Friday, September 18, 2020

A few charts and thoughts on the election

From time to time I update a chart or make a new one, and I realize it is worthy of highlighting. But then I delay posting it, looking for some broader theme to tie it too. I invariably regret doing that, so here is a short post with just 4 charts and some brief comments.

Chart #1

Chart #2

A few days ago the Census Bureau released its calculation of Median Household Income for 2019. As Chart #1 shows, this measure of prosperity increased at a historically significant rate. It rose a record-setting 8.7% from 2018 in nominal terms, and 7% in real terms, the latter being shown in Chart #2. Trump can claim credit for much of this, given his significant tax cuts and regulatory reform which began to take effect in 2018. 

It's arguable, of course, but I think Biden's agenda, which calls for significant tax hikes across the board, as well as an environmental agenda that would involve huge costs, economic turmoil (you don't easily get rid of an addiction to fossil fuels), and re-regulation (especially of the labor market), would be a drag on growth. Biden's agenda is anti-growth and anti-business, in the belief that addressing income inequality, social justice, and global warming are paramount.  

Chart #3

Chart #3 shows a huge, record-setting increase in homebuilder sentiment, which in turn foreshadows a significant pickup in housing starts. It's no secret that historically low mortgage rates have been a boon to the housing market and home construction, as well as to consumer sentiment. Who couldn't love sub-3% mortgage rates? 

Mortgage rates are low because the 10-yr Treasury yield, currently only 0.7%, is at levels once that though impossibly low, and the 10-yr is the primary driver of mortgage rates. And Treasury yields are low not because the Fed is promising to keep short-term rates near zero for the next 2-3 years, but because investors the world over are desperately demanding safety and security. The Fed is keeping rates low because it is forced to accommodate the world's huge demand for safe assets. On the bright side, the wave of risk aversion that has carried Treasury yields to unbelievably low levels is helping to generate a wave of new willingness to invest in homes as well as many other hard and financial assets. Remember, the new meme that the Fed is promoting is "Borrow and Buy," as I have noted in recent posts. When interest rates are super-low, it pays to borrow, and it pays to buy almost anything that will eventually benefit from renewed growth and—possibly—higher inflation.

Chart #4

On a less promising note, Chart #4 shows that passenger air traffic, which a few weeks ago was picking up (Labor Day holiday-related) has now resumed its flat trend. This detracts from the otherwise V-shaped recovery narrative that we have seen in housing, employment, industrial production, and retail sales. I think the economy will continue to improve at a relatively fast pace, but it's not yet gangbusters.

For all the promise of renewed growth, it remains the case that this year's gargantuan government spending and income redistribution will be a serious drag on growth for the foreseeable future. By borrowing many trillions, the government has commandeered a significant portion of the economy's resources and redirected those resources in ways which are very likely not as efficient as if those resources had been left in the hands of the private sector. Government can never spend other people's money as wisely and as efficiently as people can spend their own money, to paraphrase the great Milton Friedman.

From my supply-side perspective, the most important things to watch are confidence, employment, investment, and incentives to work and invest, all of which drive supply. Supply, as supply-siders believe, creates its own demand. Investment, production, and risk-taking are what deliver productivity, and productivity, coupled with more people and more work, is what delivers growth and prosperity. Spending follows production and growth; spending is not what drives the economy. 

Paying extra-generous unemployment benefits surely (and justly) helps those who were on the wrong side of government-mandated shutdowns, and it helps sustain consumption. But in the end it is harmful to the overall economy. There is no free lunch. It is increasingly clear that, as I predicted last April, government-ordered shutdowns were a catastrophic mistake, since nowhere in the world have they managed to derail the spread and devastation of the Covid virus, while in every case they have been hugely expensive and economically destructive to the lives and businesses of countless millions.

Supply-siders, as well as conservatives generally, believe that free markets and individual freedom are what create the fertile ground in which growth prospers. Modern-day liberals (as opposed to traditional liberals) believe that government actions (income redistribution, subsidies, price controls, regulations, industrial policies) are the main drivers of growth. Conservatives put their trust in individuals and businesses; liberals put their trust in government. You are free to choose, especially in the upcoming elections.

UPDATE (9/19/20): Mark Perry has a very interesting post on the demographics behind the household median income data. Excerpt:

It’s highly likely that most of today’s high-income, college-educated, married Americans who are now in their peak earning years were in a lower-income quintile in their prior younger years when they were single and before they acquired education and job experience. It’s also likely that individuals in today’s top income quintiles will move back down to a lower-income quintile in the future during their retirement years, which is just part of the natural dynamic lifetime cycle of moving up and down the income quintiles for a majority of Americans. So when [we hear] the incessant chatter from the mainstream media and progressive politicians about an “income inequality crisis” in America, we should keep in mind that basic household demographics go a long way towards explaining the differences in household income in the United States. And because the key income-determining demographic variables are largely under our control and change dynamically over our lifetimes, income mobility and the American dream are still “alive and well” in the US.

Monday, September 14, 2020

Consumer inflation has averaged 2% for 18 years

Depending on how you measure it, inflation has been running 1.5 - 2% per year for the past 18 years. It's a mystery to me why the Fed feels it needs to be higher. I remain convinced that less inflation is always better than more inflation, and I'm not hung up on inflation always needing to be positive. Why should money always lose value relative to goods and services?

Chart #1

We have been living in a 2% inflation world for the past 18 years. Sometimes that fact gets obscured by the sheer volatility of year-over-year inflation, which has ranged from -2.1% to 5.6% in the past two decades. Super-volatile oil prices are largely to blame for this; having ranged from $19 to $140 per barrel over this same period. Chart #1 helps illustrate this. The blue line is the total CPI, whereas the red line excludes energy prices. The Personal Consumption Deflator, on the other hand, has been running a bit over 1.5% for the past two decades; it's fairly typical for the CPI to register more inflation than the PCE deflator, since the deflator is more responsive to shifts in consumer preferences (consumers, being generally smart and thrifty, shy away from high-priced items, preferring instead cheaper substitutes).

Chart #2

Ex-energy, the year over year change in the CPI has ranged from -.7% to 3.1%, as seen in Chart #2. Taking out food prices in addition (which would be the so-called "core" rate of inflation) would make a very small difference. Energy is much more volatile than food prices, so that is my preferred measure of underlying inflation.

Chart #3

As Chart #3 shows, over the past 18 years the CPI ex-energy rate of inflation has averaged 2.0% per year (note that the index is plotted on a log scale, so its constant slope is equal to a constant rate of growth, in this case 2% per year). It may come as a surprise, but over that same period the total rate of CPI inflation has averaged almost exactly the same. In fact, since 1957, when the x-energy version of the CPI started, both ex-energy and total CPI inflation have also increased by virtually the same amount (~ 3.6% per year).

The price of oil has been by far the most volatile of any commodity. Take out oil, and you get a much better idea of where things are going on a year-to-year basis.

Chart #4

Chart #4 is interesting since it shows how much energy costs have shrunk as a share of total personal consumption. Energy today is only 3.4% of personal consumption expenditures, whereas it was almost three times more in the early 1980s. Food and energy together account for 11.7% (food is 8.2%).

Chart #5

Chart #5 compares the price of oil to the prices of non-energy commodities. Note the relatively tight correlation between the two. More importantly, note how the scale for crude goes from 1.4 to 280 (i.e., crude prices have increased by a factor of almost 200 times!), while the scale for non-energy commodity prices increases by a factor of only about 6 ⅔. Huge difference, yet very correlated! This confirms my preference for non-energy inflation as the best measure for underlying inflation trends.

The August readings for the CPI (+2.1% ex-energy over the past year) should put an end to speculation that the economy's virus-induced collapse would result in deflation. It's likely the Fed won't tighten for quite some time, but there is no reason at all to worry that they need to be easier. If I had to bet, I'd say the next tightening comes before the market expects it; that is to say, I think the risks are skewed to inflation exceeding expectations over the next few years.

Thursday, September 10, 2020

Spread monitor: looking good

Often, prices alone cannot tell the story. Knowing a stock has gone up 10% is nice, but if that happens in the context of the broad market rising 20% then it's not so nice. In the bond market, comparing one yield to another is essential to understanding value. Virtually every bond in the world is priced relative to Treasuries of comparable duration or maturity. The Treasury yield curve is the "backbone" of all yield curves; it sets the gold standard for yields of all maturities because Treasuries are the most liquid, risk-free securities in the world. Without the Treasury yield as a universal benchmark, the bond market would be much less efficient.

Looking at the "spread," or difference between the yield on, say, a corporate and a Treasury bond of similar maturity is essential to understanding the value of that bond, which in turn depends on how risky the market perceives its issuer to be. The greater the spread, the riskier, and the smaller the spread, the safer. Spreads can also tell us about the health and underlying liquidity conditions of the market as a whole. And by inference, spreads can also tell us about what the outlook is for the economy, since a healthy financial market is essential to a healthy economy.

The following charts cover the spreads I consider essential to understand the economic and financial fundamentals. Fortunately, they are all telling a good story.

Chart #1

Chart #1 looks at the "TED" spread, which is the difference between the yield on 3-mo. LIBOR securities and 3-mo. T-bills. (The acronym TED comes from Treasury vs EuroDollar.) LIBOR is a standardized measure of short-term yields of dollar-denominated securities which trade overseas in what is commonly referred to as the eurodollar market. The TED spread is equivalent to the extra yield over risk-free T-bills that investors require to accept the credit risk of a major overseas bank, since it is those banks that pay LIBOR when they borrow. Long story short, the TED spread is a good proxy for how risky the global banking system is. Current spreads are about 15 bps, which is the difference between the 25 bps yield on 3-mo. LIBOR and the 10 bps yield on 3-mo. T-bills. That's about as low as the TED spread has ever been, and that's a very good thing, because it means global financial markets are in very good shape.

Chart #2

Swap spreads are the extra yield that investors require to enter into a swap agreement with a major broker-dealer or financial institution. Swap agreements involve one party paying, for example, a fixed rate to another party and accepting a floating rate in return. Swap transactions effectively allow investors and financial institutions to efficiently manage their risk. You can find a longer explanation of swap spreads here.

Chart #2 looks at 2-yr swap spreads, which is the extra yield that one party requires in order to enter into an agreement in which the investor receives a floating yield in exchange for paying a fixed, 2-yr yield. 2-yr swaps represent a highly liquid market and are thus an excellent proxy not only for the health of financial markets but also the general liquidity conditions of financial markets (a high degree of liquidity leads to very low spreads). Current swap spreads in the US are very low, while spreads in the Eurozone have clearly moved into "healthy" territory after spending many years in not-so-healthy territory.

Bottom line: swap spreads tell us that global financial markets are in very good shape, and that can often be a good predictor of future economic health. They also tells us that central banks for the most part are not a threat to the markets or the economy. No one is being starved for liquidity, and real interest rates (and thus borrowing costs) are extremely low. Note also that this predictive ability of swap spreads can be seen in Chart #2, as swap spreads rose in advance of the 2008 recession and fell in advance of the recovery.

Chart #3

Chart #4

Chart #3 shows 5-yr Credit Default Swap spreads. CDS spreads are a very liquid market that gives a good proxy for 5-yr corporate credit risk. Spreads are trading at pretty low levels, suggesting that credit risk is minimal, and by extension, that investors perceive the outlook for the economy to be healthy. Chart #4 shows the difference between investment grade and high yield CDS spreads, something that is called the "junk spread." This too is a good proxy for the extra risk an investor experiences as he or she ventures into the junk bond arena.

Chart #5

Chart #5 is an amalgamation of the credit spreads on two classes of corporate bonds of all maturities—and there are many. Here again we see that spreads are generally low, thus the implied outlook for the economy is healthy. Investors are not overly concerned about the outlook for corporate profits. 

Chart #6

Chart #7

Charts #6 and #7 show the spreads between nominal and real yields on Treasuries and TIPS (TIPS = Treasury Inflation Protected Securities). This difference, or spread, is equivalent to the market's expectation for future annual inflation rates. In both cases, it appears the market is expecting consumer price inflation to average just over 1.5% per year for the foreseeable future. If this proves to be an accurate forecast I—and most people—will be happy. I worry, however, that the Fed wants the inflation rate to be higher, and I've learned to never doubt the Fed's ability to get what it wants.

It's important to realize that most people's understanding of how inflation works is faulty. Inflation is not a by-product of strong growth or strong demand. Inflation happens when there is more money in the system than people want to hold. Inflation lies in the intersection of a central bank's willingness to supply money and the public's desire to willingly hold that money. Too much money is what leads to inflation. There is certainly plenty of money these days, as I have documented in prior posts. What is keeping inflation in check is the apparent fact that the public is happy to hold all that money, because there are still many things to worry about and money provides security.

What we need to be attentive to is the return of confidence, since that will act to reduce the demand for money. And if the Fed doesn't react to this by increasing short-term rates in a timely fashion, we will end up with higher-than-expected inflation and eventually much higher interest rates as the Fed is forced to tighten monetary conditions. This is how almost every recession (except this year's) has started, by the way, so it's not a pleasant prospect. Fortunately I don't see this happening any time soon, but next year is still out there on the horizon....