising (Millions of Dollars):

Source: Federal Reserve

This chart may not be too alarming, but looking at the delinquencies of consumer loans in ‘rate of change’ terms, or year over year growth, paints an entirely different picture and one that makes the pullback in bank lending very understandable.

Delinquencies on Consumer Loans Rising (Year over Year Growth):

Source: Federal Reserve

As I mentioned, JPMorgan (JPM) has increased their provisions for losses on consumer loans as well as Citigroup (C).

JPM Increasing Provisions For Consumer Loan Losses:

Source: Company Filings

That is a 14% year over year increase in provisions for credit losses.

JPM and Citi Increasing Loss Provisions:

Source: Bloomberg

JPM is also reporting an increase in credit card charge-off rates.

JPM Credit Card Charge-Off Rates:

Source: Company Filings

The trough in charge-off rates for consumer credit cards was, unsurprisingly, in 2015 when total bank loan growth was hitting its peak for the cycle. With total bank loan growth decelerating and provisions for losses rising, it comes as no shock that the charge-off rates and delinquencies for consumer loans are set to increase.

The only category of bank loans that are being reported as having tightening lending standards are consumer credit card loans. This tightening of standards at the end of a business cycle, as consumers are increasingly squeezed, is consistent with past economic cycles.

Tightening Standards on Consumer Credit Card Loans:

Source: Federal Reserve Board of Governors

In summary, banks have reported, on average, that the standards for loans are loosening while the demand for loans is decreasing. This is a troubling sign because as banks make loans looser or easier to obtain, demand for loans typically increases; the opposite is happening today.

The only reasons for this are that borrowers have no use for additional loans which would slow economic growth in the future as no new projects are going to be started, or borrowers do not believe they can carry additional debt which speaks to the health of the consumer. Both of these scenarios are negatives for the outlook on the economy but are unsurprising due to the recent trends in the economic data that I have been outlining. These trends are very much in line with what I would expect given the current stage of the economic cycle and the breadth of the economic data, which is deteriorating.

Contractions in bank loan growth reduce the money supply (M2) which puts downward pressure on nominal growth and inflation. Many think inflation is set to rise but are not taking into consideration that the rise in oil prices is fairly isolated and that core inflation (ex. energy) is continuing to decline and likely to accelerate its pace of declines in the coming months.

Inflation

Over the past few months, there has been a sharp divergence in headline inflation and core inflation, inflation ex. food & energy. The rise in headline inflation can be primarily attributed to a substantial increase in oil prices. Core inflation has continued to decelerate because once you strip out energy prices, the rise in the rest of the Consumer Price Index [CPI] basket has been very weak.

I have published several research notes calling for a deceleration in inflation that will end around February 2018. My analysis showed that the most pronounced decline in inflation would come in January and February of 2018 and that remains the case. The reason inflation is likely to bottom in the beginning part of 2018 is due to the ‘comp’ effects. The comparative period of inflation gets increasingly harder from now until February of 2018. I want to point out that the recent rise in inflation is due solely to oil prices and that the deceleration in core inflation is holding true to the above thesis on decelerating inflation. The bond market (TLT) is not buying the inflation story and instead is responding to the declines in the core inflation rate as yields on the long end of the curve continue to fall and the treasury yield curve gets increasingly flatter.

Headline Inflation Rate With Comparative Periods:

Source: BLS

The above chart shows the headline inflation rate (black line) and the comparative period (grey bars). The correlation indicates that periods of lower grey bars (easier ‘comps’) come with accelerating rates of inflation and periods of higher grey bars (harder ‘comps’) come with periods of decelerating inflation. The ‘comps’ are the hardest in January in February of 2018 as shown in the chart above but there does need to be an explanation for the recent rise in the inflation rate despite the increasingly difficult comparative periods.

Headline inflation has accelerated due to a recent surge in oil prices. What is interesting, however, is how the rest of the commodity space has not had a corresponding rise. The CRB Index, a basket of 19 commodities rose less than half that of oil and the CRB Index ex-Energy index barely posted an increase over the past three months indicating the majority of the rise in the commodity space is due to oil.

CRB Index, Oil, CRB ex-Energy Index 3 Month Change:

Source: YCharts

The rise in inflation has not translated to Core CPI, which strips out energy prices. Core CPI is a less volatile measure of inflation and also the way the Federal Reserve measures inflation.

The increasing ‘comp’ effects are the same in Core Inflation which has declined with more difficult comps, as expected.

Core Inflation Rate With Comparative Periods:

Source: BLS

The easiest comparative period was seen at the end of 2015 which translated into the highest rate of core inflation. The comparative periods for core inflation have been increasing since then, and the core inflation rate has been expectedly dropping as a result. Based on these correlations and effects, the rate of core inflation will continue to decline and have its most significant downward move, as the original analysis showed, in January and February of 2018. Given how difficult the comparative periods are in those months, core inflation is likely to drop under 1% on a year over year basis.

The rise in headline inflation has not spooked the bond market (TLT) as the dynamics of the oil price rise are clear. The trend in core inflation is falling and will continue to decline until the beginning of 2018. A rapidly falling rate of core inflation will act as a powerful boost to fixed income instruments.

The US dollar has also started to rise, posting an increase of just over 1% over the past three months which will serve as a deflationary pressure, on the margin.

US Dollar Index 3 Month Change:

Source: YCharts

A few other indicators on my dashboard are sensing the coming wave of deflationary pressures. The rise in oil prices should be monitored, of course, but the underlying trend in inflation is one of deceleration. Many asset prices do not respond well to disinflationary pressures.

High yield spreads have started to widen, and the treasury curve is continuing to flatten, signaling low growth and low inflation on the horizon.

High Yield Spreads:

Source: YCharts

Treasury Yield Curve:

Source: YCharts

Takeaway & Forecast

Bank loan growth is contracting across all major categories, and banks are reporting weaker demand for loans. This indicates that the contraction in bank loan growth will continue. As bank loan growth contracts, this reduces the growth rate in the money supply (M2) and puts downward pressure on core inflation.

Growth Rate in Money Supply (M2):

Source: Federal Reserve

Inflation is already set to decline given the ‘comp’ effects but coupled with the declines in money supply growth; the disinflation could be much sharper than market participants currently believe. This unexpected decline in core inflation should boost Treasury prices and reduce yields.

Banks are beginning to tighten up their balance sheets and increase provisions for losses as the decelerations in the economy, that we have been noting for months, are becoming increasingly difficult to ignore.

If the Federal Reserve raises interest rates in December, this will further flatten the Treasury yield curve and thus reduce bank lending even further. This dynamic will make the situation described above, including reduced growth rates in the money supply and increased pressure to core inflation more dramatic.

I think at this stage in the cycle; it is prudent to stay away from banks (BAC) and any other financial institution that has exposure to the credit cycle such as Capital One (COF) and Discover (DFS). These companies, as well as the major banks, can suffer significant write-downs and negative shocks to earnings in an abrupt way if the credit cycle does, in fact, turn in the direction it appears given the above data.