Tuesday, September 16, 2014

Some interesting charts

One unique characteristic of the past two decades is the more than 30% decline in the prices of durable goods. Outside of durables, prices of just about everything else have been rising. The decline in durable goods prices began in 1995, which not coincidentally was about the time when China pegged its currency to the dollar (after devaluing it by one third the year before) and launched its export boom. We have China to thank for deflating the prices of most of the durable goods we enjoy these days. That's "good" deflation, since it's not monetary in origin, but rather the result of a huge increase in the productivity of the Chinese economy which has ended up benefiting everyone all over the world.

Personal computers are one very obvious source of durable goods deflation. Since the end of 1997, the BLS calculates that the prices of personal computers and peripherals on average have declined by about 95%—which works out to an annualized decline of 16%. Most of this decline is the result of hedonic pricing, which means that although actual prices haven't declined by anywhere near 95%, if you adjust for the increasing quality, capacity, and capabilities of personal computers and such, then prices have effectively declined by 95%. Since 2010, prices have been falling at an annualized rate of about 8% per year.

The Producer Price Index was flat in August, but up a little more than 2% over the past year. No sign of deflation here.

The dollar's recent 5% rise vis a vis the Euro owes a lot to the fact that the Fed is getting ready to tighten policy, whereas the ECB is trying hard to ease policy further. those expectations are being reflected in German 2-yr yields, now -0.06%, and U.S. 2-yr yields, now 0.53%. The first of the two charts above shows the history of 2-yr yields, while the second shows the spread between the two and the value of the Euro, which have been highly correlated.

The chart above provides convincing evidence for why the Fed is likely to pursue tighter policy than the ECB. U.S. industrial production has been rising strongly for years, whereas industrial production in the Eurozone has been relatively stagnant. The U.S. economy is fundamentally stronger than the Eurozone economy, so short-term U.S. interest rates are very likely to rise relative to their Eurozone counterparts.

The relative outperformance of the U.S. economy has been significant, and is reflected in equity prices. The S&P 500 has outpaced the Euro Stoxx index by 68% over the past five years. U.S. equities now have the added advantage of a strengthening dollar.

As measured by the difference between 10-yr Treasury yields and the level of Core PPI inflation, real yields have been in a declining trend for the past 30 years. This means that, in general, the effective cost of borrowing money for U.S. businesses hasn't been this low since the late 1970s. This is one reason why companies like Apple are borrowing money here to fund dividends and buybacks instead of repatriating overseas profits. Borrowing costs almost nothing, and they avoid double taxation on foreign profits.

Monday, September 15, 2014

U.S. Tax Competitiveness Stinks

Today the Tax Foundation released its 2014 index of International Tax Competitiveness. Of the 34 countries ranked on the basis of "more than forty variables across five categories: Corporate Taxes, Consumption Taxes, Property Taxes, Individual Taxes, and International Tax Rules," the U.S. came in #32, only a few points ahead of notoriously tax-loving France. 

The chart above shows my representative sampling of 20 of the countries included in the index.

Key findings:

Estonia has the most competitive tax system in the OECD. Estonia has a relatively low corporate tax rate at 21 percent, no double taxation on dividend income, a nearly flat 21 percent income tax rate, and a property tax that taxes only land (not buildings and structures). 
France has the least competitive tax system in the OECD. It has one of the highest corporate tax rates in the OECD at 34.4 percent, high property taxes that include an annual wealth tax, and high, progressive individual taxes that also apply to capital gains and dividend income. 
The ITCI finds that the United States has the 32nd most competitive tax system out of the 34 OECD member countries. 
The largest factors behind the United States’ score are that the U.S. has the highest corporate tax rate in the developed world and that it is one of the six remaining countries in the OECD with a worldwide system of taxation. 
The United States also scores poorly on property taxes due to its estate tax and poorly structured state and local property taxes. 
Other pitfalls for the United States are its individual taxes with a high top marginal tax rate and the double taxation of capital gains and dividend income.

As the study notes,

Taxes are a crucial component of a country’s international competitiveness. In today’s globalized economy, the structure of a country’s tax code is an important factor for businesses when they decide where to invest. No longer can a country tax business investment and activity at a high rate without adversely affecting its economic performance. In recent years, many countries have recognized this fact and have moved to reform their tax codes to be more competitive. However, others have failed to do so and are falling behind the global movement.

This goes a long way to explaining why the U.S. economy has been struggling in recent years.

Today's WSJ has an op-ed that sheds even more light on the issue.

To be sure, not all the countries that rank higher in the index have stronger economies. Indeed, the U.S. economy is doing better than most these days, although it is only managing to post annual growth of slightly more than 2%.'

If there's any surprise here, it's that the U.S. economy is not doing worse. We are still relatively prosperous in spite of our onerous and burdensome tax code. This speaks volumes to the inherent dynamism of the U.S. economy, which is rather adept at overcoming adversity. If we only freed the economy from its tax shackles, it's hard to imagine how much better we could be doing.

We need serious and far-ranging tax reform. Now.

Thursday, September 11, 2014

Federal government finances continue to improve

The latest budget data through August continue to reflect ongoing, gradual improvement in the federal government's finances. Spending growth is very slow, revenue growth is healthy, and the deficit is a very manageable 3% of GDP. 

Fiscal policy has been a significant drag on growth for most of the current recovery—not because of a declining deficit, but because of excessive spending. Spending is taxation, as Milton Friedman taught us, because spending must eventually be paid for by higher taxes. Spending is also bad because government doesn't spend money with the same efficiency as the private sector; you surely spend your own money much more carefully and frugally than you would if you got to spend someone else's money.

The good news is that even though the federal government arguably is still spending way more money than it should (federal spending is running about $3.5 trillion per year), federal spending as a % of GDP has been declining steadily for the past five years, so the drag of fiscal policy today is much less than it was just a few years ago. It's also good because the big decline in the federal budget deficit has all but eliminated the need for higher tax rates. As the public sector shrinks relative to the private sector, the private sector has more room to grow, and it's the private sector that delivers prosperity. 

The following charts illustrate some of the points made above:

Federal spending has been effectively flat for the past five years, thanks mainly to congressional gridlock and an improving economy, which in turn has reduced the need for social safety net spending. Federal revenues have been rising steadily, thanks mainly to more jobs, rising incomes, capital gains, and rising profits, and only partly thanks to higher tax rates imposed beginning last year. In retrospect, we would have been much better off not raising tax rates on anybody.

Federal spending relative to the size of the economy has declined by almost one-fifth, from just under 25% of GDP to just over 20% of GDP. This has reduced expected future tax burdens enormously, and on the margin it has helped to boost the economy's overall efficiency. Revenues are now about 17.2% of GDP, which is only slightly less than the 17.4% they have averaged since 1968.

The result of flat spending and rising revenues has been a two-thirds reduction in the federal budget deficit (from $1.5 trillion to $0.5 trillion). Relative to GDP, the deficit has collapsed from a high of 10.2% to now only 3%. 

The decline in the unemployment rate has correlated very closely to the decline in government spending relative to GDP. A significant decline in government spending relative to the economy did not in anyway harm the economy by this measure. As the graph above suggests, further declines in spending relative to GDP are very likely to coincide with a healthier labor market.

All in all, lots of good news here, even though there is plenty of room for further improvement. Things could be a lot better, of course, but at least they are getting better. 

Wednesday, September 10, 2014

Apple still looks juicy

I've been a fan of AAPL for many years, and I see no reason to stop now. Apple continues to innovate, both on the hardware and software front, they are a recognized leader in their market, and they capture the lion's share of industry profits.

Although Apple was late to the game with a bigger smartphone, it's now once again the leader of the pack. No competitor can match Apple's design, quality, reliability, ease of use, and integration. I know quite a few people who are lusting for an iPhone 6, and I'll be getting one for sure (but I'll probably get the 6 because I think the 6 Plus is too big for my tastes). It's got great new features (e.g., a much better camera, incredible video capabilities, a better quality screen, NFC, faster WiFi, and VoLTE). And of course there is iOS 8, which will be released next week and will bring delightful new features to most of the iPhones already out there in the world. Similar software advances are on track for Apple's industry-leading laptops and desktops, due out next month. No other competitor makes it so easy to upgrade your smartphone or your computer with the latest and greatest version of its operating system.

I was immediately struck by the beauty of the new Apple Watch, which is not just an amazing gadget but also a piece of jewelry that will be coveted by many. I'm sure I'll get one myself when they come out next year.

Even though Apple is the most valuable company in the world, it has only recently eclipsed the record high valuation of MSFT set in early 2000—over 14 years ago—and only by about $15 billion or so. Like Microsoft, Apple sells products and services to the entire world. Unlike Microsoft, Apple's products and services are highly regarded in the biggest and fastest growing part of the world (e.g., China).

When Apple's PE ratio fell to 10 early last year, it was a clear sign that the market thought its best days were behind it. Backing out Apple's significant overseas cash hoard, its PE ratio was approaching a miserable 8. 

The only way to make sense of that was to figure the market expected no further increase in earnings going forward, and a strong likelihood that earnings would decline. And indeed, Apple's earnings have been essentially flat for the past 2 ½ years.

Today, however, Apple's PE ratio is back up to just over 16, so that implies that the market worries much less about declining earnings. But even at a PE of 16 the market is still looking at Apple with skeptical eyes. Back out the overseas cash (and assume Apple pays onerous taxes on it), and you get a cash-adjusted PE today of 13-14, which is substantially below the S&P 500's PE ratio of 18. So today's pricing only makes sense if you assume that at best Apple's earnings will never rise meaningfully and may well stagnate or decline in coming years.

While that may prove to be the case (it's always tough to argue that the market is wrong about the future), after yesterday's announcements it's clear that Apple has two new sources of revenues in the pipeline: the Apple Watch and Apple Pay. The Apple Watch is a handsome piece of jewelry that is also a watch and a high-powered computer, yet costs only half of what the average Swiss watch costs. (Perhaps Jony Ive wasn't exaggerating when he said "Switzerland is f*cked"). The Apple Watch is by far the best-designed and most functional of all the "smart watches" on the market. Fitness buffs could go crazy for its built-in sensors, and Apple's HealthKit could find lots of traction in the healthcare field. Why couldn't Apple sell tens of millions of watches per year? The Swiss sold over 20 million last year.

And then there's Apple Pay, which has the potential to revolutionize how the world buys things. If the service is successful, Apple could get a tiny piece of potentially tens of billions of credit and debit card transactions each year all over the world. Based on my understanding of how it works, it has all the ingredients for success: it's super-easy to use and it's far more secure and private than the current system, which we know is deeply flawed. There will be millions of iPhones that could start using the system beginning next month—as many as 80 million by year end—and Apple has already signed up the biggest players in the credit card industry.

There's still lots to like about Apple.

Full disclosure: I am long AAPL as of the time of this writing, and have been for many years.

UPDATE: Here's a terrific review of the Apple Watch by the watch pro Benjamin Clymer (HT: John Gruber). It helps you appreciate the tremendous amount of work and detail that Apple has put into this. The variety and beauty of the watch cases and straps is simply amazing. This is much more than just a digital watch.

Tuesday, September 9, 2014

Tracking the decline in risk aversion

For most of the past five years I've argued that one of the dominant features of this recovery was risk aversion. The Great Recession so scared and shocked the world that risk aversion became exceptionally high. I've also argued that the main purpose of the Fed's QE program was to supply a very risk averse world with safe securities, by essentially converting ("transmogrifying") notes and bonds into T-bill equivalents (aka bank reserves). The point of QE was not to stimulate the economy, as many have argued, but to accommodate the world's intense demand for safe assets. We can be reasonably sure of this by observing that, despite a massive increase in bank reserves, there has been no excess supply of money, and we know that because inflation has been relatively low and stable and the dollar has also been stable (and is even increasing of late). In short, the Fed's injection of reserves was sufficient to satisfy the world's demand for reserves.

But since early last year things have been changing on the margin. Risk aversion is still to be found (e.g., huge increases in bank savings deposits, zero yields on 3-mo. T-bills), but it is declining. Confidence, the flip side of risk aversion, is slowly rebuilding, but it is still relatively low.

The graph above speaks directly to the existence of declining risk aversion. It shows the price of gold and the inverse of the real yield on 5-yr TIPS (a proxy for the price of TIPS). Both gold and TIPS are refuges for those who worry about inflation and end-of-the-world scenarios, so their prices reflect the intensity of the world's demand for safety. Gold prices maxed out at $1900/oz. a few years ago, which was roughly triple the average inflation-adjusted value of gold over the past century (now THAT's what I call paying a premium). TIPS prices maxed out at a negative real yield of almost 2% early last year, which meant that investors were willing to give up almost 2% of their annual purchasing power in order to capture the U.S. government-guaranteed, inflation-hedging properties of TIPS. In short, people were paying ridiculous prices to minimize risk. But that's changing.

Now it looks like TIPS real yields are on the verge of turning positive, and gold prices are on the verge of making multi-year lows. If gold breaks below $1200 and heads for $1000, and if real yields on 5-yr TIPS break above zero, those would both be signs of a significant decline in risk aversion. They would still be expensive, of course, but a lot less so.

As risk aversion recedes, then the need for QE also recedes. The Fed is on track to finish QE3 late next month, so as far as the market is concerned, QE3 is done. And the sky has not fallen, because the world no longer needs tons of new T-bill equivalents. That's good.

But declining risk aversion poses a risk to the Fed's promise that it will keep short-term interest rates exceptionally low until well into next year and even beyond. If the Fed is slow to react to a significant decline in risk aversion, the result will be higher-than-expected inflation. That's because declining risk aversion will be replaced by a rising appetite for risk. And that will mean a greater demand for loans, and it will mean that banks will be more willing to lend.

With banks today sitting on more than $2.6 trillion of excess reserves, there is effectively no limit to how much they can increase their lending. As the first of the graphs above shows, bank lending tends to track the growth of M2 over time, so a big increase in lending would likely translate into a big increase in the money supply. To date, the M2 money supply and total bank credit have been growing at just over 6% per year for the past 20 years, and that's coincided with moderate economic growth and relatively low inflation. A big increase in money lending from banks at a time when the world doesn't particularly want to hold extra money could give us a lot more inflation (and maybe a bit more growth). As the third graph shows, bank credit growth has already picked up this year after being very sluggish since 2008, so that's another sign of declining risk aversion and rising risk appetite.

Since it would take extraordinary measures to reverse its gigantic balance sheet in a relatively short time frame, the only practical way for the Fed to avoid a significant and unwanted increase in the money supply is to increase the interest it pays on reserves by enough to make banks content to continue to hold the already-massive amount of excess reserves. If risk aversion continues to decline, the Fed is going to have to accelerate its plan to raise short-term interest rates, or risk an unwanted—and potentially huge—increase in inflation.

This is not a call for hyperinflation. But I think we are getting closer to the day when the Fed starts falling behind the inflation curve, and that could prove to be very unsettling. This all bears watching very closely. Keep an eye on real yields, gold prices, and bank lending.