Thursday, November 16, 2017

AAPL still looks good

I've been a fan of Apple's ever since I bought the stock about 15 years ago. I've had a number of posts on Apple over the years, all of which have been bullish. I'm still optimistic about Apple's prospects, even as it approaches the $1 trillion capitalization mark.

I got my new iPhone X a few days ago, and it is by far the most beautiful and exciting of all the iPhones I've ever had (and I've owned every model they've made). Face ID is surprisingly fast and seamless (and accurate!), the display is much larger and a pleasure to look at, the build quality is superb, the battery life is much longer, the camera is much better, and the gestures that replace the home button are powerful and easy to use, not to mention it's wicked fast. It costs more than its predecessor (iPhone 8), but it delivers much more at the same time. Since my digital life revolves around this little jewel, I'm happy to pay extra, and I'm sure tens of millions of others will feel the same way. Apple can no longer be accused of not innovating. Its flagship product has leapfrogged the competition, and it's become the "apple" of everyone's eye.

The iPhone X is going to set sales records. Face ID is almost surely coming to Apple's entire product line over the next year, and that will very likely trigger a wave of upgrades. But the market, believe it or not, is still not convinced that Apple's best days lie ahead. Apple's cash-adjusted PE ratio today is less than 17, giving it an earnings yield of 6%. That implies, in my judgment, that the market still suspects Apple will have a hard time increasing earnings. If expectations were solidly behind continued earnings gains, Apple's PE ratio would be a lot higher. Following are some nifty charts which tell the story.

Chart #1

Wow. One of the Great American Success Stories, told in one chart. (Note the y-axis is done with a semi-log scale.)

Chart #2

If the market were wildly optimistic about Apple, it would be tough to recommend the stock. But as the chart above shows, Apple's PE ratio has been below 20 for the past seven years, even as its stock price as more than quadrupled. As I've suggested in my prior posts, the market has consistently under-appreciated Apple's ability to grow. And that still looks to be the case, with the S&P 500 trading at a PE of just under 22 (using earnings from continuing operations), and Apple's PE trading at more than a 10% discount to that. If you adjust for the mountain of cash that Apple has sitting offshore, Apple's PE ratio is trading at almost a 25% discount to the broad market.

Chart #3

As the chart above shows, Apple's earnings haven't grown nearly as fast in recent years as its stock price. In the past 5 years, earnings per share have grown over 45%, while the stock price has more than doubled. The way I see it, the market has become a lot less pessimistic about Apple's prospects in the past 5 years, which is why Apple's PE ratio has increased from a meager 10 in early 2013. But the market is still cautious.

Chart #4

Is a $1 trillion capitalization reasonable? Apple is not outrageously priced compared to other companies, as Chart #4 shows. Microsoft today is only $250 billion behind Apple's current market cap, and most of what MSFT sells is software and services. This chart is a great David vs. Goliath story, with once-tiny Apple leapfrogging its gigantic former rival. 20 years ago the market thought MSFT would control the entire PC market within a few years. Today Apple has made tremendous gains, but they still don't have a majority of smartphone sales, nor a majority of PC sales. There's plenty of room for Apple to grow.

Chart #5

One final note: I could be wrong, but it strikes me that Apple has set an important precedent with the pricing of iPhone X. Prior to this, Apple (and most of its competitors) routinely brought out better, faster, and more capable products for the same price as what was being replaced; customers were thus getting more and more power and features for the same price. Now, for the first time, a hi-tech computer product has come out that is not only better but more expensive. Apple has demonstrated pricing power in an industry that has suffered from 20 years of deflation. You can see that in Chart #5 above.

The BLS uses what is called "hedonic pricing" to calculate that personal computer and peripherals have effectively fallen continuously over the past 20 years—if you get more of something for the same price as before, its price has effectively fallen. The index in the chart has fallen by more than 96% over the past 20 years. But it should also be apparent that the rate of decline has been slowing ever since the early 00s. In the initial heydays of PCs, prices fell 35% a year; then 20% per year; then 10% per year. In the past 12 months, prices have fallen by a mere 3.3%. The pricing and the success of the iPhone X may be among the first signs that in coming years you can expect to pay more in order to get more when it comes to computers.

Full disclosure: I am long AAPL at the time of this writing, and have no plans to sell in the near future.

Wednesday, November 15, 2017

The yield curve is not a red flag

In the past week or so I've see more and more people worrying about the flattening of the Treasury yield curve. I've also seen breathless stories about how the nation's malls are emptying, subprime auto loan defaults are surging, and student loans are defaulting. While these are all disturbing developments, a lot of other things will need to happen before the economy is at risk of falling into another recession. In that regard, I note that credit spreads are still relatively low, swap spreads are very low, real yields are very low, inflation and inflation expectations are right where they should be, and the financial system has tons of liquidity.

The following charts put some meat on my argument, and all contain the most up-to-date data available as of today.

Chart #1

The first chart sums it all up: it's Bloomberg's index of all the factors that contribute to financial market conditions. By this measure, financial conditions are about as good as they get. The following charts drill down into these factors to see how they stack up and what they mean.

Chart #2

The chart above is one of my favorites. It shows that two things have preceded every recession since 1960: real interest rates (blue line) have risen sharply, and the Treasury yield curve has gone flat or inverted (red line). That's another way of saying that the Fed has been the proximate cause of every recession in modern times. They have tightened monetary policy to such an extent that the economy just couldn't take it anymore. Until 2008, when Quantitative Easing started, the Fed tightened policy by withdrawing bank reserves from the financial system. Banks need reserves to back up their deposits, so when reserves become scarce they must pay more to get the reserves they need: this pushes up short-term interest rates. It also results in a general scarcity or shortage of liquidity. Rising rates and tighter liquidity conditions start eroding the economy's underpinnings. The economic and financial fundamentals deteriorate until people are forced to sell and panic ensues.

Chart #3

This time around, however, things are VERY different. Because of Quantitative Easing, the Fed can't tighten like they used to. They can't even begin to make bank reserves scarce enough to forces short-term rates higher. As Chart #3 shows, there are about $2 trillion of excess reserves in the system: way more than banks need to back up their deposits. The Fed gets around this by paying interest on reserves, which it never did before. In the old days banks always wanted to minimize their reserve holdings because they paid no interest. Nowadays banks don't worry so much, because reserves pay interest that is close to what T-bills pay; reserves are an asset today, whereas they were a deadweight loss before. By increasing the rate it pays on reserves, the Fed directly impacts all short-term interest rates without there being any shortage of liquidty.

So this tightening cycle that we are now in will be very different from past tightening cycles, because it will be a long time (years) before the banking system approaches the point at which bank reserves become scarce—the Fed is going to unwinding its balance very slowly. The Fed can "tighten" by raising short-term interest rates, but they can't create a shortage of liquidity like they did before. So it's not surprising that despite higher short-term interest rates and a flattening of the yield curve, there is as yet no sign that financial market conditions are deteriorating, as the following charts demonstrate.

Chart #4

Chart #4 shows the 40-year history of the Treasury yield curve. The bottom two lines show the yields on 2- and 10-yr Treasuries, while the top line (blue) shows the difference between the two (i.e., the slope of the yield curve). Here we see that flatter and inverted curves are always the result of short-term interest rates rising by more than long-term interest rates. That's the Fed in action. We also see that the yield curve can be fairly flat, as it is today, for many years before a recession hits (e.g., the mid-90s). To really squeeze the economy, you need not only a flat curve but much higher interest rates and a shortage of liquidity.

Chart #5

Chart #5 shows the real yield curve in action. Real yields are the true measure of how high or low interest rates are. A 10% yield in a 10% inflation environment is not a big deal, but a 10% yield in a 2% inflation environment is a killer. The blue line is the Fed's real short-term interest rate target. Currently it is about zero, or it will be next month, when the Fed will almost surely announce that the rate it pays on reserves will rise to 1.5%. That's just a tiny bit less than the underlying rate of inflation (1.6%), according to the PCE core deflator, which is the Fed's preferred measure of inflation. (PCE Core inflation is typically about 30 to 40 bps less than CPI inflation.)

As the chart also shows, the front end of the real yield curve is pretty flat. What that means is that the market doesn't expect the Fed to tighten much more after the December meeting. The 5-yr real yield on TIPS is effectively the markets' expectation for what the real Fed funds rate will average over the next 5 years. Note that prior to the last two recessions the real yield curve inverted: the blue line rose above the red line. That meant that the market expected the Fed to start lowering interest rates in the foreseeable future, because the market sensed that monetary conditions were beginning to undermine the economy's fundamentals. That's not the case today.

Chart #6

2-yr swap spreads are among my most favorite indicators, because they have been good leading indicators of economic conditions. In normal times, swap spreads are 10-30 basis points. Today they are 18 bps. Just about perfect. That means that liquidity is abundant and systemic risk is low. The financial markets are not worried at all about widespread defaults or a liquidity squeeze. The Fed hasn't tightened at all, by this measure.

Chart #7 

Chart #8

As charts 7 and 8 show, credit spreads are fairly low. Despite the news of defaults in certain sectors of the economy, investors by and large are not worried much about widespread defaults. This also tells us that the Fed hasn't really tightened at all. Corporations can borrow as much as they want without having to pay onerous interest rates.

Chart #9

Finally, Chart #9 shows that the market's expectation for consumer price inflation over the next 5 years is 1.85%, just a bit shy of the Fed's professed target of 2%. That's plenty good enough for government work, as they say. The Fed has delivered 2% CPI inflation (annualized) for the past 20 years, and the market fully expects more of the same. Nobody is worried that the Fed is going to have to tighten unexpectedly.

Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.

Monday, November 13, 2017

Delaying tax cuts is ballooning the deficit

Trust politicians to do the opposite of what they should do. The overriding problem that is keeping Congress from achieving true, growth-friendly tax reform is concern that lower tax rates would mean a larger budget deficit. Consequently, politicians are trying to "pay for" lowering some taxes by raising others and/or reducing allowable deductions. Instead, they should be focusing on the urgent need to cut taxes in order to reduce the deficit and strengthen the economy.

I discussed this in greater detail in a post last month (Not cutting tax rates is boosting the deficit). Here's the short version of the story: Since February 2016, when there first emerged a growing consensus that the corporate income tax rate was too high and needed to be cut, revenues from corporate and individual income taxes have flatlined, while federal spending has continued to increase. As a result, the deficit has jumped from $405 billion to $683 billion. The logical explanation for the huge shortfall in revenues (despite the fact that tax rates have not fallen and income and profits have continued to increase at healthy rates) is that people and companies have been actively engaged in minimizing their tax liabilities by deferring income, not realizing capital gains, postponing investments, and accelerating deductions. Why? Because there is a reasonable chance that by doing so they will be able to take advantage of lower tax rates in the future. By inference, this strongly suggests that if Congress manages to cut tax rates, then federal revenues will surge and the deficit will decline, and the economy will benefit from increased investment, spurred by lower corporate income tax rates and increased business investment.

Here are some updated charts which fill in the story:

Chart #1

Spending has been rising at a 4-5% annual rate for the past several years. Revenues, however, have gone flat since Feb. 2016. This is notable, because since then, personal incomes and corporate profits have continued to rise, and there has been no cut in anyone's tax rate. A static forecasting model would have projected continued increases in income tax revenues.

Chart #2

The revenue shortfall can be traced to the individual and corporate income taxes. Together, these two important sources of federal revenue have been flat to slightly down since Feb. 2016. Meanwhile, payroll taxes have been increasing at a steady 5% annual rate, which is exactly in line with wages, incomes, and higher contribution limits. Payroll taxes are very difficult to avoid or postpone.

Chart #3

Chart #4

As a percent of GDP, federal spending and revenues are not terribly out of line with historical norms, as Chart #3 suggests. As Chart #4 shows, the federal budget deficit is not out of the range of what we experienced from the mid-70s to the mid-80s.

Chart #5 

In nominal dollar terms, today's budget deficit has grown from $405 billion in the 12 months ended Feb. 2016 to $683 billion in the 12 months ended Oct. 2017. That's an increase of $278 billion, or 68%. At this rate it is going to be a problem fairly soon. Bear in mind, however, that the main driver of the increase in the deficit is the unusually slow growth (especially given that the economy has been growing) in corporate and individual income tax revenues. This could improve quite rapidly if tax rates on corporate and individual incomes are reduced in a meaningful fashion.

People and businesses respond to incentives; that is at the heart of all economic analysis (or at least it should be, but the CBO unfortunately refuses to believe it). Since the chances of lower tax rates are appreciably greater than zero, people and businesses have an incentive to minimize their tax liabilities, and the unusually slow growth of federal revenues supports this thesis. If Congress keeps dragging its feet on this issue, or if a cut in corporate taxes is postponed until 2019 (as the Senate is stupidly proposing), then the deficit is going to get worse, investments are going to be postponed, and the economy is likely to weaken.

The weakness in federal revenues is also a good indication that tax rates on businesses and individuals are too high. The fact that US corporations have avoided repatriating as much as $3 trillion in overseas profits is very strong evidence that corporate income taxes are too high. As my mentor Art Laffer taught me, tax rates that affect behavior in inefficient and uneconomic ways are by definition too high. The best tax rate is the one that people are content to pay, and are least likely to avoid paying. We all know that taxes are a fact of life. But when the marginal rate on corporate profits is 35-40%, and the marginal rate on individual income is 50-65% (as is the case today, including state taxes), taxes are obviously too high, because evasion is high (because the rewards to tax evasion are huge), and revenues are low.