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Welcome back. There is something about the second half of August that feels like a Sunday afternoon, with the work week looming. US consumers, at least, seem to have the Sunday blues. Some thoughts on that, and on the enduring strangeness of the banking industry, today.
Markets whistle past the stagflation graveyard
Well this sounds bad:
The Consumer Sentiment Index fell by 13.5% from July [to August], to a level that was just below the April 2020 low of 71.8. Over the past half century, the Sentiment Index has only recorded larger losses in six other surveys, all connected to sudden negative changes in the economy: the only larger declines in the Sentiment Index occurred during the economy’s shutdown in April 2020 (-19.4%) and at the depths of the Great Recession in October 2008 (-18.1%). The losses in early August were widespread across income, age, and education subgroups and observed across all regions.
That’s Richard Curtin, the economist in charge of the University of Michigan surveys. He called the results “stunning.”
The markets didn’t care. On Friday, after the survey landed, stocks nudged higher and 10-year yields nudged lower. Maybe the din of fantastic corporate news — revenue, earnings and profit margins are expanding at the fastest pace in more than a decade — render the fears of individual consumers irrelevant. Certainly, the cheery backdrop makes it easier to write off the result as reflecting two temporary factors: a temporary setback in the fight against Covid, and a temporary surge in prices.
The “it’s all an aberration” school will not be bothered by this chart, which plots the level of the consumer sentiment survey against year-over-year changes in consumer spending (the data are from Refinitiv):
At three periods over the past two decades, marked with the red arrows above, steep drops in sentiment were followed by rapidly slowing spending. The notable exception seems to be the drop in sentiment in mid-2015, which was coincident with, rather than coming ahead of, weaker spending. Maybe the chart is just noise, but it makes sense to me that people who feel bad about the economy would go on to spend less money.
Economist Don Rissmiller, of Strategas, points out that the prospect of weaker spending, combined with still high-ish inflation expectations (3 per cent or so) might suggest stagflation. Stagflation is very bad. But if we do get it, Rissmiller thinks a mild case of it is likely:
So far, US consumer prices surges have been tied to “reopen” sectors (cars, hotels, travel). However, global supply constraints appear to be continuing to pressure prices & expectations. We don’t have 1970s-style stagflation, but we are still not comfortable with the underlying inflation dynamics (eg, local rents & wages starting to move up). A form of stagflation-lite is not easily dismissed here
That point about rent is particularly important, inasmuch as rent increases don’t tend to be reversed. Rissmiller points, for example, to Zillow’s rent index:
Matt Klein, over at The Overshoot, is a persistent and well-informed member of the inflation-is-transitory crowd. But even the judicious Klein notes that prices at fast-food restaurants and cleaning businesses are rising, probably driven by higher wages. He thinks the trend is worth watching:
We can all be happy when the workers who have the least get a little more. But what it means for the economy is not yet clear.
Almost everyone has systematically over-egged their inflation forecasts for years, which should make us humble about predicting that it will increase now. There are lots of good reasons for much of the inflation we are seeing to be temporary, and many measures look to have topped out already. But on balance, persistently higher, but not wild inflation, seems like a possibility, given that some historically sticky prices are rising and the money supply has grown so fast. Combined with lower spending, higher inflation would hurt. The reflation trade may be dead. The inflation/stagflation question lives on.
Banks: the world’s worst cartel (part I)
Here is William Cohan, writing in the FT last week:
it has become exceedingly difficult to topple an established banking franchise. The barriers to entry in global banking have become so large — between intense regulation, huge capital requirements, giant balance sheets, and client loyalty — that they have become cartel-like fortresses.
I think Cohan has got something wrong here, but his core observation is dead right. Banks’ business, in theory, is all about prudence and customer service. They are stewards of capital and risk managers; because they sell mostly commodity products, relationships and stability are key. But they constantly get in messes that make a mockery of these values — and this doesn’t seem to do them much lasting damage, so long as they manage to remain solvent. This is weird.
Think of Credit Suisse. Recent events (Spygate mess, Greensill mess, Archegos mess) have demonstrated serial and comic incompetence. Yet:
no one expects Credit Suisse to go the way of Lehman Brothers. While reputational damage at the big banks makes for riveting journalism, it is also fleeting. Has JPMorgan suffered lasting repercussions from the London Whale trading scandal? Is Goldman Sachs still missing a beat after its global criminal settlement over its role in the looting of Malaysian state fund 1MDB? Is Morgan Stanley suffering from its own $1bn Archegos loss, or from the $9bn loss it suffered at the hands of a trader in 2007? Of course not. These firms are more powerful and more impenetrable than ever.
Cohan doesn’t even mention Wells Fargo, which opened thousands of fake accounts in order to hit dumb performance targets and then comprehensively fumbled its response to the scandal. Wells’ stock has been whipped, and rebuilding its compliance and controls systems is costing a bundle. But it’s still the third-largest bank in America by both loans and deposits, because for the underlying business of a large bank, prudence and competence just don’t seem to matter much.
Cohan explains the mystery by saying banking is a cartel, in other words, an association that blocks competition. This is a popular enough idea, especially among Bitcoin Bros:
Here is the thing, though. If bankers have formed a cartel, they stink at cartel-ing. Here, for example, are the long-term returns the KBW banking index, the S&P 500, and the four huge consolidator banks picked out in the tweet above:
Over the past 30 years or so, here is what the wicked banking cabal’s machinations have delivered: just one of the four huge banks (JPMorgan) has managed to outperform the S&P 500. The fourth biggest (Citigroup) has delivered a few miserable percentage points of return a year. The US banking industry as a whole has delivered half the returns of the index.
Banks’ return on equity, I should note, has been pretty good for the last year or so, as the government has basically taken on all the credit risk and the capital markets have gone wild. But this will end, and at some point return on equity at even the big banks will drift back down to, at most, a few percentage points about their cost of capital.
A natural and compelling response to this simple point is that the cartel is not run for the benefit of shareholders, but of bank executives. Spend a few years in the C-suite of a megabank, however incompetently, and your grandchildren will never have to do a day of work.
So banks’ return on equity before executive pay might look a bit better. But the cartel label still doesn’t fit. Banks, for example, seem to have minimal pricing power in their retail, commercial banking, and trading operations. In the areas where they do have pricing power (IPO and M&A fees, overdraft fees) explanations other than cartel-like barriers to entry apply.
So a mystery remains: if banks are not a cartel, why are they so resilient in the face of their own failures? More on this tomorrow.
One good read
This piece, by my colleagues Robin Wigglesworth and Laurence Fletcher, describes the tentative resurgence in the hedge fund industry. It made me think about investing’s old double problem. It’s hard enough to generate alpha by picking the right assets; It’s just as hard, or harder, to pick the asset-pickers. One thing is improving, though. Across the industry, hedge fund performance and management fees are falling.
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