Monday, January 14, 2019

Key economic indicators are mostly positive

Lots has transpired since equity markets hit their lows the day before Christmas '18. Markets were panicked over a number of things: the shutdown of the federal government, mounting trade tensions with China, slowdowns in the Eurozone and Chinese economies, downward revisions to profit forecasts (e.g., Apple), the proximate return of trillion-dollar federal deficits, the path of monetary policy (e.g., the flatness of the yield curve), the plunge in oil prices (from $77/bbl in early October to $42 by Christmas), and the rise in credit spreads. Over the past two weeks these fears have lessened, but the market is still worried.

The following charts (all of which include the most recent data available as of today) present a good overview of just where key economic indicators stand today. (My next post will feature key financial indicators.) We're not out of the woods, since the indicators are not uniformly positive, but it remains the case, as I've said several times in recent months, that the U.S. economy's fundamentals remain healthy. The recent turmoil is thus more likely a panic attack than the beginnings of another recession.

Chart #1

The labor market has rarely been so healthy, as suggested by Chart #1. The number of job openings now exceeds the number of people looking for work! Today is arguably the best time to be looking for a job in generations.

Chart #2

Chart #3

Small businesses employ the great majority of Americans, and small business owners are still very optimistic about the future (see Chart #2), despite the market turmoil of the past several months. In fact, the biggest problem facing most small businesses is the difficulty in finding qualified people to fill their job openings. Hiring plans, as shown in Chart #3, remain very expansionary. Optimism among those capable of creating growth is very important.

Chart #4

If we consider the less numerous number of manufacturing/industrial concerns (Chart #4), the ISM manufacturing survey reveals a disturbing drop in sentiment in December. This unfortunately coincides with the weak numbers coming out of the Eurozone in recent months. Undoubtedly, the recent market turmoil has made corporate executives a bit circumspect in regards to the future. This doesn't necessarily mean we're on the verge of another recession however: these surveys have experienced several periods of weakness in prior years which were subsequently reversed without an intervening recession. Whatever the case, Chart #4 is probably the least optimistic chart in this collection.

Chart #5

Nevertheless, and despite the weak ISM surveys, Chart #5 shows that industrial production in the US reached an all-time high last month, and it has made impressive strides since late 2016. The Eurozone, in contrast, has stalled and weakened on the margin, as uncertainty over the future of the EU, coupled with an oppressive tax and regulatory environment, has plagued sentiment and confidence. China has slowed down as well. Most data point to the Chinese economy growing at its slowest pace (4-5% or even less) in over two decades, and the stock market is down some 30% in the past year. For that matter, it is hard to name any country outside of the U.S. that is enjoying healthy growth. Does this mean the U.S. is doomed? Or does it just mean that conditions here are so favorable that we are likely to once again be the world's engine of growth in coming years? As an optimist, I'm inclined to the latter interpretation; in my experience it always usually pays to give the U.S. economy the benefit of the doubt.

Chart #6

US freight shipments, shown in Chart #6, have surged over 14% since Trump's election. This is one of the most impressive signs I have seen that the US economy is growing at a healthy, and perhaps surprising pace. The rest of the world is having problems, but we are doing about as well as could be expected, to judge from this chart.

Chart #7

Chart #7 shows a subset of freight shipments—truck tonnage—which is also quite strong. But it also shows how the recent surge in physical activity in the US economy is at odds with the recent decline in equity prices. This could be a very good sign that the market selloff is due more to "panic" than to any actual or impending economic slump.

Chart #8
   

As Chart #8 shows, car sales in the US have been relatively flat for several years. I had expected to see sales rise above previous record levels, if only to make up for the extensive and extended decline in sales that began in 2008 (i.e., years of very weak sales plus an aging fleet should have translated into above-average new car sales for at least a year or two). Regardless, flat car sales do not necessarily imply future economic weakness, and could simply reflect a pause. Bear in mind that jobs are growing at a healthy 2% pace, real incomes are rising, and the population continues to increase.

Chart #9

As is the case with car sales, housing starts have stalled in the past year or so. Furthermore, builder sentiment (the red line in Chart #9) has slumped of late. Does this portend the beginnings of another housing crash? I doubt it. I think it just reflects the fact that housing supply had run a bit ahead of demand, which began to be hurt by rising prices and rising mortgage rates. In other words, housing had become less affordable, a problem which is naturally solved by a combination of flat to lower prices, slower growth in new home construction, and a reduction in borrowing costs (mortgage rates have dropped almost half a point in the past several weeks). This all smacks of a market-driven adjustment process, not the beginnings of another housing crash. It's also important to note that in recent years the housing market has not been distorted by government mandates, unlike the boom of the early 2000s, when Congress forced banks to make un-sound loans which were subsequently purchased by Fannie Mae and Freddie Mac.

Chart #10

The Fed recently updated its estimates of household financial burdens, as shown in Chart #10. Here we see that financial obligations (monthly payments for mortgage debt, consumer debt, auto loans, rent, homeowners' insurance and property taxes) are about as low, relative to monthly disposable incomes, as they have been for many decades. Households have been unusually responsible in the management of their finances. This puts a very important sector of the economy on solid footing.

Chart #11

The economic outlook is far from perfect, but there are numerous signs of strength and general health. Things would be better if there weren't so many headwinds. Regardless, at the very least the above observations are consistent with current Fed estimates of 2.5% GDP growth in the fourth quarter. And it is reasonable to expect growth of at least as much in coming quarters, as Chart #11 suggests (i.e., the current 0.9% real yield on 5-yr TIPS is consistent with a real GDP growth trend of 2.5 - 3%). That's not gang-buster growth, but it's better than we've seen for most of the past 9 years. 

In my next post, due out shortly, I will review a number of key financial indicators: interest rates, spreads, volatility, the dollar, and commodity prices.

Friday, January 4, 2019

The Fed apologizes, and the outlook improves

Two weeks ago I noted that the Fed had screwed up badly. But all was not lost: "all it takes is a few words to put things right. The damage done to date is not significant or permanent, and it is reversible." Today we got those words: according to Powell, the Fed is "listening carefully to the markets." The threat of an overly-tight Fed has now all but vanished. The Fed and the market are dancing together again, with both participants expecting no further Fed tightening moves for the foreseeable future, but with a possibility of an ease later this year (i.e., the market is relieved, but still cautious).

Prior to this welcome Fed news, the Labor Dept. earlier today released a surprisingly strong December jobs number which was way above expectations (+312K vs +184K). This put the kibosh on concerns the US economy was slowing down, at least for the foreseeable future. Credit spreads have rallied from their highs, though they are still somewhat elevated.

For the time being some of the market's worst fears are being calmed. What remains to be seen is the result of the ongoing negotiations with China, which get underway next week (and in which my good friend and excellent economist David Malpass will be participating). If Trump can turn down the tariff-war heat, the entire world will be breathing a huge sigh of relief, and risk markets will move decisively higher. Already, the Brazilian and Argentine stock markets are up some 15% in just the past week in dollar terms, though they remain deeply depressed.

It bears repeating that what Trump hopes to achieve is NOT higher tariffs, but rather lower or zero tariffs, lower or reduced export subsidies on the part of China, and a reduced likelihood that China will continue to expropriate US intellectual property. Any move in this direction will be a direct benefit to global trade, and that in turn will benefit all concerned. Trump is putting at risk US prosperity (by raising tariffs as a negotiating tactic) in order to force China to do something that in the end will be of great benefit to both China and the US. It's a risky gambit, to be sure, but the potential rewards are Yuge. It's also worth repeating that it seems China must be threatened in order to do the right thing, and the threat must be not only palpable but terrifying. And China won't feel that kind of pressure unless you and I (and the market) also get to the point that we are terrified of the consequences of a tariff/trade war. With luck, we may have seen the worst of this deal-making process.

Chart #1

Chart #2 

Long-time readers know that I routinely focus on more than just one month's worth of job statistics and on just the private sector job numbers. The monthly numbers are so volatile as to be almost worthless, and private sector jobs are the only ones that matter. But a six- or twelve-month average of the numbers can give us valid insights into the broad trends of the labor market. Charts #1 and #2 show that today's number, however surprisingly strong it was, was not out of line with past experience. Yes, monthly jobs growth was at the high end of its range, but as Chart #2 shows, the trend growth rate of jobs has been only slowly picking up over the past year or so. Both the 6- and 12-month growth rates of private sector jobs are now slightly above 2.0%, but that's up from a low of 1.6% in September 2017. The economy really is getting stronger, albeit slowly. The momentum of a gradual strengthening of the mighty US economy is much more significant than the ongoing marginal slowdown in the Chinese economy.

In addition to a pickup in US jobs growth, we also are seeing a pickup in the growth of the labor force, which increased 1.6% last year—up significantly from 0.5% growth in 2017. It's also welcome news that the unemployment rate ticked up to 3.9%, since that means that despite the outsized growth in jobs, the number of people entering the labor force was even greater (i.e., many of the new entrants to the labor force are still looking for a job). A stronger economy and rising wages are attracting people who were formerly on the sidelines of the jobs market. This is terrific news, since it means the economy has plenty of untapped upside potential. (Doomsayers had been insisting that the low rate of unemployment meant that it would be difficult if not impossible for the economy to grow at a 3% or better pace.)

Chart #3

News of a stronger economy has contributed to a meaningful reduction in credit spreads, as Chart #3 shows.  High-yield, 5-yr credit default swap spreads (arguably the most liquid and meaningful indicator of the outlook for corporate profits) have tightened by some 60 bps in the past week or so, thanks to perceptions of a stronger economy coupled with rising commodity prices and a reduced threat of an overly-tight Fed. Swap spreads remain very low and firmly in "healthy" territory. So not only is the outlook for corporate profits improving (as indicated by declining credit spreads), but also it is the case that liquidity remains abundant in the financial markets and systemic risk remains quite low. In other words, we are most likely on the recovery side of another case of "panic attack."

Chart #4

As Chart #4 shows, the market is now much less worried (as measured by the ratio of the Vix index to the 10-yr Treasury yield) than it was just a week or so ago (the ratio has declined from a high of 13.2 just before Christmas to now 8). Last week we had the threats of 1) an overly-tight Fed, 2) a slumping economy, plus sundry other worries: China slump, trade wars, Eurozone weakness, collapsing oil prices, and the federal government shutdown. We can now scratch the first two off this list. There are still a lot of concerns out there, but we are moving in a positive direction.

Happy New Year!

Sunday, December 23, 2018

Equity valuations have improved dramatically

With the price plunge which started in early October, the PE ratio of the S&P 500 (using Bloomberg's measure, which is based on 12-mo. trailing earnings from continuing operations) has fallen from a high of 23.3 last January to 16.48 currently. To put this into perspective, consider that today's PE ratio is below the 60-yr average of this measure (16.9), and it is about equal to the market's PE ratio just prior to the onset of the Great Recession. Relative to the current yield on 10-yr Treasuries (2.79%), stocks now boast an earnings yield (the inverse of the PE ratio ) which is 3.3 percentage points higher, whereas it was only 2 percentage points higher at the end of 2007, and it has averaged only 0.4% over the past 60 years. Looking ahead, the S&P 500 is priced to a mere 14.2 times 1-yr forward expected earnings. In short, and during the course of a year in which the economy has grown 3%, stocks have fallen from an arguably over-valued level to now outright cheap. And the Fed hasn't even begun to tighten monetary policy (though the market certainly fears they will).

Clearly, the market has lost a tremendous amount of confidence in the staying power of earnings and the health of the economy. Otherwise, stocks today would be a screaming buy relative to just about any other risk asset. Sure, there are lots things to worry about: Trump, China, tariff wars, a US slowdown, and another government "shutdown." But there is nothing preordained about how these worries will be resolved. Lots of things can change, and meanwhile the economy's fundamentals remain rather healthy (fabulous corporate profits, very low unemployment, rising wages, a reasonably strong dollar, unusually high consumer confidence, and very low swap spreads). It's not hard to be optimistic when the market is suddenly so pessimistic.

Chart #1

As Chart #1 shows, PE ratios last January climbed to a high of just over 23 on the strength of corporate tax cuts (and the promise of higher after-tax earnings). Now that the tax cuts are a reality and we've seen the growth in corporate profits, It makes sense for PE ratios to back off a bit. But to a level that is below the long-term average?

Chart #2

Chart #2 shows the difference between the earnings yield on stocks (the inverse of the PE ratio, and the dividend yield that would accompany stocks if corporations paid out all current earnings in the form of dividends), and the risk-free yield on 10-yr Treasury bonds, is 3.3%. Investors currently demand an additional 330 bps of yield in order to accept the perceived additional risk of stocks vis a vis Treasuries.   More often than not, however, the equity risk premium is far lower than it is today. During the boom times of the 80s and 90s, the equity risk premium was negative. Investors were so confident in the stock market that they were willing to give up yield in order to benefit from an expected price appreciation. Once again, investors are consumed by pessimism and fear.

Chart #3 

Chart #3 shows the latest estimate of after-tax corporate profits (this accompanied last week's revision to Q3/18 GDP figures). Profits surged some 20% in the year ending last September. Similarly, 12-month trailing reported (GAAP) profits grew almost 23% in the year ending last November. And now the market seems to be thinking that all of this will go up in smoke.

Chart #4

Chart #4 shows the ratio of corporate profits to GDP (using the ratio of the two lines in Chart #3). Profits have been running at the historically unprecedented level of 10% of GDP for most of the past 9 years. Maybe this is unlikely to continue; maybe profits fall back to 8% of GDP. That would still be well above the long-term average. Why shouldn't PE ratios also trade above their long-term average, especially considering the generally low level of interest rates?

Chart #5

Chart #5 compares the earnings yield on stocks to the yield on BAA corporate bonds (a decent proxy for all corporate bond yields). Corporate bondholders get first claim on corporate profits, with equity holders last in line. Since the yield on corporate bonds is safer than the returns promised to equity holders, it only makes sense for equity investors to accept a lower earnings yield—as they did for most of the 80s, 90s, and early 00s—because they expect to receive capital gains in the future (which in turn implies an optimistic outlook). The periods during which the reverse held (i.e., when earnings yields exceeded bond yields) were generally dominated by fear: e.g., the late 1970s, and the years following the Great Recession, and now. Today, the fact that earnings yields exceed corporate bond yields is a sign that investors are worried about the future and are thus willing to pay a premium for the safety of corporate bonds. (Note: This paragraph has been re-written from its original version to more accurately and correctly describe the message of Chart #5.)

Chart #6

Chart #6 compares the market's worry levels (the Vix/10-yr ratio) to the level of stock prices. We're deep within another bout of anxiety, and prices have fallen some 18% from their recent all-time high. It's not hard to imagine fear reaching even higher levels—commensurate with prior episodes of panic attacks—and prices even lower levels. But at today's levels prices are "vulnerable" to any good news.  Maybe the Fed will reconsider its plan to raise rates twice next year; maybe China will deal (actually they already are offering concessions); maybe the government shutdown won't prove any more painful than before. 

Some words of wisdom distilled from several famous investors: 1) The price of a stock is only important on the day you have to sell it. 2) One should delight when stocks become cheap, not despair.

UPDATE (12/24/18: 10:00 PST) Looks like the panic is close to reaching levels associated with the worst of past selloffs. Here's the latest version of Chart #6: