What does GE know that we don’t? That was my initial reaction to the news this week that GE is exiting the finance business that has provided it a seemingly endless stream of profits over the last three decades. Well, except for that little interruption that has come to be known as the Great Recession. Back in 2008, Jeffrey Immelt was going hat in hand to Hank Paulson because he couldn’t get anyone to buy his commercial paper with a maturity longer than a period measured in hours. The wholesale funding markets that allowed GE to leverage its AAA credit rating into one of the largest finance companies in America – the world – had gone kaput and it took a guarantee from the FDIC and a capital infusion from Warren Buffett to keep them afloat.
Was it fear of a repeat of that episode that convinced Immelt to get out of the finance business? I don’t know but I can’t help but wonder. Despite the best efforts of the world’s central banks – and maybe because of those efforts – the global financial system is still more fragile than anyone in officialdom wants to admit. The repo market that so many of the world’s financial engineers depend on is in disarray and banks are backing away from the market. Part of the reason is regulatory and part due to the Fed and other central banks, but the fact is that liquidity still ain’t what it used to be – and likely never will be thank God – and GE certainly knows that better than most. That they have chosen to get out of the business says a lot more than just that they want to get back to their roots as an industrial company.
I think too that this may be a turning point for the US economy although that probably won’t be apparent for many years. The US economy has, over the last few decades, become more and more dependent on financial engineering – rather than the real thing – for growth and I hope this is merely a first step away from that trend – although GE’s announcement that they would use the proceeds from the sale of the finance business to fund a stock buyback is not that encouraging. It is hard to imagine with interest rates pegged at zero, money freely available to questionable companies on questionable terms and financial markets bubbly around the world, but we may be witnessing the end of an era. They say the first step of recovery is admitting you have a problem and Jeff Immelt just stood up.
But we’ve got a long way to go in the deleveraging process and it might help if we got started. Companies are still leveraging up to fund stock buybacks – a $1 trillion run rate in the first quarter – and to pay dividends rather than invest in their businesses. Corporate America is applying the LBO concept economy wide, getting what they can out of the company while the getting is good, long term consequences be damned. At the individual level, Americans do seem to be embracing a bit more frugality – the savings rate is rising again – but globally the trend is still toward ever more debt. Whether companies, governments and individuals will be able to service that debt when the next recession arrives is a question no one is even asking right now. Or maybe GE and Jeff Immelt did and decided that the answer was no.
As for that next recession, I don’t know when it will arrive but the US economy is certainly not hitting on all cylinders. For now, the bad data is mostly confined to the industrial/manufacturing side of the economy but there is no guarantee that it will stay that way. A lot of the industrial slowdown is a function of the slumping energy sector and if oil prices keep falling – we’ve had a big rally off the lows but the Saudis, intent on killing the shale industry, are keeping their spigots wide open – there will be more to come. I’ve said before that I don’t know if the shale bust will be enough to push the US economy into recession and I still don’t know. But the slowdown has already moved beyond the oil patch. The Empire State Manufacturing survey results released last week showed a drop into negative territory and the last I checked New York was busy banning fracking. I think it is a safe assumption that the manufacturing and energy companies facing a slowdown are also consumers of services and it will eventually show up there too.
The Empire survey wasn’t the only one to disappoint last week. Retail sales were less than expected but at least managed to post a positive number for a change. The NFIB Small Business Optimism index fell sharply. Industrial production fell but at least some of that was due to weather changes that affected utility output. Housing starts did manage to beat expectations but are still running at a less than 1 million annual rate. The Philly Fed survey had a decent headline but that obscured some pretty bad internals – new orders, backlog and shipments were all down. Is all the recent weak data pointing to a recession? Based on the market indicators I follow, such as credit spreads, the answer to that is no or possibly a weak maybe but definitely not yes…yet. That could change – and quickly – but for now the consensus is that the economy will improve in the second half and so far the market is buying it.
Assuming that continues to be the case, the selloff at the end of the week probably won’t lead to anything other than the correction I’ve been looking for, if even that. The impetus for the selloff was frankly a bit mysterious. Was it fears of a Greek Euro exit? Really? Now? If it was, Draghi probably calmed those fears over the weekend by saying that the Euro was sacrosanct. What about the change in China’s margin requirements and short selling rules? Really? If that was it, someone is going to have to connect those dots for me because I don’t see how that translates into selling in Europe and the US. And in any case, the Chinese took pains to release a statement over the weekend intended to calm fears they are trying to push the market down. And if you had any doubt about that they also eased banks’ capital requirements. I still think we are due – overdue – for a correction in stock prices and it may be that last week was the beginning of that much needed froth removal.
With an economy that continues to struggle 6 years after the financial crisis and real interest rates still very low – and falling recently – it perhaps shouldn’t be surprising that GE decided to get out while they can. The opportunities for big mistakes in this environment are numerous while low risk lending (or what seems to be low risk) offers little to no profit. Add in an uncertain liquidity environment and the rewards start looking mighty puny in relation to the risks. Even if finance companies can find worthy borrowers, they have no control over the actions of the Fed and the odds of a mistake by that august group have likely never been higher.
Through deregulation and a Fed standing ready to ease at any sign of weakness, we built an economy dependent on finance for growth. Now, through re-regulation (although not simple and strict enough for my taste), slightly more sane capital requirements (which I would make even higher and harder to fudge) and a Fed with no further rate cuts in its bag of tricks, maybe the finance industry can shrink once more into the background where it belongs. Let’s hope that GE’s exit from the business is the first of many, a canary in the coal mine, the beginning of us starting to work our way out of the hole we’ve been busily digging for ourselves the last 3 decades.
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