Wednesday, July 18, 2018

Why are interest rates so low?

Late last year, in my Predictions for 2018, I thought the main theme for the year would be "waiting for GDP." Policy changes in the previous year had set the stage for much stronger growth, higher interest rates, and a stronger dollar, but I thought the market would be skeptical until clear signs of stronger growth emerged. While there is still every reason to believe economic growth is accelerating, the evidence of a new economic boom is still not yet conclusive. The economy is improving on the margin, but budding tariff wars are dampening enthusiasm and keeping risk aversion alive.

Interest rates have moved higher over the course of this year: 5-yr real yields on TIPS have increased from 0.3% to 0.7%, and 10-yr Treasury yields have risen from 2.3% to almost 2.9%, paced by a 0.5% boost to the Fed's short-term interest rate target. That's small potatoes in the great scheme of things. Both the bond market and the Fed have priced in somewhat stronger growth, but these moves are still modest compared to what one would expect from a solid package of supply-side tax cuts and reduced regulatory burdens such as we saw enacted last year. These things take time, to be sure, and we're still in the early innings. Meanwhile, the risk of tariff wars is driving demand for hedges, and Treasuries are the market's favorite port when economic storms threaten. Consequently, interest rates arguably are still depressed relative to where they should be in a robust growth environment.

Back in December I cautioned that higher interest rates would not be well-received, and a month later the equity market shed over 10% of its value in a few days. More recently, nerves have been tested as US-China trade relations deteriorate and reciprocal tariff hikes are announced. In December I thought that further gains in equity prices would not come from higher earnings multiples but rather from rising earnings; so far, the PE ratio of the S&P 500 has fallen from 21.7 to 21.3, and earnings per share (based on trailing 12-month reported earnings) have increased only modestly, from 123.2 to 132.1. Earnings are going to have to continue improving if equities are to march still higher, and that is all part and parcel of a ratcheting up of economic growth that is likely underway but still not yet obvious.

In the meantime, as we await news of unusually strong economic activity, a stronger dollar has accompanied weaker commodity and gold prices, and all have conspired to squeeze emerging market economies, much as I feared. But the dollar is only moderately strong, commodity prices are still quite strong, and the Fed has yet to tighten monetary policy, so the pressure on emerging market economies is nowhere near what it was in the late 1990s and earl 2000s. I think we'll see emerging markets begin to recover, especially as—and if—evidence of a stronger US economy emerges.

Chart #1

The point of Chart #1 is to demonstrate that real yields tend to track the real growth rate of the economy. Currently, real yields on 5-yr TIPS (the best market-based proxy for short-term real yields I know of) are consistent with economic growth of about 2.5% per year. This happens to be only slightly higher than the 2.2% annualized growth the economy has registered since mid-2009, when the current business cycle expansion began. If the market (and the Fed) were convinced that real growth would be 4% or better, we would very likely see real yields on TIPS trading in the range of 3% or so.

Chart #2

Chart #2 demonstrates the link between market-based real yields on 5-yr TIPS, and the ex-post real yield on the Fed's target funds rate. The real funds rate is the Fed's true target, since that is the best measure of borrowing costs. Note that the real funds rate has been zero or less for the past decade, and it hasn't increased much, if any, for almost a year. The red line, the real yield on 5-yr TIPS, is essentially the market's expectation for what the blue line will average over the next 5 years. The market is not expecting the Fed to do much in the way of tightening, but it is definitely pricing in somewhat tighter policy for the foreseeable future.

Chart #2 is also a good way to look at the shape of the real yield curve, which is arguably more important than the shape of the nominal curve, which has been flattening for the past several years (the 2-10 spread is now down to about 25 bps). What we see in Chart #2 is that the real yield curve has been steepening over the past year—expectations of future real rates have risen relative to current real rates. Taken together, the shape of the real and nominal yield curves tells us not that the economy is being squeezed, but rather that neither the market nor the Fed are very enthusiastic about the idea of a stronger economy. 

Chart #3

Chart #3 shows that nominal Treasury yields have been unusually low relative to the prevailing rate of inflation for the past seven years. Only in the past year have nominal yields begun to catch back up to inflation—and they're still relatively low. The fact that the bond market has been willing to accept only paltry real yields for so long is a function, I believe, of a relatively strong degree of risk aversion and a lack of enthusiasm for real growth prospects. Markets have been willing to accept minimal returns in exchange for the safety of Treasuries. In a stronger growth environment, this would not be the case. If inflation holds around 2% and the economy picks up convincingly, I would expect 5-yr Treasury yields to rise to 4% or more.

Chart #4

Chart #4 compares the ISM manufacturing survey to quarterly real GDP growth. If there is any one chart that makes the case for a significant pickup in growth, this is it. Based on past experience, the current ISM reading suggests second quarter growth could be well in excess of the 4% that is currently expected. But that tells us nothing about the long-term outlook for growth. The second quarter GDP release is almost certain to be strong, but doubts still linger about later quarters.

Chart #5

Chart #5 shows the growth rate of private sector jobs. Much has been made of recent "strong" jobs reports, but the truth is that the growth of jobs remains rather mild compared to recent years. The best that can be said is that the growth of jobs over the past 6- to 12-months has increased from 1.6% several months ago to now about 2%. With these kinds of numbers, strong-growth skepticism is warranted. In order to get 4% or better GDP growth, we're going to need a big increase in productivity, and that in turn is going to require lots of new investment. I think we'll see it, but we can't find the evidence yet. 

Chart #6

Today's release of June housing starts was disappointing (+1273K vs +1320K), but as Chart #6 shows, starts can be very volatile from month to month. Strong sentiment readings from builders suggests we haven't yet seen the peak in housing construction, but for the time being housing is not going gangbusters.

Chart #7

Architecture billings have been in positive (increasing) territory for quite some time now, and that points to increased construction spending for the next 9-12 months, according to the AIA. But compared to past cycles, it's hard to see anything like a boom underway.

Chart #8

Chart #8 compares industrial production in the U.S. to that of the Eurozone. Production is rising, but not by much compared to prior peaks. 

Chart #9

If conditions in the U.S. were booming, not only would you expect to see much higher interest rates, you would also expect to see a very strong dollar. However, as Chart #9 shows, the dollar today is only modestly higher than its long-term average vis a vis other currencies.

Chart #10

In past cycles, a strong dollar has tended to correspond to weak commodity prices (note that the dollar is plotted on an inverted scale in Chart #10) and vice versa. But: although the dollar today is a lot stronger than it was 5 years ago, commodity prices are roughly unchanged compared to 2013. That's good news for emerging market economies, since they are particularly sensitive to commodity prices. They are also sensitive to competing returns in the U.S. and other developed economies. Despite the relative strong dollar, it remains the case that real returns in developed economies are still unusually low, and commodity prices are still historically high. So recent concerns about emerging market economies are likely overblown. Look for some recovery from recently-depressed levels.

Chart #11

In the final analysis, the biggest concern these days is the potential fallout from escalating tariff wars. To give Trump the benefit of the doubt—which not many are willing to do these days—his ultimate objective is to lower all tariff and non-tariff barriers, and he believes this can be accomplished only by a demonstrated willingness to do the opposite: Trump is playing a game of "tariff chicken." Chart #12 shows facts that he arguably believes bolster his strategy. In the past 12 months, the US has imported about $525 billion of Chinese goods, while at the same time exporting to China only $135 billion. China is selling almost four times more "stuff" to us than we are selling to them. So, the thinking goes, if both countries jack up tariff rates to prohibitive levels, the Chinese have much more to lose than we do, particularly since our economy is still half again as big as China's. At some point the Chinese will wave the white flag, we'll all agree to reduce or eliminate tariffs and intellectual property right theft, and sweetness and light will return to international trade relations.

We can't rule out a successful end to today's tariff wars, but neither can we be confident that they will inexorably lead to a repeat of the Smoot-Hawley tariff wars which in turn led to the Great Recession. I continue to believe that tariffs are so universally understood to be bad and even stupid that eventually our leaders will do the right thing and make trade freer and fairer. Why bet against what would be a win-win for all parties? (Zero tariffs are an economist's dream, since by facilitating free trade they would be a boon to all countries.) So I remain optimistic, but there is ample reason for many to remain cautious and concerned.

And that is another reason why interest rates remain so low and the U.S. economy appears to be reluctant to take off for points north of 4%.

Friday, June 29, 2018

Corporate profits are huge

I've had many posts over the years highlighting the strength of corporate profits. This post adds to the list, but it is notable for being the first to highlight the impact of Trump's tax reform on after-tax corporate profits. As I mentioned last December, Trump's reduction in corporate income taxes translated (via math) into a 20% one-time boost to the after-tax profits of a given level of nominal profits. According to yesterday's release of revised GDP stats for the first quarter, after-tax corporate profits (adjusted for inventory valuation and capital consumption allowances, a measure Art Laffer convinced me was the best, being based not on GAAP profits but on true economic profits using IRS filings) reached a record $1.92 trillion (annualized), up almost 17% from a year ago. That's equal to 9.6% of GDP, a level that has been exceeded in only 4 quarters in our nation's recorded history. After-tax profits are likely to move higher still, once the full impact of lower corporate income tax rates filters through to the data as the year advances.

Corporate profits paint an attractive picture for today's investors, since equity valuations seem only moderately higher than their long-term averages, even as profits reach very high levels relative to GDP, as I discuss below.

 Chart #1

Chart #1 compares after-tax corporate profits to nominal GDP. Over the past three decades, profits have increased at a much faster pace than nominal GDP. (Note that the two y-axes have a similar ratio from bottom to top, and both are semi-log.)

 Chart #2

Chart #2 shows the same measure of profits, but as a percent of nominal GDP. Note that for many decades prior to the current business cycle expansion, the ratio of profits to GDP averaged just over 6%. Five years ago I thought that the market was skeptical that profits would remain at such "elevated" levels and would inevitably revert to their 6% of GDP mean. Yet profits just get stronger. If there has been any long-term theme in my posts since late 2008, it's that the future ends up being better than the market expected, even though the economy's growth rate has been sub-par. The market has held relatively dismal expectations for many years, and has been pleasantly surprised. That's why equity prices have been moving higher.

 Chart #3

Chart #3 shows the traditional measure of stock market valuation: the ratio of trailing 12-month after-tax profits per share to share price (using reported earnings from continuing operations). Currently, the PE ratio of the S&P 500 is 20.9 by this measure. That's higher than the 16.8 average since 1960, but it is also lower than past extremes.

Chart #4

Stocks are attractive today because they have an earnings yield of 4.8%, which is substantially higher than the 2.8% yield on 10-yr Treasuries (see Chart #4). Consider: the PE ratio of a 10-yr Treasury bond is 35! With stocks, you get a much better yield than risk-free Treasuries, plus you get plenty of upside should the economy continue to exceed what are still modest growth expectations. These conditions hold only because the market continues to worry that future profits will inevitably revert to their historical mean.

 Chart #5

Chart #5 substitutes after-tax corporate profits using the National Income and Product Accounts for the traditional measure of GAAP profits (i.e., reported earnings). I've normalized the ratio so that the long-term average is similar to that of the traditional PE ratio. Note the extreme overvaluation of stock prices in the late 1990s. Today's valuations by this measure are very close to their long-term average. (I discuss the difference between NIPA and GAAP profits in this post.)

A disinterested observer might look at the charts above and wonder why stocks aren't more expensive, especially relative to risk-free bonds. One reasonable answer would be that the market must be worried about another collapse or correction or even a recession. To be sure, there are legitimate things to worry about, chief among them being that Trump's tariff wars could get out of hand and precipitate a global recession. Quite simply, today's valuations imply that risk aversion is still alive and well, a theme I've revisited many times in recent years.

Tuesday, June 19, 2018

The US keeps on truckin'

Truck tonnage continues to post significant gains, according to the American Trucking Association's latest release. Tonnage is up 7.8% year over year, and it is up at an annualized rate of 7.8% year to date.

Chart #1

Chart #1 is an updated version of the one in my post last month, "Truck tonnage evidence of a Trump Bump." As it suggests, there is a strong correlation between truck tonnage—a good proxy for the physical size of the economy—and equity prices.

From the ATA's latest release, including some relevant facts:
“This continues to be one of the best, if not the best, truck freight markets we have ever seen,” said ATA Chief Economist Bob Costello. “May’s increases, both sequentially and year-over-year, not only exhibit a robust freight market, but what is likely to be a very strong GDP reading for the second quarter.

Trucking serves as a barometer of the U.S. economy, representing 70.6% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

For all the reported angst over Trump's escalating trade war with China, the Vix/10yr ratio has barely budged (see Chart #2), which suggests the market does not expect much if any damage to occur as a result. My own assessment is that rising tariffs are acting as a headwind to growth, but that this will not prove terribly disruptive. Without this headwind, the economy would likely be on its way to sustained growth of 4% or more; with the headwind, we're more likely to see 3-4% growth. For Trump's purposes, I believe, higher tariffs are a temporary disruptive factor that is necessary to achieve a long-term reduction in overall tariff barriers and freer overall trade. It's a risky gambit, to be sure, which could backfire if China continues to counter Trump's tariffs with more of their own. But in the end, tariffs are so universally understood to be counter-productive that I find it hard to believe the escalation won't reverse sooner or later.

Chart #2

Meanwhile, the ongoing flattening of the yield curve (see Chart #3) is not a danger signal. It's more accurate to say that it reflects the market's judgement that, if anything, tariff wars will keep the Fed from hiking rates more than just a few times over the course of the next year, because the economy is not likely to "overheat." To date, no one is suggesting the economy will prove so weak that the Fed will need to lower rates: that's what would be necessary for the curve to invert. We'd also need to see much higher swap and credit spreads, which so far remain quite low, as I noted yesterday.

Chart #3