Tuesday, January 21, 2020

Truck tonnage update

Over the years I've had numerous posts featuring Truck Tonnage, as calculated by the American Trucking Association. I've used it as a proxy for the physical size of the economy, and over time it's had an amazing ability to track the rise in equity prices. Unfortunately, over the past year it's also been unusually volatile, and this has detracted from its reliability. To correct for what I surmise is faulty seasonal adjustment in the series, of late I've used a 3-month moving average. The December datapoint was released today, so I have updated my chart and included a chart of the raw data.

Chart #1

Chart #1 shows the raw data as released by the ATA (white line), and its 3-mo. moving average (magenta). Note the unusual volatility this past year. The rise in truck tonnage has been muted over the past year, and at best is suggestive of a deceleration in economic growth (and at worst an indication of a stagnant economy in 2019). That's not a great revelation, however, since we've had plenty of evidence that the economy—especially manufacturing activity—was negatively impacted by Trump's tariff wars.

Chart #2

Chart #2 compares the 3-mo. moving average of Truck Tonnage with the S&P 500 index. For most of last year, truck tonnage was suggesting that the equity market was overly cautious given continuing growth in trucking activity. For now, it would appear that the equity market has "caught up" with truck tonnage. Unless and until trucking activity picks up, the chart now suggests that the upward momentum of equity prices is likely to fade.

UPDATE: Today also saw the release of another timely indicator of economic activity: the Chemical Activity Barometer (for an earlier post on this subject see here). After being relatively flat for the previous 18 months, it turned up convincingly in January (see Chart #3). An increase like this suggests that industrial production—which was flat to down last year—will begin to rise in coming months (see Chart #4).

Chart #3

Chart #4

Friday, January 17, 2020

Green shoots the bond market is ignoring

So much winning! Global equity markets are pushing higher, and many are at all-time highs. Chinese equities and the yuan are perking up. The threat of tariff wars is receding. Industrial commodity prices are turning up. Housing starts in the US are soaring. Consumer confidence is high. Financial market fundamentals are very strong.

So why are yields on Treasuries so low? Why are real yields on 5- and 10-yr TIPS near zero?

The following charts flesh out the details and speculate on what is driving this amazing apparent divergence between stocks and bonds.

Chart #1

As Chart #1 shows, US stocks have outpaced Eurozone stocks by roughly 85% since the bear market ended in March 2009. Moreover, Eurozone stocks until recently had failed to advance for almost 5 years. News last month of a trade deal with China pushed both markets to new high ground.

Chart #2

As Chart #2 shows, the US market has been outpacing Chinese equities for years. News last month of a trade deal added over 10% to the market value of Chinese equities while also boosting US equities.

Chart #3

As Chart #3 shows, the Chinese yuan has risen almost 5% since last September, when rumors of a trade deal first surfaced. The chart also tells us that the Chinese central bank is not trying to control or defend its currency by buying or selling its foreign exchange reserves. Sentiment and capital flows are therefore the key to the yuan's value, so the fact that it has risen in recent months is proof that the trade deal is a positive for China. Rising equity markets worldwide say that the trade deal is good for just about everyone, for that matter. What's good for China is good for everyone, since it means more trade and more prosperity.

Chart #4

That's a very good thing, since world trade has been stagnant ever since Trump's trade wars started in early 2018, as Chart #4 shows. We should soon be seeing a pickup in global trade and global industrial production, both of which have been stagnant or weak for some time now.

Chart #5

Industrial commodity prices, shown in Chart #5, have jumped 7.5% since news of the trade deal broke. This is likely due at least in part to the market's expectation that world trade and manufacturing activity will revive shortly. It is also good news for emerging markets, since they are very dependent on sales of commodities.

Chart #6

December housing starts blew past expectations (1608K vs 1380K), as was foreshadowed by a surge in the homebuilders' sentiment index, as shown in Chart #6. The US housing market looks to be on solid and fertile ground, and that all but precludes a recession for the foreseeable future. Indeed, this could be a precursor to a broader pickup in the US economy, which has been growing only modestly this past year.

Chart #7

Chart #7, Bloomberg"s Consumer Comfort index, recently reattained the high-water mark it set in the boom years of the last 1990s. 

Chart #8

Incomes are rising, jobs are growing, and fewer and fewer people are getting laid off. In fact, as Chart #8 shows, the number of initial unemployment claims as a percent of the workforce is at an all-time low. That spells "job security" and all these things are boosting confidence. 

In addition to the above economic "green shoots," key financial market indicators tell us that liquidity is abundant, the Fed is non-threatening, and the bond market has confidence in the outlook for corporate profits. What's not to like?

Chart #9

2-yr swap spreads, shown in Chart #9, are excellent leading and coincident indicators of financial market and economic health. Swap spreads both here and in the Eurozone are low, and that in turn suggests that liquidity conditions are excellent, systemic risk is low, and the outlook for economic growth is therefore positive. 

Chart #10

Chart #10 shows 5-yr Credit Default Swap spreads, which are a very liquid measure of generic corporate credit risk and a excellent indication of the market's confidence in the outlook for corporate profits. Spreads today are very low; in fact, things haven't been this good for a long time.

Chart #11

Chart #11 shows actual corporate credit spreads by credit quality for the past 24 years, and they confirm the message of Chart #10. The private sector of the US economy is in great shape.

Chart #12

Chart #12 is the best way to track the stance of the Federal Reserve's monetary policy. It strongly suggests that two things the Fed has a lot of influence over—the shape of the yield curve and the level of real short-term yields—have consistently preceded every recession in the past 60 years. An inverted yield curve and high real yields are what crush economic activity. Today, however, the yield curve is upward-sloping and real yields are zero. Fed policy is thus absolutely non-threatening. Liquidity is not being restricted, and borrowing costs are low. Inflation is also low. It's monetary nirvana.

So with all this good news, why are Treasury yields so low?

Chart #13

As Chart #13 shows, 10-yr Treasury yields today (1.8%) are just half a point above their all-time lows of 1.3%. Not only that, but 10-yr Treasury yields today are below the level of consumer price inflation, which has been averaging 2% or a bit more for the past three years. Whatever is going on, the world is paying very high prices for the safety of Treasuries. At the very least that is a good indicator that the bond market is not overly confident about the outlook for the future.

Chart #14

Chart #14 compares the 2-yr annualized rate of growth of GDP (which gives us a sense for what the market believes is the prevailing rate of growth) to the real yield on 5-yr TIPS (which is an excellent proxy for the prevailing level of real yields as well as the market's expectation for the effective stance of Fed policy over the next five years). Two things to note: real yields tend to track GDP growth rates, and the current level of real yields suggests the market is not expecting any meaningful pickup in US growth—nor any meaningful change in the Fed's current accommodative monetary posture—for the foreseeable future. Indeed, it wouldn't be hard to look at this chart and conclude that the bond market is expecting growth to slow down further.

Chart #15

Chart #15 shows the equity risk premium, which is the difference between the earnings yield on stocks (i.e., the inverse of the PE ratio) and the yield on 10-yr Treasuries (the world's proxy for long-term safety). That's the yield premium the market demands for taking on the risk of equities. That premium today is about 2.7%, and that's quite a bit above the average of the past 60 years. I take that as a sign that the stock market is still very cautious, as is the bond market. Which goes directly against the message of credit spreads, which are very tight and thus reflective of optimism. 

Chart #16

According to Bloomberg, the current PE ratio of the S&P 500 (which is calculated using profits from ongoing operations) is a bit over 22. For the past 60 years it has averaged about 17. Chart #16 is based on a different calculation of corporate profits, since it uses corporate profits economy-wide, which is drawn from the National Income and Products Accounts. Nevertheless, it gives about the same answer: PE ratios are above-average, but still well below levels that later proved to be excessive valuations (e.g., 1961-62 and 2000). In other words, relative to the prevailing level of Treasury yields, current PE ratios look fairly attractive from a historical perspective.

Chart #17

I'll close with Chart #17, which compares the ratio of copper to gold prices (blue) to the level of 10-yr Treasury yields (red). Over the past decade, these two utterly distinct variables have shown a remarkable tendency to move together. The rationale for that is that the ratio of copper to gold prices is a proxy for changes in global economic growth conditions: stronger growth creates more demand for copper, while at the same time reducing demand for gold, and vice versa.. The recent uptick may be a precursor of more to come. If global growth picks up as many of the above charts suggest, then the copper/gold ratio should rise, and 10-yr Treasury yields should rise as well.

Bond investors would be well-advised to buckle their seat belts in preparation for a descent to lower bond prices. Stock investors who fret that an equity bubble may be forming should be braced for a bumpy ride higher.

Sunday, January 5, 2020

Federal debt is not a threat to the economy

Many people are saying that our national debt—which now exceeds $17 trillion and is growing by more than $1 trillion per year—is a disaster just waiting to happen. Right? Well, not exactly. Even though federal debt has soared relative to GDP in the past decade, the burden of the debt is about as low as it's ever been. Still, the growth in debt does reflect some structural problems that are working to keep the economy from achieving its full potential.

Let me put things into perspective:

Chart #1

Chart #1 shows the the swelling size of our national debt, which is correctly measured as the amount of Treasury debt that is held by the public, and that now stands at $17.16 trillion. Too often I see people saying the national debt is over $23 trillion, but that figure is inflated since it includes some $6 trillion which the government owes to itself (i.e., excess revenues that the social security administration has "lent" to the Treasury). You can see the current figures here.

Chart #1 uses a semi-log scale for the y-axis, so that means that a constant slope is equal to a constant rate of growth in nominal terms. Note that the slope of the line for the past 7-8 years has been flat (i.e., the growth rate has been constant). Note also that the slope was steeper in the mid-80s and in the 2008-2012 period. Federal debt is growing, but not nearly as fast as it was growing in other times.

Chart #2

It's common to hear people argue that with so much debt being issued, interest rates will inevitably have to rise. But as Chart #2 shows, the size of the debt (when measured relative to the size of the economy, which is essential, since a bigger economy can support a bigger debt load, just as households can with rising incomes) has tended to move in a very counterintuitive fashion with respect to interest rates. Slower growth in debt tends to coincide with rising interest rates, and faster growth in debt tends to coincide with falling interest rates. What explains this? It's tempting to search for an explanation for this relationship, and I make an attempt later in this post.

Chart #3

Nevertheless, the size of federal debt relative to the economy is far less important than the prevailing level of interest rates, as Chart #3 demonstrates. The true burden of the national debt is not the amount we owe but the ratio of interest payments on the debt relative to our national income (GDP). Because interest rates are at historically low levels, the current burden of our national debt is about as low as it has ever been, even though the debt has soared to 78% of GDP. 

Chart #4

It's worth noting that households' debt burdens (Chart #4) are also about as low as they have ever been. Everyone benefits from lower rates, but in addition, households have eschewed debt while embracing the safety of Treasuries. Total household liabilities have only increased by 11% since their peak in 2008, according to the Fed. Treasury yields are low because the demand for Treasuries is strong: households now hold over $2 trillion of federal debt, up hugely from $300 billion in 2008. Most of the rest is held by corporate and institutional investors, sovereigns, and foreign investors in general. China alone holds some $2 trillion of Treasury debt.

Chart #5

Chart #5 shows why we have come to have a $17 trillion debt. It's simple: government spending has exceeded revenues for just about forever. Note how revenues reliably weaken during recessions and pick up during recoveries. A stronger economy creates jobs, rising incomes, and rising tax payments. Tax receipts thus have a strong cyclical component. One reason for the apparent shortfall in revenues—which began at least a year before Trump's tax cuts—is that the past decade has seen the weakest growth of any expansion in history. 

Chart #6

Spending, on the other hand, is driven largely by transfer payments (medicare, medicaid, social security and income security), which now constitute about 70% of all federal spending (see Chart #6). In the 12 months ended last November, transfer payments totaled $3.2 trillion, while total federal spending totaled $4.5 trillion. No amount of budget cutting is going to make more than a modest dent to federal spending. The elephant in the spending living room is transfer payments, which are paid out according to people's "eligibility," and not according to any Congressional budget appropriations. To control spending will require that Congress change the eligibility formulas for things like social security and medicare. 

Chart #7

Chart #7 shows federal spending and revenues as a % of GDP. Here we see that the trends are relatively flat, and the current levels of spending and revenues are not greatly different from what they have averaged since WW II. Revenues do look a bit weak currently, but this is most likely due to the fact that economic growth in the current expansion has been sub-par (2.2% vs. a long-term average of about 3.1%). Revenues haven't picked up much in the current recovery because it has been a weak recovery and because tax rates were cut modestly for individuals and significantly for corporations in 2017. But tax cuts aren't the whole story: revenues weakened at least a year before Trump's tax cuts took effect, and in the past year revenues have been rising at more than a 4% rate. Corporate tax revenues plunged in 2017 and 2018, as expected, but in the first 11 months of 2019 they are up over 10% from the same period in 2018. The Trump tax cuts were a one-time event which was expected to result in much lower corporate revenues initially, to be followed by rising revenues in years to come as overseas profits are repatriated and increased business investment (of which there are few signs to date, unfortunately) results in rising profits in the future.

A digression on debt:

Broadly speaking, debt is a zero-sum game, since one man’s debt is another man’s asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. If the borrower fails to repay his debt (i.e., he defaults), then the borrower benefits by being relieved of some or all of his debt service obligations, and the lender suffers by not receiving some or all of his expected cash flows. Part of the interest the lender charges the borrower goes to offset the risk of default. Most of the time, debt serves a vital economic function by linking savers with borrowers.

Ideally, the lender expects the borrower to use his money to fund a productive investment, such that the return on the investment will exceed the interest on the debt. If all the money loaned to borrowers is invested productively, everyone is happy—borrowers make money and lenders get repaid with interest. The problems with debt come not when people borrow money but when they use borrowed money to make unproductive investments or to simply finance consumption. (It's not the debt, it's the spending, stupid!) It's not clear at all whether using 70% of federal government borrowings to fund transfer payments is a wise use of borrowed money. Taking money from those who are working and giving it to those who are not working creates unproductive and anti-growth incentives. 

So it's not crazy to think that much of the federal government's debt has been used unproductively, and this is one reason why our economy's growth rate over the past decade has been sub-par. We've been squandering scarce resources (capital) and creating perverse anti-growth incentives. The potential size of this problem is staggering. In the past decade, after-tax corporate profits have totaled about $16.5 trillion, while federal debt has increased by about $9.4 trillion. In a sense, over half of the profits generated by corporate America have effectively been used to finance federal government spending. If the government hadn't borrowed all that money, it might have been used more efficiently by the private sector. Efficient investment, of course, boosts jobs, incomes, and overall prosperity. Inefficient investment leads to stagnation.

Meanwhile, slow growth has made people more cautious and that has increased the demand for money and people's demand for safety—thus the ready absorption of over $9 trillion of Treasury securities at very low interest rates. The Federal Reserve justifiably has accommodated the increased demand for money and safety by reducing interest rates. So in the current environment, slow growth and low interest rates go hand in hand, and the same conditions that drive low interest rates make lots of debt manageable. 

What will happen going forward? If the economy picks up steam, and if tariff wars begin to unwind (as appears to be the case), then money demand should decline, caution should recede, and interest rates should therefore rise. At the same time, a stronger economy would likely result in a further pickup in revenues, a smaller deficit, and slower growth in federal debt. So rising interest rates should go hand in hand with slower growth in total debt even as the burden of debt would tend to rise because of higher interest rates. This is not a recipe for disaster—it's a rosy scenario that we should dearly hope develops!

Chart #8

Meanwhile, nominal and real interest rates are unusually low, which means that the bond market does not yet expect to see accelerating economic growth. In fact, as Chart #8 suggests, the market seems priced to a further slowdown in growth; real interest rates on 5-yr TIPS moved into negative territory this week for the first time since April 2017. 

This market is not overly enthusiastic about the future, which gives me comfort that an optimistic approach to risk should be rewarded.

Things to watch for going forward; Real interest rates on TIPS are key barometers of the bond market's expectations for economic growth in the years ahead. If they rise this would be a good sign. Swap spreads are key indicators of the health of financial markets and leading indicators of economic health; right now they are very low and that is very good. Any rise above 30-35 bps on 2-yr swap spreads would be a flashing yellow light. Credit spreads on corporate debt are key indicators of the market's confidence in the outlook for corporate profits; currently they are relatively low and that is good. Commodity prices have been relatively low, but recently they show signs of perking up; if this continues that could be an indicator that the global economic outlook is improving. The residential construction has been in a period of consolidation in the past year or so, but recently appears to be picking up, and that is good. Any slowdown in the growth of bank savings deposits would be a good sign that risk aversion is declining and optimism is rising, and that would be very good. 

Looking ahead, I'm optimistic that the economy will continue to grow. I don't see a risk of recession nor do I see any significant acceleration. I'll be watching the aforementioned indicators to see if things improve enough to get really excited.