Wednesday, October 1, 2014

Manufacturing still looks strong

Against a backdrop of renewed doubt and uncertainty (Eurozone deflation? Russian aggression? China slowdown? Asset market bubbles ready to pop?), it is reassuring that news released today from the Institute for Supply Management shows the U.S. manufacturing sector remains quite healthy. 

The ISM manufacturing index slipped at little in September, but is still consistent with fairly robust conditions. As the chart above suggests, real GDP in the third quarter is likely to be in the range of at least 3%, which would actually represent an improvement from the average growth rate of 2.2% over the past five years..

The export orders index also slipped a bit, but it is running about average for the current expansion. At the very least there is no sign here of any significant deterioration in overseas demand for U.S. goods, and that implies that the rest of the world is at least not on the verge of another recession.

The prices paid index suggests some moderate inflation pressures, but nothing out of the ordinary.

The employment index slipped a bit, but remains relatively strong. This suggests that in general, businesses remain optimistic enough about the future to expand their hiring.

This chart paints a very clear picture of this year's divergence between the U.S. and Eurozone economies. It's quite unusual, which is why the market is worried.

The good news from the Eurozone is that swap spreads are relatively low, which in turn suggests that systemic risks are low and the economic and financial fundamentals in Europe remain positive. The Eurozone economy is suffering from external shocks (e.g., Russia, Ukraine) and policy missteps (e.g., fiscal austerity via higher taxes), but not from overly restrictive monetary policy. Manufacturing conditions have deteriorated this year, but that's not necessarily going to lead to a big recession. If anything, the relatively low level of Eurozone swap spreads is encouraging. It's much easier for economies to recover from problems when financial markets are liquid and healthy. If swap spreads were a lot higher, that would be a different story.

Tuesday, September 30, 2014

A pause for home prices

According to Case-Shiller, housing prices in 20 large metropolitan areas fell, on average, in the months of May, June, and July, following over two years of steady and impressive gains (the index is calculated monthly using a three-month moving average and published with a two month lag). I doubt this is the beginning of another major downturn in prices—it's much more likely to be just a "pause that refreshes." That's because mortgage rates remain very affordable, the economy is still growing, personal incomes are still growing, and the Fed hasn't tightened monetary policy. (see charts below)

Case-Shiller also reports a series of housing prices in 10 major metropolitan areas which extends back to 1987. Here we see that real home prices have only increased at an annualized pace of 1.7% in the past 27 years, and prices today, in real terms, are about the same as they were in 2002. Real incomes, in contrast, are up at a 2.7% annualized pace over the same period. Couple that with the fact that mortgage rates today are 4-4.5%, whereas they were twice as high in 1987, and you find that housing prices are much more affordable these days.

It's a good thing that the housing market has cooled off somewhat, since that will give folks like my daughter and her husband a chance to search for and bid on a home in a less-frenetic atmosphere. They were beginning to think that they had missed the affordable-housing train.

The first of the above two charts compares the increase in housing prices since 1987 with the increased cost of renting a home ("homeowner's equivalent rent," which gets a weighting of about 25% in the Consumer Price Index). Home prices have only slightly outpaced the increase in rents in the past quarter-century. The second chart shows how the rise in home prices tends to feed into the calculation of the CPI with a lag of about 18 months. The recent pause and decline in prices is likely going to moderate the rise of the CPI over the next year or so.

Thursday, September 25, 2014

Argentina: a slow-motion train wreck

The Argentine economy is in recession, the central bank's forex reserves are dangerously low, having fallen by almost half in the past few years, and inflation is raging. Worst of all, the government is doing everything wrong. Its peronist/populist president is completely out of touch with how economies work, and its economy minister is a young, starry-eyed socialist and former economics professor who wouldn't be able to get a teaching job in the U.S. to save his life. 

Under Argentina's pegged exchange rate system, a loss of reserves is an unambiguous sign of capital flight: more money wants to leave the country than wants to come in. To enforce its currency peg, the central bank must sell dollars to accommodate those who want out. With reserves now critically low, the central bank has taken the further (and inevitable) step of rationing access to the official exchange rate. This means that those who want out are forced to use the parallel—or "blue"— currency market.

The problem started about four years ago. Once the government started rationing access to the official peso rate, a parallel, or black market for dollars soon developed and the official and "blue" rates started to diverge. The current gap between the blue rate and the official rate is now more than 70%, a sure sign that confidence in the peso is extremely weak. As the chart above shows, a similar gap opened up in the second quarter of last year, and it preceded a major devaluation of the official peso by some 8 months. Another official devaluation is almost certain, and with it should come even higher inflation and a further loss of confidence. Unfortunately, Argentina's leadership does not understand what is happening and refuses to take the appropriate corrective action, so hope for improvement is nil.

Fixing things would, among other things, require a substantial tightening of monetary policy. For years, Argentina's central bank has expanded its balance sheet in classic "money printing" fashion, by lending significant sums of money, mostly in the form of newly-printed currency, to the government, in exchange for a flimsy promise that it will be repaid. Argentina is literally a proving ground for the theory that when too much money (actual peso currency) chases a limited amount of goods, the result is inflation. As the chart above shows, the amount of pesos in circulation has increased at a 30% annualized rate for the past five years, even as the demand to hold pesos (people would much rather have dollars) has plunged. A rapidly rising money supply and a declining demand for that money is nothing less than a perfect inflation storm.

Fixing things would also require a return to free market policies, a commitment to a stable peso (e.g., something like dollarization), free capital flows, and a recognition that past debts must be honored. Unfortunately, the current government is loathe to even consider such measures, even though they could produce powerfully positive results.

Watching Argentina implode is like watching a slow-motion train wreck. It's inevitable and terribly destructive, and all for no purpose except to enrich the ruling class.

Venezuela is in much worse shape than Argentina, and Brazil is in a recession, and the Brazilian real is once again in decline. Even Chile, which had been doing so well for so long, is succumbing to bad policy decisions, with the result that its economy is slowing, inflation is rising, and the Chilean peso is falling. South America is in a world of hurt, with no lifelines on the horizon.

The bond market is not worried about the economy

A week ago I argued that there was "no need to fear Fed tightening," because both bond yields and the Fed were reacting to declining risk aversion and an improving economic outlook. My point: higher yields are not a threat to growth, they are a by-product of an improved growth outlook.

This week I change the focus slightly, and look at the behavior of Treasury yields during business cycles. What has happened this year is very typical of what happens as the business cycle matures. The yield curve has flattened somewhat, but it is nowhere near the flatness that typically presages a recession.

The chart above shows the history of 2- and 10-yr Treasury yields. The long secular decline in yields since the early 1980s has been driven by declining inflation, declining inflation expectations, and, more recently, by slower growth expectations.

2-yr yields are equivalent to what the market thinks short-term interest rates will average over the next 2 years. Rising 2-yr yields are thus a sign that the market is ratcheting upwards its expectations for Fed tightening, because the Fed has a very powerful influence on short-term interest rates. 

10-yr yields, on the other hand, are largely driven by the market's expectations for economic growth and inflation. The Fed can influence these expectations to some extent, but not by much. The chart shows that even though the Fed purchased trillions worth of notes and bonds in three rounds of Quantitative Easing, 10-yr yields rose during each episode of Quantitative Easing. Yields rose because the market perceived that the Fed's bond purchases were correctly addressing a problem and thus improving the outlook for growth. Yields fell after QE1 and QE2 because the market realized that the Fed had not done enough to address the world's demand for safe assets, and this threatened the outlook for growth. We now know that QE3 is virtually finished, but yields have only declined marginally, which in turn suggests that this time the Fed has done enough.

Some have suggested that the recent decline in 10-yr yields and the rise of 2-yr yields might be the bond market's way of telling us that a tightening of monetary policy next year could prove debilitating to the economy. But as the chart above shows, the current spread between 2- and 10-yr Treasuries is still quite wide—the yield curve is still plenty steep. The economy has flourished for years with a yield curve as steep as today's. It's only when the curve gets flat or inverted that the economy is approaching trouble.

The chart above shows that every recession since 1960 has been preceded by a severe tightening of monetary policy. Very tight money shows up in high and rising real short-term interest rates (the blue line) and a flattening or inversion of the yield curve (red line). Today both of these indicators remain firmly planted in "easy money" territory.

Conclusion: the bond market is not displaying any concerns about what might happen to the economy when the Fed starts raising interest rates next year.

Business investment makes a comeback

After being relatively flat for most of 2013, capital goods orders—a good proxy for business investment—have rebounded strongly this year. Today we learned that August orders exceeded expectations (+0.6% vs. +0.4%), and the decline in July orders was revised down from -0.5% to just -0.2%. On a year over year basis, orders rose 7.5% through August.

This series suffers from a mysteriously deficient seasonal adjustment which can be largely corrected by looking at the 3-mo. moving average, which I've shown in the chart above. Using the smoothed series, we find that the 6-mo. annualized gain in orders is a very impressive 14.5%.

Inflation-adjusted orders are still about 15% below their 2000 high, but they are closing in on their pre-recession high. Thus, while the level of orders is still disappointing, the change on the margin is quite encouraging, and that's what matters the most to markets and the economy.

Business confidence has picked up this year, with the result that today's new investment in capital goods should lead to increased worker productivity and somewhat faster real growth in the months and years to come.

We see the same picture in Commercial & Industrial Loans, which are a good proxy for bank lending to small and medium-sized businesses. As the chart above shows, the growth rate of C&I Loans picked up starting last January. Since mid-January, loans are up at a 14% annualized rate. This reflects a significant improvement in confidence on the part of banks and businesses (banks more willing to lend, businesses more willing to borrow).

These—increased confidence, increased lending, increased investment—are the undercurrents which are causing the economic outlook to improve, validating the equity market's gains, and driving note and bond yields higher.