Sunday, March 8, 2015
With loan maturities of 96 months no longer uncommon, the downside from a recession – that is, higher than anticipated defaults – looms larger. Longer maturies likewise amplify the downside from the return of interest rates to historic averages. If your footprint is auto finance, you can't ignore this: even if you yourself don't directly handle, hold or insure paper, your customers do. So what are the prospects for the next year or two?
First, what about the next recession? We began pulling out of the Great Recession in 2009Q3, and while we've seen a couple down quarters – GDP is "noisy" – the bottom line is that we'll soon have gone 23 quarters – almost 6 years – without a downturn. Doesn't that mean one is due?
I think not. Despite the jargon of "business cycles", in looking back over the last 60 years of growth in the US, Japan and Europe I don't see any pattern whereby growth builds monotonically until something snaps. Instead recessions result from a variety of causes: some from central banks trying to dampen inflation, some from foreign shocks, some from swings in the prices of long-term assets. In short, random factors dominate. The every-four-year pattern of the 1950s hasn't been repeated. Similarly, the Great Moderation, the 25-year period from 1983 to 2008 that saw only two brief, shallow downturns, looks to be a matter of good fortune, and not of better policies (contrary to the boasts of many macroeconomists). But if a downturn is due to chance, then the fact that we've had a string of good quarters doesn't make it more likely that the next one will be bad. What about Europe, China, Brazil? – yes, but if you look carefully, there are always storm clouds on the horizon. The chance of a recession in the next year appears about the same as always – low, but far from zero. The industry however is now flipping a coin 8 years in a row, not 3 or 4...
What of interest rates? Headline unemployment is 5.5%, and more members of the Federal Open Market Committee are speaking of a rate hike. Following a good March jobs report the perception is that we'll see one by September. Bond markets reflect that, too. One-year rates were 0.27% (on Friday, March 6, following the latest employment data), while six-month rates were at .08%. Calculating the back-to-back 6 month yields that will give a one-year return of 0.27% – that is, basic arbitrage – implies in a half-year 6 month rates will be at 0.46%.
But by my reckoning employment is still 6.3 million jobs shy of where it ought to be, taking into account lower population growth and the baby boomer retirement. Furthermore, headline inflation is … wait, we have deflation! Alternate measures – the CPI excluding food and energy, the trimmed mean CPI, PCE – show inflation low and decelerating, while wages aren't rising. Since wages account for about 70% of all costs, that too is consistent with low to no inflation. Janet Yellen makes sure the FOMC as a whole keeps this is broader picture in mind, and she is personally less discomfited by a few dissenting votes than her predecessor. I'm less sure than bond markets that we'll see a move in September. In any case the rise will be muted.
Without inflation, the other component that in the long run would boost interest rates is faster expansion of the overall economy. In the short run we can run above trend by lowering unemployment and boosting capacity utilization. We've not seen a V-shaped recovery to date, though I certainly hope that changes: it's better to put people back to work sooner rather than later. With 96 month car loans, though, we need to look beyond the next couple years, when capacity effects will vanish. At that point the size of the overall economy reflects a combination of the productivity level, the size of the labor force, and capital per worker.
So ... if GDP is a function productivity, labor, and capital, then what about captial? Business investment is at roughly pre-recession levels; there's no reason to think it's about to jump to historically unprecedented levels. The other component is housing investment, which has bounced back from its 2010 trough, but still remains worse than at the bottom of the 1981-82 recession. So new constructions appears set to stay low for years to come. As to labor, lower birthrates over the past 20 years mean the working-age population will expand slowly even after the baby boomer retirement boom passes, at about 50,000 a month against a labor force of nearly 160 million. Neither K nor L will give us growth.
That leaves productivity. Despite the hoopla of Silicon Valley types, new technology doesn't translate directly into higher productivity. Cars are an example. New technology will make cars safer (I'm less convinced it will reduce congestion), but that remains an incremental process, new model by new model. With over 250 million vehicles on the road, and the initial applications in high-end products, it will take two decades to see any economy-wide wide benefits. In the interim the cost of new technology won't be small, and we've already seen the revolution in manufacturing and new product development: robots have long been pervasive on factory floors, while young engineers wouldn't know what to do with drafting tools and may never have seen a real blueprint.
Again, interest rates seem to reflect that: seven-year bonds are yielding just 2.04%, and 10 year bonds are at 2.24%. Using the yield curve to calculate implicit future 1-year yields, we see rates hitting 2.5% only in 2018 and 3.0% only in 2025, and not even then if we assume future rates include a term premium.
Caution is due: the yield curve is not a good predicting of the economy 5 years hence, and economists aren't either, even if today all indicators suggest the good times will roll on forever.
Readers can readily find current data for inflation measures, investment and the like on FRED.
I've written previously about the risk of obsolescence, as the pace of technical change may lead the resale value of cars to fall faster than in the recent past, even as the intrinsic durability of light vehicles continues to increase.