Wednesday, October 22, 2014

Robust construction and CRE conditions

Surely this news is not widely appreciated:


According to the American Institute of Architects (AIA), their September billings index "shows robust conditions ahead for [the] construction industry." The billings index, shown in the chart above, is registering new highs for the current business cycle. Furthermore, "the recently resurgent Institutional sector is leading to broader growth for the entire construction industry.”


According to the CoStar Group, "demand [for commercial property] continues to outstrip supply across major property types, resulting in tighter vacancy rates and continued investor interest in commercial real estate." Furthermore, "price gains in [their] equal-weighted U.S. Composite Index, which is influenced more by smaller non-core deals, accelerated to an annual rate of 13.6% in August 2014." And, "rising occupancies have bolstered net operating income across a number of markets."

The outlook for the construction and commercial real estate (CRE) sectors of the economy hasn't been this strong for many years.

This lends support to my belief that the U.S. economy is doing better than most people realize or expected. That's been the case for this entire business cycle. That's why the equity market has been moving higher even though this has been the weakest recovery in history.

Tuesday, October 21, 2014

How China could explain the decline in gold

In January, 2013, I wrote a post titled "Developments in China explain the end of gold's rise." I speculated that China's spectacular growth over the previous two decades, which included a monster accumulation of foreign exchange reserves and a significant appreciation of the yuan, could have been the driver for the the incredible rise in gold prices. I then noted the slowing in China's accumulation of forex reserves, the slowing in Chinese economic growth, and the beginnings of stabilization of its currency, and asserted that "the boom in gold is over." Shortly thereafter gold suffered a significant decline which I followed up on in a post in April, 2013: "Gold is relinking to commodities."

Here's the short version of how the link between China and gold works: the outstanding stock of gold doesn't change very fast, growing only about 3% a year. But the spectacular growth of the Chinese economy beginning in the mid-1990s created legions of newly prosperous Chinese whose demand for gold pushed gold prices to stratospheric levels. China's economic boom attracted trillions of foreign investment capital, which China's central bank was forced to purchase in order to avoid a dramatic appreciation of the yuan, and to provide solid collateral backing to the soaring money supply needed to accommodate China's spectacular growth. China's explosive growth and new-found riches were what fueled the rise in gold prices. But in recent years the bloom is off the rose.

I think these same dynamics are still in play. Chinese economic growth has definitely slowed, China's forex reserves only increased by 6% in the year ending September, the yuan is unchanged over the past year, and gold prices are down by one-third from their 2011 peak. Here are some updated charts to illustrate what's going on.


China's economy is no longer booming, but 7% growth still ranks as very impressive. China's economy is not collapsing, it's maturing. Even 7% growth is unsustainable for long periods. We ought to expect further slowing in the years to come.


The growth in China's foreign exchange reserves was exponential for many years, but now it's slowed to a trickle. Capital inflows (money wanting to invest in the China boom) have slowed, while outflows (money looking for diversification overseas and money to pay for China's growing appetite for foreign goods and services) have picked up, and the two are coming into balance. That means the BoC doesn't have to buy up capital inflows to keep the currency from appreciating. The yuan is likely to be much more stable going forward.


As it is, the real value of the yuan has appreciated by an astounding 83% in the past 20 years, despite the valiant attempts by the BoC to prevent excessive appreciation. Slower growth and more balanced capital flows mean there is no more need for currency appreciation.


A strong currency and a strong economy have enabled China to enjoy a low rate of inflation for the past 15 years or so. Happily, inflation in the U.S. and China has converged. China's economy has accommodated to its strong currency, and capital flows are coming into balance. On a PPP basis, there is very little pressure for the yuan to keep appreciating.


The spectacular rise in China's forex reserves paralleled the outsized growth of its economy and mirrored the equally spectacular rise in the price of gold. Lots of newly rich Chinese (and Indians, for that matter) were eager to acquire gold for the first time, but that demand appears now to be largely sated.


Gold is still trading well above its long-term average in real terms (I calculated that the average price of gold over the past century in today's dollars is about $650/oz.), so without the onslaught of newly rich Asian buyers its price is coming back down to more closely track those of other commodity prices.

I continue to believe that the downside risks to owning gold are much greater than the upside risks, even though I worry that central banks may inadvertently spark a round of higher inflation in the years to come (as I explained in yesterday's post). If I had to reconcile those two views, I would say that today's elevated real price of gold has effectively priced in a lot of higher inflation in the future.

Monday, October 20, 2014

Reading the bond market tea leaves

Nominal 10-yr Treasury yields have fallen from 2.6% in mid-September to as low as 1.9% last week, followed by a rise to today's 2.2%. The decline mainly reflects a moderation of inflation expectations which in turn are being driven by a 20+% decline in oil prices since June. Real yields on 5-yr TIPS—which I believe closely track the market's real GDP expectations—have gyrated in the past month or so because the bond market has been worried about the "contagion" risk that the U.S. economy faces because of slower growth in the Eurozone and Asian economies, and a "Black Swan" outbreak of Ebola. These fears have subsided of late, mainly because of no new cases of Ebola.


The chart above shows the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, and the difference between the two, which is the bond market's implied inflation expectation for the next five years. The bond market's current expectation for the average change in the CPI over the next five years is 1.6%, which is somewhat lower than the 1.9% long-term average 5-year inflation expectation since TIPS were introduced in 1997. But it's not even close to the deflation expectations that gripped the market towards the end of 2007. Inflation expectations are down because oil prices are down over 20% in the past three months. That has already resulted in a slowing in headline consumer price inflation: the CPI rose at an annualized rate of only 0.6% over the past three months. Meanwhile the core CPI is running just under 2%.


As the bond market sees it, inflation is going to be a little lower in the next few years than it has been in the past few years, thanks to lower energy prices. But over the next 10 years, as the chart above shows, the bond market is expecting the CPI to average 1.9%. That's somewhat lower than the 2.3% annualized rate of CPI inflation over the past 10 years, but it hardly smacks of deflation fears. We've seen levels this many times in the past. Inflation expectations appear to be "well anchored."


The chart above shows the 5-yr, 5-yr forward measure of bond market inflation expectations (i.e., what the market believes inflation will average from 2019 through 2024), which is currently about 2.3%. Note again the absence of anything suggesting deflation. This expectation is fully in line with historical experience.

Putting this all together, we find that the bond market is expecting inflation to be a little below 2% for the next several years, followed by a modest pickup to just over 2% in subsequent years. On average, the bond market sees inflation in the next 10 years being only moderately less than it has been in the past 10 years. There's nothing unusual about any of this.

What is unusual is the bond market's apparent conviction that the massive expansion of the Fed's balance sheet, which has resulted in the creation of $2.7 trillion of excess reserves in the banking system, will not result in any unusual increase in inflation. It's hard to argue with the market, but at the same time it requires a leap of faith of sorts to believe that banks will not want to greatly increase their lending activities to take better advantage of their huge holdings of excess reserves, which currently pay only 0.25% (and by so doing, create an excess of money relative to the demand for it—the classical source of higher inflation). It's theoretically possible for the Fed to increase the interest rate it pays on reserves by enough to keep banks content with holding $2.7 trillion of idle reserves, but we're all in uncharted waters on this subject.

One reason the bond market does not find it difficult to ignore the risk of rising inflation is the chronic weakness of the U.S. economy. This remains by far the weakest recovery ever. Weak growth has been strongly associated with low inflation risk ever since the invention of the Phillips Curve, which postulated that inflation was a by-product of strong resource utilization, particularly labor. High unemployment, a hallmark of recessions and weak economies, was thought to lead to low inflation, and vice versa. The Fed repeats this mantra all the time: the economy is likely to continue to have lots of slack, and that will keep downward pressure on inflation, so they probably won't have to raise rates much for a very long time.

I've preferred to view the absence of inflation as a phenomenon associated with strong risk aversion—not weak growth. Banks—and most everyone in fact— have been extremely risk averse in the current recovery. The demand for money and safe assets like bank reserves has been very strong. Banks have thus been content to accumulate excess reserves, and businesses and consumers have preferred to deleverage rather than leverage up, and banks have taken in mountains of savings deposits. But risk aversion is on the decline, and bank lending is picking up on the margin.


Confidence is picking up, but it is still well below its former peak, as the chart above shows. But if confidence continues to build, then the dynamics of the bond market and inflation could change meaningfully. Banks would feel more comfortable lending, and businesses and consumers more comfortable borrowing. Businesses might feel more comfortable expanding too. All of this would be consistent with a decline in the demand for money and safe assets at the same time as bank lending and the amount of money in the economy increase. That is how we could get to higher inflation: it only takes a return of confidence.


And confidence might turn more positive before too long. Republicans look set to take control of the Senate in a few weeks, according to the latest pricing in the Iowa Electronic Markets. As the chart above shows, the probability that Democrats lose control of the Senate has risen to 92%. It's not unreasonable to think that Congress will attempt to pass more business- and growth-friendly legislation before too long (e.g., lower and flatter tax rates for corporations, scaling back Dodd-Frank, lower marginal tax rates for individuals in exchange for fewer deductions, and market-style reforms to Obamacare). Would Obama want to take a strong stand and veto everything, even as his popularity has collapsed and faced with yet another big electoral defeat for his party? Would Democrats refuse to override his veto considering so many of them these days are trying to distance themselves from his growing list of failures? I doubt it. A friendlier tailwind from Washington would reinforce the trend to rising confidence and could push economic growth up a notch or two.

It could also push inflation higher as well, if the Fed waits too long to ratchet up short-term interest rates. Start worrying if the mood of the country improves and the Fed is slow to react.