Written by: Samira Fatehyar
Synopsis
Listen to the podcast version here:
Let’s first start by diving into new economic data that has been released. We’ll look into a number of indices that can tell us what is happening right now in the economy. We then look into US banks and how they are bracing for the worst to come. Finally, we dive into our bi-weekly segment of the European View. We’ll talk about their recent stimulus deal as well as a strict housing measure introduced in Barcelona, Spain.
Economic Update
As always, I like to first start off with some updates on the economic front. There is always a lot of data that comes out and I try to discuss the more relevant indicators. This time we will start off with the Consumer Sentiment Index which is in Graph 1, below.
Graph 1
Consumer Sentiment Index (July 2019 to July 2020)
https://tradingeconomics.com/united-states/consumer-confidence
Before I begin discussing what the graph means, I think it would be helpful to differentiate between the Consumer Sentiment Index and the Consumer Confidence Index (which I talked about last time). The Consumer Sentiment Index comes from the University of Michigan where they survey 500 households nationwide to gauge how they feel about the overall economy. The Consumer Confidence Index comes from the Confidence Board and they survey 5,000 households across the country. They also gauge how people feel about the economy in general. They work together and help paint a picture about the psychology of consumers.
Now looking at Graph 1, we can see that Consumer Sentiment decreased from June to July, or from 78.1 to 73.2. Again, this really can’t tell us much about the future but at this moment in time, consumers are feeling quite uncertain about the economy. Analysts were hoping that June’s numbers were going to demonstrate the start of a V-shaped recovery, but we have now fallen back down. It will be telling to see what happens in August.
Another important metric that we should review is that of the Industrial Production Index. Graph 2, below, shows the current data.
Graph 2
Industrial Production Index from June 2019 to June 2020
https://fred.stlouisfed.org/series/INDPRO
Looking at the above chart, Industrial Production Index does not look like it’s been doing well since February. As with most economic metrics, Covid-19 has acted as a catalyst in a lot of negative ways. So what exactly does Industrial Production Index tell us? It is an index based on several different industries that includes mining, manufacturing, gas, and electricity. It shows the changes in production output and underscores any structural changes happening in the economy. Looking at the chart, we notice that we may very well be recovering in those industries since hitting our lowest point in April. This is definitely a positive indicator and shows that we are producing, though not as much as pre-Covid-19, but definitely trying to rise above April 2020 levels.
On Wednesday of the past week the National Association of Realtors (NAR) released Existing Home Sales numbers for June 2020. The headlines boasted that existing home sales have shot up by 20.7%. This is great news considering that many parts of the country experienced shut down measures that even prevented realtors from showing homes. But as an economist, I think this headline is misleading. It definitely seemed to have jumped 20.7% but this was a month to month change. Meaning this is all relative to the three months prior when home tours were cancelled for many areas in the US. Let’s take a look at Graph 3 below to understand it.
Graph 3
Total Existing Home Sales, Seasonally Adjusted Annual Rate (June 2016-June 2020)
https://www.nar.realtor/sites/default/files/documents/ehs-06-2020-summary-2020-07-22.pdf
I think the graph gives a great visualization to understand what has occurred. Yes, there has been a recovery, but still nothing close to pre-Covid-19 levels. It all depends on what July numbers will show. Though if we look at year-over-year change, June’s numbers are still down 11.3% from June 2019. I’ve been asked numerous times, why can’t you just be positive about the numbers being released? They look great and it seems like we are recovering! Unfortunately (or fortunately), I was academically trained in the field of economics but more specifically macroeconomics. We tend to look at many different indicators to get a sense of the bigger picture. The main reason I am not comforted by this data is because the NAR also reported that prices are still increasing. I’ve attached Graph 4 to illustrate this.
Graph 4
Median Price of Existing Home Sales (June 2016-June 2020)
https://www.nar.realtor/sites/default/files/documents/ehs-06-2020-summary-2020-07-22.pdf
As I have touched on in previous blog posts, the US wage growth before COVID-19 was low but we are still seeing housing costs rising, which does not make sense and frankly cannot be sustained. Prices now are higher than it’s been in the past 4 years. This is worrisome to me because we are still seeing high unemployment numbers. If homeowners end up losing their jobs and cannot afford their mortgages, we may very well see a flood of foreclosures. In addition to this, there is a flood of evictions waiting to happen as the federal moratorium for evictions were lifted over this past weekend.
Bank Troubles
There was some recent developments in the banking sector that I thought we should all be made aware of. Five major banks in the US: Citigroup, US Bancorp, Bank of America, Wells Fargo, and JP Morgan Chase have warned of a total of $104 billion worth of loans getting defaulted on. This should highlight just how bad banks think the near future is going to be. With the $600 monthly federal unemployment stimulus ending, many don’t know how they will be able to keep up with many of their loans and other debts.
From the looks of these five banks’ quarterly reports, they have collectively set aside about $35 billion. Many analysts say they may be over preparing. In my opinion, there is no such thing. The economic environment is still very uncertain. I’ve made a table from all the information I gathered from the quarterly earnings reports from the five major banks, below.
Table 1
Provision for Credit Loss from Quarterly Reports of 5 Major Banks
Just to be extra clear, Provision for Credit Loss is an approximation of potential losses that a business expects due to credit risk, or the probability that a borrower won’t be able to repay their debts.
So looking at the above table, we see that these 5 banks have put aside almost $35 billion for bad debts. Their profits for the second quarter were hit hard because they set so much money aside. I think this is very healthy as opposed to the way banks were behaving during the Financial Crisis of 2008. They are putting aside money to bail themselves out, so to speak, which is how businesses should be running. Who would have thought that after bailing out that banks during the Financial Crisis of 2008 that they would become responsible enough to look after themselves? Well, it’s not that simple. Due to the Fed’s new stress test requirements, these banks were forced to put a large amount of money aside. As I’m sure you’re aware by now, I have been upset by many of the actions taken by the Fed thus far, but this is one action I can get behind. I believe that we should do everything in our power to hold businesses responsible for themselves.
Graph 5, below, shows how much of a profit hit the banks took during the second quarter.
Graph 5
Net Income for Citigroup, JP Morgan Chase, and Wells Fargo
https://www.ft.com/content/f1bbaf65-7cb7-4855-ba7f-d9bda5f4b053
Compared to how bad the Financial Crisis of 2008 got, this reduced net income is not that bad. But this is something we need to continue to keep an eye on.
Another interesting thing to note is assumptions all 3 banks had their forecasts based on. JP Morgan mentioned that they based their forecast on conservative assumptions and do not foresee another need to put aside money for future credit loss. Citigroup based their forecast on the unemployment rate peaking in the low to mid teens while US GDP falls precipitously. Wells Fargo’s assumptions were a bit more interesting in that they assumed that unemployment rate would fall to 10% this year and that the US would resume growth by the second half of the year. They also foresee housing prices stabilizing while commercial real estate prices declining by 10-15%. I find it interesting that they see housing prices stabilizing but commercial real estate prices decreasing. In the past, we have always seen commercial real estate following a somewhat similar but delayed trend to residential real estate. Personally, I foresee both residential and commercial real estate prices falling, for many of the reasons I’ve discussed previously (the eviction moratorium being lifted, unemployment continuing to stay at high levels, many businesses closing due to lockdowns, and so on).
A footnote in many of these quarterly reports was that they foresee the majority of bad credit being from credit card debt. It will be interesting how much actually happens and how much will be from credit card debt vs mortgage defaults.
European View
I have been receiving a lot of questions regarding the stimulus deal that is being discussed in Europe and think it would be a great topic to cover. In addition to this, I’d like to dive into Barcelona, Spain and see what they are doing to curb their housing affordability crisis. The more we know about what other countries are doing to solve this issue, the more we might be able to come up with a solution that would work for us.
European Stimulus Package
So let’s first understand some basic facts surrounding the European Union (EU). The EU is a 27-nation bloc that deals with political and economic policies together. A major misunderstanding is confusing the EU with the Eurozone. The Eurozone is made up of 19 of the 27 nations of the EU, and they share the same currency.
I mentioned this in a previous post, but the European Debt Crisis of 2012 took a large toll on the EU has a whole, but many of the Mediterranean countries were hit the hardest. Many of the wealthy northern EU members had to essentially bail out the less financially responsible Southern members. So, when the EU called its members to come together to discuss this stimulus package, it was no walk in the park. But, in the end, they did come up with an agreement of a 750 billion euro stimulus package. The breakdown is in Chart 1, below.
Chart 1
Breakdown of European Stimulus Deal
https://www.bloomberg.com/news/articles/2020-07-21/eu-leaders-reach-deal-on-750-billion-euro-virus-recovery-fund?sref=jbVt2saA
So we can see that 360 billion euros will be issued as low-interest loans, while the remaining 390 billion euros is made up of grants. It should be noted that 1/3 of the funding is meant to combat climate change. So, in addition to making sure countries can fiscally survive this crisis, the EU is looking ahead to make sure that they are doing some part in making a cleaner future.
The big question with the EU stimulus package is how is it going to be paid for. The Dutch Prime Minister was part of the many hardliners against the large sum being allocated towards grants. He was joined by leaders of Sweden, Denmark, and Austria in his distrust of such a large amount. It was initially discussed to have 500 billion euros allocated towards grants but the bloc finally compromised with 390 billion euros. They do not trust their Southern counterparts because of what had transpired during the Debt Crisis of 2012. All four countries compromised because they would receive budget rebates of more than 50 billion euros over the next 7 years.
Okay, so how will this all be funded? Through the issuance of joint EU debt as well as some of it coming out of the EU budget and will have to be repaid by 2058. This also means that the countries that contribute more are likely to bear more of the financial burden. Looking at the map below, you can see how many countries have increasing debt as well as countries that have been more fiscally responsible. Italy and Greece seem to have the highest debt-to-GDP ratio and it’s only going to increase, unfortunately. An interesting trend here is that, for the most part, the northern EU countries tend to have less debt to GDP as compared to their southern counterparts.
Map 1
Map of Debt Load around Europe
https://www.bloomberg.com/news/articles/2020-07-21/why-europe-s-pandemic-recovery-deal-is-a-big-deal-quicktake?sref=jbVt2saA
Bond issuance and the european central bank
It would be beneficial to discuss the bond issuance that was entailed in the stimulus package. For years now there has been talks about introducing a so-called Eurobond, where the whole EU bloc would issue the debt together, instead of individually issuing bonds, which is what is in the agreement under the current stimulus package. After many years of debate with the topic, the European Parliamentary Research Service sent out a briefing in April 2020 entailing what a Eurobond might look like. In the briefing, the European Parliament wanted to see how
“eurobonds ‘would offer a viable alternative to the US dollar bond market, and [how] they could foster integration of the European sovereign debt market, lower borrowing costs, increase liquidity, budgetary discipline and compliance with the Stability and Growth Pact, promote coordinated structural reforms, and make capital markets more stable.’”
This is important to highlight because it shows Europe’s desire to be able to compete with the US dollar bond market. They explored 3 possibilities of how this would be implemented. If you’d like to understand more about the 3 possibilities, I encourage you to read the briefing.
Now another interesting point to discuss is that of the European Central Bank’s (ECB) role. I wanted to understand what the ECB was doing to help stimulate the European economy, especially since there is a predicted 8.3% contraction of the European economy set for this year. Like many central banks around the world, the ECB has found ways of increasing the money supply. See, the ECB for a few years now, has been allowed to buy corporate bonds because their debt markets are nowhere near as deep as the US’s. This means that they cannot just buy government bonds from those within the European Union to sustain the levels of money supply that they need. So I was curious to see what the requirements were for the credit ratings of these corporate bonds that the ECB has been purchasing. It turns out that they won’t buy anything below a BBB- rating, which is the cut-off for being defined as an investment grade bond. This was quite the contrast to what we have been seeing from the Federal Reserve in the US, who has been buying junk-rated corporate bonds, but more on that in a bit.
Compared to the US
I think the first thing we should do is recount all the stimulus packages as well as what the Federal Reserve has contributed to the markets. We have passed several funding programs to help people through the economic impact of COVID-19. We have paid out the following:
$50 billion to state funding through the Stafford Act
$8.3 Billion emergency coronavirus funding, of which $1.03 billion went to state, local, and tribal governments
$2.2 Trillion, which was the biggest stimulus package in Modern American history
$150 billion went to state and local governments
$500 billion went to lending to businesses as well as states and local governments
$484 Billion to replenish the Paycheck Protection Program
Pending a new coronavirus stimulus package/extending the Federal weekly unemployment benefits
So far, the US government has spent nearly $2.7 trillion to deal with the economic fallout of the coronavirus pandemic. In Graph 6, below, we can see that the national debt has increased by almost $3 trillion since March.
Graph 6
US National Debt (June 2019-June 2020)
https://www.statista.com/statistics/273294/public-debt-of-the-united-states-by-month/
It’s important to point out that when we hear or see the word trillion, we don’t necessarily understand the magnitude of how large a number it actually is. The most current estimate of our national debt is about $26.5 trillion. That is $26,500,000,000,000. So, if we were to break it down to how much each taxpayer owes, it’s roughly $213,277. That’s insane. It’s also worthy to note that we haven’t experienced such an increase in a short amount of time in modern history. So in total, we have tried to save the economy through bailouts and loans for businesses as well as the $1,200 stimulus check to every individual and we still have a long journey ahead. Personally, I don’t think this is the right approach, but more on that later.
If we also take into account how much the Fed’s balance sheet has increased we observe another problem, which is in Graph 7 below.
Graph 7
Fed’s Total Assets from June 2007 to June 2020
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
So what’s the problem?
Well let’s first review some basic monetary economic rules. The Fed is able to increase the money supply by purchasing securities. Securities, for the most part, is based off of bonds and stocks. Usually the Fed buys Treasury bills and that tends to be enough. When we increase the supply of anything, we know that it becomes less valuable. This then introduces the concept of inflation, which deals with purchasing power. If you can’t buy the same basket of goods because it’s more expensive, this means inflation went up. When inflation increases, interest rates decrease because it becomes cheaper to borrow because there is a larger supply of money available. Because of this, we have been witnessing historically low interest rates. But so far, thankfully, inflation hasn’t created too much of a problem and that’s due to other things in play, that I’d rather talk about in a later post.
Now going back to why a $2 trillion increase in the Fed’s balance sheet is not a healthy sign. As discussed, the Fed usually tends to buy Treasury bills, but we know recently they have also included corporate bond ETFs as well individual corporate bonds. All of which has been labeled as junk-rated bonds. So in order to increase the money supply we are buying bad debt from companies that are insolvent. Yes, you read that right. I can say that at least the ECB has a standard but now the Fed is picking and choosing which corporations get to survive. I just find it interesting that Wall Street, which is so adamantly opposed to socialism, is welcoming the bailouts, and not to mention morally hazardous behavior, with open arms.
At the same time, the Fed is punishing people for not buying stocks. How so? Well, they are currently purchasing massive amounts of long term Treasury bonds. When this occurs, prices of these bonds increase and yields decrease. Any investor would say that they wouldn’t want to purchase an asset at a high price only to receive little to no return. So they are being pushed into buying other assets, most go to stocks, but some are also being pushed to other asset classes. Take a look at gold and the news of it nearing record highs. This is a big deal as gold is seen as a hedge against a volatile market, whether it actually works as a hedge is a different story but to many investors, this is a safe bet.
But at the same time, I think this could possibly explain why we are continuing to see real estate prices rise. With many people looking for alternative assets, real estate is a great place for people to park their money for sometime. At least, that’s what many have done in history. The problem I see this time around with doing that is the impending flood of evictions and foreclosures that most likely will happen in the market. As we discussed, a larger supply of anything, will decrease its price. The same can be said for real estate, so although investors may be looking for a place to park their money and earn a return in the short run, it will have many long-term consequences.
My Take: A Solution to this Crisis
I have been very vocal about my disagreement with how we have handled the coronavirus economic fallout. While the EU is working together to bailout countries, we have been working together to bailout corporations, some in my opinion, have been an absolute waste of money. We, as Americans, have been adamant about how proud we are of capitalism. True capitalism would not be in support of a government or central bank bailing out corporations. If we are so willing to bail out corporations, why aren’t we willing to bailout the individuals? I’ve heard the story over and over again, trickle-down economics works. But in reality, it won’t work in this situation. Bailing out the airlines was one of the worst ideas I’ve ever seen. The Fed buying individual corporate bonds is an even worse idea. The Fed has increased its balance sheet by about $2 trillion. The US government has spent trillions bailing out corporations as well as giving out help through the PPP program. We’ll never know who the recipients were for some of those loans.
So, what’s the solution? Let’s do a preliminary calculation. If we have roughly 350 million people living in the United States, and we gave every individual $20,000, that would amount to $7 trillion. Yes, it’s a very large number, but look at how much we’ve already spent trying to bailout corporations and how successful that’s been. I’ve heard the arguments. The average American is financially illiterate. I will re-iterate this once again, I can name a large list of American corporations that have been insolvent for years and yet we are still keeping them alive. The way I see it, no matter how the average American citizen spends their money, it pumps money back into the economy. The way corporations spends their money, doesn’t necessarily. And every how the average American spends it, it gets taxed. So the government already starts recouping that money. If we were to shut down the country for 4-6 weeks to get the virus under control and pay every individual $20,000, we could actually survive the coronavirus economic fallout. We have record breaking amounts of people lining up at food banks. We have a record breaking amounts of people losing their health insurance. We have record breaking amounts of people needing unemployment benefits. Shouldn’t we be helping the individual instead of Wall Street? Don’t misunderstand me, I’m neither for or against socialism, but it’s mind boggling to me to see our willingness to bailout the corporate citizen but not the American citizen. If we’re going to remain as anti-socialists, shouldn’t this also apply to Wall Street?
Barcelona, Spain
Last time, I talked about Lisbon, Portugal and how they started a new program to help their housing affordability crisis. To continue on the same topic, I saw that Barcelona, Spain is introducing a more strict program to deal with their housing affordability crisis.
Ever since the Global Financial Crisis of 2008 and the European Debt Crisis of 2012, Spain has been struggling like many of its southern European counterparts. The Catalonian government (where Barcelona is located in) has announced that if landlords haven’t rented their units in the past 2 years and have not had any utility usage in those units, that the government will buy those housing units at 50% market value and lease it out as public housing. Though many lawmakers are hoping that they don’t actually have to buy these units but that this incentivizes landlords to rent it out at a lower price. See, a lot of these landlords have opted into having vacant units as opposed to renting the units out at a lower price, which honestly baffles me. But, in any case, these landlords have decided that they would wait it out until the real estate market comes back and they can start renting their units out at higher prices.
I can see where the government wants to do something right to help with the affordability crisis but to threaten to take people’s property away? I just can’t understand it as an American. Again, officials have stressed that this is more of a threat than an action they want to impose. I’m sure there are definitely other ways of incentivizing landlords, like what officials in Lisbon, Portugal are doing, but it might just come down to cultural differences. What I mean by this is that maybe the only way to get people’s attention in Spain is to threaten to take away their property. This, of course, is just a mere assumption, but like I said, it seems extremely more strict than what Lisbon did, just next door.
Concluding Remarks
People have asked me, “Why can’t you share some good news?” The blunt and honest answer? I would rather be called a pessimist and be wrong than to be an optimist and be wrong. I feel like preparing for the worst to happen is a lot better than expecting everything to be rainbows and sunshine and then be wrong. As I’ve said in the past, I truly hope I’m wrong about the economic future, but I also think it’s important to share my thoughts when I look at the data and what it means for our future. If it helps just one person, it makes all of my hours of research worth it!
Stay safe everyone and I’ll write you in 2 weeks!