Friday, July 31, 2009
The GDP statistics out today contained extensive revisions to previously-released data, but nothing to suggest that the recession didn't end a month or so ago. As the first chart shows, the speed of decline moderated significantly in the second quarter. As the second chart shows, money velocity (defined as nominal GDP divided by M2) has all but stabilized, dropping only 0.4% in the second quarter. In short, the economy has all but completed its healing process. Money that was hoarded is now slowly being released.
The main drags on the economy over the past several quarters have been 1) weakness in business investment (nonresidential construction and capital spending) and 2) a decline in inventories. Going forward, the economy is going to have strong tailwinds at its back, as inventory reduction slows, net exports continue to improve, and velocity starts to rise. Positive growth in the current quarter is now very likely.
The stock market began to sense all this back in March. Back in early March the market was priced to the expectation that the economy was going to fall off a cliff, with massive bankruptcies, deflation, depression and widespread unemployment sweeping the country and the world. With the economy now having recovered its balance, the market has been forced to reprice for a less dismal outlook.
Thursday, July 30, 2009
Measured in dollars, the Brazilian stock market is up 130% from its low of late last year, with a stronger real contributing almost one fourth of the gain. This is an undeniable green shoot. Brazil is rebounding on a number of fronts, enjoying the benefits of rebounding commodity prices, rebounding global growth, rebounding consumption, a strong currency, and relatively stable politics. What's good for Brazil is good for the global economy, even ours. There is some powerful momentum here, and good fundamentals to go with it.
Full disclosure: I am long SLAFX and EMD at the time of this writing.
The runup in almost all commodity prices this year is widely dismissed with the argument that it's all due to mindless, government-mandated, stimulus-funded stockpiling of commodities by the Chinese, so prices will sooner or later fall. To be sure, there are numerous reports of Chinese stockpiling of things like copper. But look at the rebound in the prices of miscellaneous commodities such as hides, rubber, tallow, plywood and red oak. This index, a subset of the broader JOC index, is up 37% from its low, and the broader index is also up 37% from its low. I find it very difficult to believe, as I've said before, that the rise in commodity prices is all due to the Chinese. Can they be stockpiling almost every commodity on the planet? I think the simplest explanation is probably the correct one: commodity prices are up because global demand is rebounding and central banks are very accommodative.
The claims data released today are free of the seasonal adjustment problem caused by the earlier-than-expected automaker layoffs. As expected, claims rose. But the trajectory for claims is still downwards. As this chart shows, the 4-week moving average of claims is up only slightly from what it was six months ago, and that was well before the peak in claims that came at the end of March. The labor market is still distressed, but a lot less than before. We're making slow progress, but it's still progress.
Wednesday, July 29, 2009
The data from 2007 has just come out, but the story hasn't changed much. Bottom line: the rich pay the vast majority of taxes. The top 1% of income earners in 2007 paid about 40% of all federal income taxes. The top 5% paid about 60% of all federal income taxes, and the top 10% paid 70%.
Note that while the top income tax rate has dropped by half since 1980, the share of taxes paid by the richest 1% of Americans has doubled. This sums up the power of the Laffer Curve very powerfully.
As Mark Perry points out, the top 1% of income earners now pay more tax than the bottom 95%!
As the Tax Foundation points out, "We are definitely overdue for some honesty in the debate over the progressivity of the nation's tax burden before lawmakers enact any new taxes to pay for expanded health care."
California's fiscal problems stem directly from the fact that its tax structure relies heavily on the rich to foot the bills. That's fine when the economy is strong, but whenever we hit the inevitable recession or slowdown, that causes tremendous fiscal dislocations. The federal government relies very heavily on the financial health of the upper crust of society, something that is not necessarily healthy nor prudent nor fair. Imposing even greater tax burdens on this golden-egg-laying-goose to pay for a fantasy healthcare scheme is not a good idea.
Another quick update to this series of posts. Credit spreads continue to narrow. Very good news, since it means that default risk is falling, and that is because the outlook for the economy is brightening. A recovering economy and accommodative monetary policy add up to a wonderful tonic for corporate bond investors.
Note that the gap between junk spreads and investment grade spreads (second chart) has fallen by more than half since early March, which not coincidentally was the bottom of the equity market. The stock and corporate bond markets are saying exactly the same thing: this recovery in the prices of risky assets is the real thing. This sort of price action is highly significant and won't be easily derailed. Why? Because the financial crisis of last year was fundamentally a crisis of confidence, an extreme fear of counterparty risk; the dramatic narrowing of credit spreads is the best sign yet that this crisis of confidence has passed. As a result, all the money that went into hiding during the crisis is now returning to the light of day. Money velocity is picking up, and that in turn is lifting the economy. It's a virtuous cycle.
Full disclosure: I am long equities, investment grade bonds, high yield bonds and emerging market bonds via a variety of vehicles at the time of this writing.
Thousand-page bills, unread and indeed unwritten at the time of passage, are the death of representative government. They also provide a clue as to why, in a country this large, national government should be minimal and constrained. Even if you doubled or trebled the size of the legislature, the Conyers conundrum would still hold: No individual can read these bills and understand what he's voting on. That's why the bulk of these responsibilities should be left to states and subsidiary jurisdictions, which can legislate on such matters at readable length and in comprehensible language.
As a corollary to this, where in the Constitution does the federal government derive the authority to legislate a healthcare mandate?
None of this is very surprising given the general disdain with which business investment is viewed in Washington. The biggest incentive that business has to ramp up investment spending today is that corporate income taxes and taxes on capital in general (e.g., dividend income and capital gains taxes) could be significantly higher in the future (i.e., invest and produce quickly before things get worse). But that is hardly the thing of which big recoveries are made.
Still, as the chart shows, a big increase in capital spending is not a necessary condition for a recovery. The economy rebounded strongly in the second half of 2003, yet capital spending had not increased meaningfully by that time. So I'll stick with the "glass half-full" interpretation here, and say it's a good thing that conditions are stabilizing instead of declining.
Tuesday, July 28, 2009
The index of housing prices calculated by the folks at Case-Shiller has been the only index that has registered significant price declines in recent years. It's not based on a nationwide average of housing prices, however; instead it focus on 20 major metropolitan markets, and those are the markets where apparently prices have fallen the most. Regardless, the index has now registered hardly any decline at all in the past three months, and actually increased 0.5% in May. This might be the first clear sign that we are at or very near the bottom in housing prices. As the chart also shows, prices in inflation-adjusted terms have dropped 36% from their peak—certainly enough to change the dynamics of the housing market going forward.
Venezuela is known to produce some of the best quality Arabica coffee anywhere and, unlike many countries in the region, traditionally consumed most of it itself.And Venezuela's oil industry is suffering also, in addition to the whole country suffering from an exodus of the country's best and brightest:
But more recently large quantities of coffee have been smuggled across the border to Colombia, where prices have been more than double the fixed 470 Bolivares ($218) per bag that producers are paid in Venezuela.
On-and-off food shortages for years have dogged the government of President Hugo Chavez, a former paratrooper who has nationalized several industries and expropriated land as part of his socialist revolution.
Critics point the finger at price and foreign exchange controls that have slowed investments in expansion and maintenance and eroded productivity.
Producers say rising costs and prices fixed by the government have caused production to fall and illegal exports to rise.
It is a real shame that President Obama thinks so highly of Chavez, and so little of the free market. Fred Barnes notes that "the president talks as if free market solutions are nonexistent, and in his mind they may be. Three weeks after taking office, he said only government "has the resources to jolt our economy back into life." He hasn't retreated, in words or policies, from that view."
Artists, lawyers, physicians, managers, and engineers are leaving the country in droves. An estimated 1 million Venezuelans have moved away since Chávez took power, and a study by the Latin American Economic System ... reports that the outflow of highly skilled labor from Venezuela ... rose 216 percent between 1990 and 2007.
The exodus is sabotaging the country’s future, and no industry has been harder hit than Venezuela’s oil sector. A decade ago, Petróleos de Venezuela ranked as one of the top five energy companies in the world. Then Chávez named a Marxist university professor with no experience in the industry to head the company. PDVSA’s top staff immediately went on strike and paralyzed the country. Chávez responded by firing 22,000 people practically overnight, including the country’s leading oil experts. As many as 4,000 of PDVSA’s elite staff are now working overseas, and the talent deficit has crippled the company: PDVSA produced 3.2 million barrels of crude oil a day when Chávez took control, but now pumps only 2.4 million, according to independent estimates.
HT: Mark Perry, Ramiro
The rebound in industrial metals (and most commodities, for that matter) is impressive. It's very hard for the economy bears to explain this. I think it clearly reflects both a monetary impulse and a growth impulse, and a lot more of both than the market seems to be thinking.
Monday, July 27, 2009
Conditions in the bond market continue to normalize. As the second chart shows, the spread between 10-year Treasury yields and the yield on mortgage-backed securities is well within the range of "normal." As the first chart shows, the spread between jumbo and conforming mortgage rates has come down from a high of 200 bps last November, to a bit less than 90 basis points today. The net result is that borrowing costs for homebuyers are relatively low, and they have not risen materially in the past several years. Loans may be harder to come by (qualification standards are higher, minimum down payments are higher), but those who get loans should be quite happy with the rate they get.
Regardless, with conditions in the bond market continuing to normalize, getting a loan ought to be progressively easier as time goes by. New lenders and lending channels are appearing, particularly for jumbo loans. That the conforming/jumbo spread is still higher than average is a sign that the market is still inefficient, but the existence of this inefficiency is attracting lenders to the jumbo market, since they can earn an above-average spread over Treasuries.
This chart calculates the real yield on T-bonds by subtracting the annual change in the Core CPI from the yield on 10-year Treasury bonds. Note that real yields were chronically low in the 1970s, and were chronically high in the 1980s and 1990s. It's not a coincidence that low real yields in the 70s occurred alongside rising inflation, or that high real yields in the 80s and 90s occurred alongside falling inflation. That's because real yields along the Treasury curve tell you a lot about how easy or how tight monetary policy is expected to be. High real yields reflect an expectation of persistently tight policy, while low real yields reflect an expectation of persistently easy money.
Tight money in the 80s and 90s kept real yields high, and high real yields meant that an investment in bonds was competitive with other investment opportunities in the economy. Thus investors had an incentive to hold bonds, and at the same time, because real borrowing costs were high, they had a disincentive to borrow money. Thus the demand for money was relatively high, and this created a relative shortage of money in the economy. With money in short supply, prices for tangible assets remained relatively low. Indeed, the CRB spot commodities index fell about 30% from the early 1980s to 2002. Not surprisingly, core inflation fell from double digits to 2% over the same period.
Monetary policy has been relatively easy for the past 5 years now, and particularly easy in the past year or two. The Fed acknowledges that monetary policy is very accommodative, and they tell us they plan to stay that way for quite some time. It's not surprising, then, that T-bonds are relatively unattractive. Looked at from another perspective, there is so much concern out there (in the market and among the Fed governors) that weak economic growth will have adverse consequences, that the market is willing to pay relatively high prices for the safety of T-bonds.
On the margin, however, these concerns are diminishing, as evidenced by the gradual decline in the Vix index, the ongoing decline in credit spreads, and the rising level of equity prices. Borrowing costs are falling for many consumers and businesses, making debt more attractive on the margin. It all adds up to falling money demand, even as the Fed resists tightening money supply. The result is a relative abundance of money, and we see the signs of this in rising commodity prices. We should expect other tangible asset prices, such as housing prices, to begin to rise as well, probably by the end of this year if not sooner. The last shoe to drop will be rising inflation, of course, since it takes time for monetary policy to flow through the economy and hit the CPI. The only thing that is not apparent in all this is how soon inflation will rise, and by how much.
Sunday, July 26, 2009
This is big news for markets, since it means that passing his legislative agenda will be increasingly difficult. As a supply-sider and libertarian, I think big government, higher taxes, and rising regulatory burdens are bad for the economy and the market. And with Obama's true agenda now completely out of the closet (he's the biggest of the big spenders and tax hikers this country has seen since FDR), bad news for his agenda is very welcome news for the market.
Saturday, July 25, 2009
The housing collapse and its painful aftermath, including that $15 trillion wealth loss for U.S. households (so far), do not … represent a market failure. Rather, they represent the dangerous confluence of three policy errors: government policy aimed at providing access to home ownership for American households irrespective of their ability to afford it; the Fed’s claim that it could not identify bubbles as they were inflating but could fix the problem afterward; and a policy of granting monopoly power to rating agencies like Standard & Poor’s, Moody’s, and Fitch’s to determine the eligibility of derivative securities for what are supposed to be low-risk portfolios, such as pension funds.
The long-term solution is for government to stop playing favorites, as it has for decades with housing. Home ownership should neither be penalized nor favored under government policy. We have seen how that distortion led inexorably to a degree of wealth destruction we have not seen in our lifetimes. The distortion of the market introduced by government intervention can and must be brought to an end.
Friday, July 24, 2009
As is the case with most commodity prices these days, the price of crude oil is reversing a good deal of what it lost last year. I think the commodity price signal is a powerful one, because it tells us that 1) global demand is reboundng, 2) deflation is nonexistent, 3) there is no shortage of money, 4) monetary policy is becoming inflationary (i.e., the Fed should be implementing its exit strategy now, not later, and 5) the crisis of last year was temporary in nature, not a sign of any long-term structural problems.
That tells us that the Fed has been exceptionally and proactively accommodative during this recession, more so than during other recessions. If the steepness of the curve is a measure of how easy money is, then monetary policy is unquestionably very accommodative. It also tells us that with all this monetary stimulus, the economy is very likely to pull out of the recession. Indeed, I think a recovery is already underway. A steep curve is very good for the financial sector, since banks can borrow at a very low interest rate and lend out along the curve and earn a spread. Credit may still be difficult for some to obtain, but not because it's not available. It's because the banking sector has had to regroup after taking huge hits, and traditional sources of lending have in many cases been shut down by the crisis and by the knee-jerk reaction of politicians trying to step up regulatory efforts. But with time this problem will disappear, and the rise in home sales activity all across the country is a good sign that this is already happening. The corporate bond market is reviving as well.
With no shortage of money and a Fed hell-bent on seeing the economy recovery, you don't want to be pessimistic. The Fed always gets what it wants. The only problem is that this time they may get more than what they want, in the form of higher inflation. But for now that remains a problem for later this year or next year. The important thing today is that things are turning up.
This is big, what’s happening. President Obama appears to have misstepped on a major initiative and defining issue. He has misjudged the nation’s mood, which itself is news: He rose from nothing to everything with the help of his fine-tuned antennae. Resistance to the Democratic health-care plans is in the air, showing up more now on YouTube than in the polls, but it will be in the polls soon enough. The president, in short, may be facing a real loss.
His news conference the other night was bad. He was filibustery and spinny and gave long and largely unfollowable answers that seemed aimed at limiting the number of questions asked and running out the clock. You don’t do that when you’re fully confident. Far more seriously, he didn’t seem to be telling the truth. We need to create a new national health-care program in order to cut down on government spending? Who would believe that? Would anybody?
I suspect voters, the past few weeks, have been giving themselves an internal Q-and-A that goes something like this:
Will whatever health care bill is produced by Congress increase the deficit? “Of course.” Will it mean tax increases? “Of course.” Will it mean new fees or fines? “Probably.” Can I afford it right now? “No, I’m already getting clobbered.” Will it make the marketplace freer and better? “Probably not.” Is our health care system in crisis? “Yeah, it has been for years.” Is it the most pressing crisis right now? “No, the economy is.” Will a health-care bill improve the economy? “I doubt it.”
The White House misread the national mood. The problem isn’t that they didn’t “bend the curve,” or didn’t sell it right. The problem is that the national mood has changed since the president was elected. Back then the mood was “change is for the good.” But that altered as the full implications of the financial crash seeped in. The crash gave everyone a diminished sense of their own margin for error. It gave them a diminished sense of their country’s margin for error. Americans are not in a chance-taking mood. They’re not in a spending mood, not after the unprecedented spending of the past year, from the end of the Bush era through the first six months of Obama.
The final bill, with all its complexities, will probably be huge, a thousand pages or so. Americans don’t fear the devil’s in the details, they fear hell is.
I would add that anything that diminishes Obama's ability to push through a hard-left agenda is good for the economy and good for the market.
The reasoning goes back to a post I made last week, in which I discussed the changes in the demand for dollar currency. The value of the dollar has been a good proxy for the world's demand for safety and a good proxy for the velocity of money. As panic set in late last summer, people all over the world flocked to the dollar as a safe haven. People stopped spending money, stockpiling it in the form of currency and in the form of higher money balances. The economy and the stock market sank as demand collapsed. It all reached a head in early March of this year, as fear of massive deficits and massive tax increases paralyzed financial markets.
Since that time, everything has reversed. The economy avoided the catastrophe many had feared, and Obama's legislative agenda has stalled and his approval ratings have plunged. People have stopped accumulating dollar currency and money deposits, and so spending is starting to ramp up. The economy is starting to come back to life.
The stock market is very sensitive to changes of this sort. The risk of massive tax increases in the future has gone down. Instead of collapsing into a depression, the economy may be managing to grow a bit. On the margin, these are huge changes, and easily capable of driving a major equity rally.
Now, I continue to believe that a weaker dollar is not a good thing. If the Fed fails to execute its exit strategy in a timely fashion, the dollar would likely weaken considerably from here, and that would not be a good thing because it would increase the risk of inflation and cause confidence in the dollar to fall, which in turn would be bad for investment and ultimately bad for the economy. But if a weaker dollar on the margin means that money balances are now being spent rather than accumulated, that is obviously good for the economy since it means that fear is subsiding and confidence is returning.
Thursday, July 23, 2009
Both of these charts suggest we've seen the worst of the housing crisis. Existing home sales are picking up after being very depressed, most likely because prices are down, and financing is relatively cheap. The inventory of unsold homes is falling, even as foreclosures rise, a sign that again, homes are more affordable. And the second chart reminds us that the housing slump, by this measure, was worse in the early 1980s.
This chart takes the 4-week moving average of claims and compares it to the level of claims one year ago. No matter how you look at claims, the message is the same: we've definitely seen the worst of the recession and most likely the end.
Wednesday, July 22, 2009
I thought Obama's press conference this evening was just great, because it reinforced Mike Ross's view that Obama is pushing things too fast with little or no reason. As I watched Obama spend 5 minutes or more on each question, I kept trying to imagine George Washington spending that much time answering questions when he was President. Or Ronald Reagan. No, they would never have dredged up the travails of individuals struggling with a government-dominated system in order to argue for yet more government domination. They would have limited themselves to proposing a solution that came from the people, not from the government. From the free market, not from bureaucrats.
Time after time, Obama threw up straw men (e.g., we can't possibly continue with the status quo), in order to argue that his view (which is maybe the same as Nancy Pelosi's, but no one knows for sure, since it seems he is more interested in passing anything that gives more power to the government than passing something which makes sense) is far superior. And the reason for such haste? Because the government systems (Medicare, Medicaid) that have been distorting the healthcare marketplace for decades are bound to make things worse, and so we've got to change things immediately by giving government even more power over our lives. Huh??
Didn't anyone teach the brilliant Obama that one of the best ways to solve apparently intractable problems is to first question the assumptions inherent in the problems themselves? The alternative to passing the Democrat's half-baked healthcare reform is not to maintain the status quo, which stinks, but to do something that involves less government, not more. That was the big thing missing in tonight's White House press conference.
By the same logic, it should not be too difficult for the Fed to execute its exit strategy if it chose to do so. The Fed currently holds about $620 billion of Agency and MBS securities. If they sold $100 billion of those securities a month that would be similar in order of magnitude terms to the amount of debt that Treasury is selling to fund this year's deficit. And their balance sheet would shrink dramatically, almost as fast as it increased last year.
And despite all the Treasury issuance this year, and despite the difficulties the bond market has had for the past year, and despite all the losses that major institutional investors have suffered, the average price of mortgage-backed securities has not changed materially year to date.
It's a very big bond market out there, and hundreds of billions and even trillions are not that hard for the market to absorb, believe it or not.
Sugar prices have soared 70% from their December lows, returning to the highs of early 2006. They were significantly higher a long time ago, however, when commodities were caught up in the inflationary boom times of 1974 and 1980. So is China buying up the world's sugar supplies, or is something else going on? Bloomberg tells me that the demand for sugar is very strong in India, and producers are having trouble keeping up with global demand in general.
Maybe it's just a "dead cat bounce," but I'm very impressed by the rebound in risky asset prices. The market cap of the global equity market has risen fully 50% from its March 9th lows (vs. 41% for the S&P 500), or $13 trillion in less than 19 weeks. In retrospect, this looks like the "panic rally" that I started talking about in late December and early January. Except that I was a couple of months early in the call, and I missed the Obama-panic selloff of February and early March.
As he laid it out in his op-ed in yesterday's WSJ, the Fed's exit strategy looks sensible. I've argued that the exit strategy shouldn't be all that difficult. It should start when it is clear that the economy has come out of the woods (which appears to be the case already), and when risky asset prices start moving higher (of which there is evidence in abundance: equity prices, commodity prices, energy prices, junk bond prices, even commercial mortgage-backed security prices). Stronger markets for risky assets are not only the signal to begin the exit strategy, they also provide the perfect environment, since the Fed needs to sell many hundreds of billions of risky assets to unwind their quantitative easing of last year.
Already the Fed has unwound some of the liquidity additions of last year, as the op-ed explained, but meanwhile they are still buying more Treasuries and MBS. The Fed's balance sheet hasn't shrunk by much so far.
Although the exit strategy is sensible and feasible, it has not yet been executed. As I argued a month or so ago, the Fed should have already started to withdraw liquidity, and every day that goes by that they don't, the inflationary pressures (stemming from an excess of dollars) accumulate. We can already see this happening: the dollar is down over 10% from its highs earlier this year; gold is up over 10%; commodities continue to rise; and the yield curve is very steep. And Bernanke takes pains to say the Fed is not likely to tighten anytime soon.
We are going to need to watch all of these indicators, as well as the changes in the Fed's balance sheet and the money supply numbers, very carefully. There's no reason yet to sound the alarm about hyperinflation, but inflation complacency is not where you want to be. The Treasury bond market cheered the exit strategy earlier this week, but I think that is a naive reaction. T-bond yields are likely to continue to drift higher until the Fed takes some positive action to shrink their balance sheet.
A tighter Fed does not imply higher bond yields, nor do higher bond yields pose a threat to the economy. The bond market actually loves tight money, since that keeps inflation low. In any event, it would be the most natural thing in the world for interest rates to rise as the economy improves, mainly because interest rates are still very low, in a way that makes sense only if the economy remains mired in a funk and deflationary pressures lurk under every rock. The worst thing would be for the Fed to delay tightening for too long, since that would set up an inflationary problem that would push bond yields sharply higher and require a huge Fed tightening and an eventual recession in a few years' time.
Full disclosure: I am long TBT and long TIP and TIPS as of the time of this writing.
Copper, long thought by economy-watchers to be the smartest of commodities (thus the nickname "Dr. Copper") is now up 102% from its December lows. Clearly there are some major forces at work out there, one of which is that the world is making considerable progress toward regaining the conditions that prevailed prior to last year's financial crisis. We have definitely seen the worst of the economy, and I would be very surprised if the economy has not been in recovery mode for the past month or two.
Tuesday, July 21, 2009
This chart comes from a recent paper by Art Laffer. The blue line represents the percent of salaried workers that are paid the minimum wage or less. According to the most recent data, only 3% of those working for an hourly wage earn the minimum wage or less. Ask anyone you know to guess what percent of the workforce earns minimum wage, and I'll bet anything that they will answer with a number that is much higher than 3%. Those who earn the minimum wage are a vanishing breed, believe it or not. And that should make us proud.
The black line represents the minimum wage in today's dollars (i.e., adjusted for inflation). Note that it has stayed roughly constant for more than 20 years, while the percentage of workers earning that wage has dropped by almost 75%. It's not a coincidence, Art argues, that the huge relative decline in those earning minimum wage occurred during a period in which the federal government by and large pursued growth-oriented policies (e.g., declining tax rates). Giving incentives (lower tax rates) to those that create the jobs results in a huge increase in the number of unskilled workers that end up getting jobs, and most of them ended up getting jobs that paid more than the minimum wage since the total number of jobs has vastly increased over this 20+ year period. Incentives work much better than mandated wage hikes when it comes to alleviating poverty.
Art also explains the unfortunate consequences of the minimum wage:
While increasing the minimum wage is a seductive populist agenda item, it is incredibly harmful to the economy. All an increase in the minimum wage succeeds in doing is pricing people out of the job market, and particularly those people who have no ability to defend themselves, such as the poor, the minorities and the disenfranchised. The people who need entry-level jobs in order to gain the requisite skills to earn above the minimum wage are precluded from ever getting jobs in the first place if the minimum wage is too high.As Art further notes, it is a real shame that the minimum wage "will be 41% higher [on July 24th] than it was two years ago." This will only retard the recovery, since the economy will not be taking full advantage of the huge numbers of unemployed teens.
When times are good, the minimum wage is not a large concern. In economic parlance, the equilibrium price for unskilled labor is above the price floor set by the minimum wage. When the economy turns south, though, a high minimum wage is often above the market-clearing wage for unskilled labor, meaning there is a surplus of labor, which shows up as higher unemployment among the least qualified workers. And that certainly seems to be the case today. Teenage unemployment has surged from 15.1% in July of 2007 to 24.0% in June of 2009. Meanwhile, black teenage unemployment has risen from 26.4% in July of 2007 to 37.9% in June of 2009.
These are the unintended and very unfortunate consequences of misguided government policies such as are being pursued by the Obama administration.
Government-generated statistics are subject to delays, errors in data collection, faulty seasonal adjustment, bad guesstimates, and sometimes major revisions well after the fact. You can't be misled by spot commodity prices, however. They are available in real-time, and they reflect the purchasing, selling, and speculative decisions of billions of people around the globe.
As this chart shows, spot prices for industrial metals are up over 50% from their lows of last December. Many people will argue that all this is just a reflection of massive stockpiling on the part of the Chinese, financed artificially with the trillions of reserves they have also stockpiled. Or at the very least it represents force-fed stimulus plans that will only result in over-building and eventual collapse.
Regardless of whether Chinese demand is artificial or not, it means real work for all the companies and countries that produce industrial raw materials. And the Chinese aren't just going to be sitting on a mountain of industrial scrap. The Chinese economy has a furious demand for all sorts of things, with a growing population eager to work and catch up to the living standards of the world's industrialized economies. The government has plenty of resources with which to feed this growth machine, in the form of trillions of reserve assets and a sterling credit rating. It's almost inconceivable to me that China could consume so much and grow so much (7-8% growth projected for this year) without this growth spilling over into the rest of the world. What's good for China is good for everyone, as they used to say about GM.
So I view the sustained rise in most commodity prices as an excellent sign that the global economy is picking up. I think it also reflects to some degree the fact that monetary policy as practiced by the world's major central banks is almost uniformly accommodative. To the extent the latter is true, the rise in commodity prices is foreshadowing rising inflation in the years to come. That's a bit disturbing, but in the meantime, rising commodity prices can only be classified as one of those "undeniable green shoots."
In after-market trading today following another blowout earnings release, AAPL is up to $158, almost double its price when I first recommended it in mid-January. At that time the street was worried about Steve Jobs' health, but I thought the company was well-positioned to prosper on its own. Apple's secret is a culture of excellence and industrial design that has little or no parallel in the industrial world. Excellent software and excellent hardware, including the iPhone, make an unbeatable combination. As I said back then, if you don't want to buy the stock, at least buy one of Apple's products and see for yourself.
At this point I don't see any serious competition. Windows 7 may end up being a lot better than the failed Windows Vista, but it doesn't look to be much more than an able competitor to Apple's Leopard OS that came out a few years ago. The big problem Microsoft faces with Windows 7 is that the IT folks and many consumers will be very slow on the uptake, having been burned with Vista. Plus, it will require new hardware for many. I'm willing to bet that a lot of folks will give Macs and the iPhone a try, rather than struggling through yet another Windows software and hardware upgrade.
Apple's latest revision to its OS will come out this September, before Windows 7 is released, and it will not require new hardware. Indeed, it promises to run much faster on most existing Macs, and will reportedly save 7 GB of hard drive space. Simpler, smaller, and faster is always better than bloat.
Apple stands to continue to gain market share for the foreseeable future in the personal computer, business computer, and smart phone markets, having already captured most of the MP3 player market. With its operating leverage applied to significant market share gains, AAPL should continue to be a money machine, at the same time it thrills the world with technological marvels that are also stunning to look at.
Full disclosure: I am long AAPL at the time of this writing.
Monday, July 20, 2009
Credit spreads are very important measures of the economy's health, as I've been emphasizing since last October. At that time, a significant decline in swap spreads (a highly liquid proxy for AA bank credit risk—here's a basic primer on what they are) was one of the very first signs that the worst of the credit crisis had passed. The decline in swap spreads has consistently led the decline in other credit spreads, and declining swap spreads have done a pretty good job of foreshadowing improvements in the overall economy. Swap spreads can back down to a semblance of "normal in May, but as these charts show, other credit spreads still have a ways to go. It might take another year for these spreads to come back down to normal. Still, these spreads are making downward progress, and that is essential if the economy is to be on the road to recovery, as it appears it is.
Elevated spreads are a sign that the market is fearful of default risk, and default risk is typically high during recessions for obvious reasons (e.g., money is expensive, cash flow is hard to come by, demand is weak). But with the economy on the mend, money very cheap (banks can get money from the Fed to support lending for almost nothing), and no sign of a general decline in prices, actual defaults are likely to be less than the market is expecting. That in turn implies that high yield bonds and emerging market bonds (where rising commodity prices have dramatically improved the outlook for cash flow) are still attractive investments. High spreads mean relatively high yields, and declining spreads mean rising prices or better price performance relative to Treasuries.
Full disclosure: I am long HYG, EMD, and PAI at the time of this writing.
So from an investor's standpoint, the key question today is whether we see a very slow and drawn out recovery or something a little better. I'm in the latter camp, because I see improvement across the board in a number of important fundamentals, all of which I have discussed in the past few months:
Swap and credit spreads have declined significantly. Implied volatility in stock and bond options has declined significantly. Commodity prices are up signficantly (e.g., the CRB spot commodity index is up 24% from its December low, crude oil is up 47%, copper is up 88%). Currency growth has all but ceased (implying the end of declining money velocity). Residential construction has bottomed, and housing prices are probably at or near their lows. Weekly unemployment claims are down 23% from their high. Credit card delinquencies are down. ABS and CMBS prices are up. Used car prices are up 16% this year. Shipping rates and volumes are up. Corporate layoffs are way down. Corporate profits (the NIPA version) are still fundamentally healthy. The yield curve is very steep. High yield and emerging market bond prices are way up. Treasury bond yields are way up from their year-end lows. Core inflation measures have not declined meaningfully.
As I see it, the economy is recovering despite the best efforts of Obama and the Democrats to saddle the economy with huge new tax and regulatory burdens. The Fed hasn't helped either, with very erratic monetary policy over the years and now a monstruous increase in the monetary base that goes so far beyond anything we've ever seen that the average person can't possibly understand what is going on.
I've always been willing to give the economy the benefit of the doubt when it comes to recovery; I don't think you can underestimate the ability of this economy to overcome adversity. If it weren't for bad fiscal and monetary policy the economy would be booming by now. Instead it is probably going to grow about 3% a year for the foreseeable future, although that's not enough to make a huge dent in the unemployment rate.
If the current decline in Obama's approval ratings continues, if Obamacare fails to pass before the August Congressional recess (an increasingly likely outcome, thank goodness), and if the cap and trade bill gets postponed to next year, then the outlook could brighten considerably. It pays to be optimistic these days.
Sunday, July 19, 2009
Here's an updated version of a chart I've shown before, using June data for container exports from the Ports of Los Angeles and Long Beach, and goods exports through May. Things haven't bounced quite as much as I was expecting. However, I do think it's clear from this chart that the free-fall in global trade which began in the fourth quarter of last year has at the very least stopped, and has reversed to some degree. On a year over year basis, outbound LA container shipments were down only 9% in June, whereas they were down 29% last December.
... in early July, Biden said "We misread how bad the economy was." This one is a bit different to explain away, since the administration billed itself as having super-genius comprehension of the problem and the necessary solutions. Now, many suspect, President Obama finds himself staring at a portrait of FDR, murmuring "Help me, Obi-Wan. You're my only hope."
What Biden meant to say, in his puckish way, [is] that they misunderstood what an economy is, and how it works. Piling up a mountain of proposed taxes, mandates, regulations, do-nothing programs and pork unseen in such dimensions since Pink Floyd floated a dirigible pig over an outdoor concert might, in fact, prevent recovery.
So do not criticize him; applaud his palaver, and hope for more.
Friday, July 17, 2009
What We Know That Ain't SoHT: Andrew Coors
Will Rogers famously said, "It isn't what we don't know that gives us trouble, it's what we know that ain't so." So it is with the health care debate in this country. Quite a few "facts" offered to the public as truth are simply wrong and often intentionally misleading.
There are large groups of people in this country who want socialized medicine and they sense that the stars are aligning, and now is their time to succeed. They rarely call it socialized medicine, but instead "single payer health care" or "universal coverage" or something that their public relations people have told them sounds better. Whatever they call it, they believe (or pretend to believe) a lot of wrong-headed things, and they must be stopped. Step one is understanding how and why they are wrong. Step two is kicking their asses back to Cuba where they can get in line with Michael Moore and Al Gore for their free gastric bypasses.
Myth #1 Health Care Costs are Soaring
No, they are not. The amount we spend on health care has indeed risen, in absolute terms, after inflation, and as a percentage of our incomes and GDP. That does not mean costs are soaring.
You cannot judge the "cost" of something by simply what you spend. You must also judge what you get. I'm reasonably certain the cost of 1950's level health care has dropped in real terms over the last 60 years (and you can probably have a barber from the year 1500 bleed you for almost nothing nowadays). Of course, with 1950's health care, lots of things will kill you that 2009 health care could prevent.
In the case of health care, the fact that we spend so much more on it now is largely a positive. We spend so much more on health care, even relative to other advances, mostly because it is worth so much more to us.
In summary, if one more person cites soaring health care costs as an indictment of the free market, when it is in fact a staggering achievement of the free market, I'm going to rupture their appendix and send them to a queue in the UK to get it fixed.
Myth #2 The Canadian Drug Story
The general story is how you can buy many drugs in Canada cheaper than you can buy them in the US. This story is often, without specifically tying the logic together, taken as an obvious indictment of the US's (relatively) free market system. This is grossly misguided.
Here's what happens. We have a (relatively) free market in the US where drug companies spend a ton to develop new wonder drugs, a non-trivial amount of which is spent to satisfy regulatory requirements. The cost of this development is called a "fixed cost." Once it's developed it does not cost that much to make each pill. That's called a "variable cost." If people only paid the variable cost (or a bit more) for each pill the whole thing would not work. You see, the company would never get back the massive fixed cost of creating the drug in the first place, and so no company would try to develop one.
Drug companies that spent the enormous fixed costs to create new miracles are charging a relatively high cost in the free and still largely competitive world (the US) to recoup their fixed cost and to make a profit. But socialist societies like Canada limit the price they are allowed to charge. The US-based company is then faced with a dilemma. What Canada will pay is not enough to ever have justified creating the miracle pill. But, once created, perhaps Canada is paying more than the variable cost of each pill. Thus, the company can make some money by also selling to Canada at a lower price as it's still more than it costs them to make that last pill.
If we all tried to be Canada it's a non-working perpetual motion machine and no miracle pills ever get made because there will be nobody to pay the fixed costs.
Myth #3 Socialized Medicine Works In Some Places
This is a corollary to the "Canada as parasite" parable above. The funny part is socialized medicine has never been truly tested. Those touting socialism's success have never seen a world without a relatively (for now) free US to make their new drugs, surgical techniques, and other medical advancements for them.
To put it simply, right now the US's free system massively intellectually subsidizes the world's unfree (socialized) ones. That sucks. The only thing that would suck worse is joining them without anyone to subsidize us all.
Myth #4 A Public Option Can Co-Exist with a Private Option
Part of the current junta's plan is to add a "public option" for health insurance. That is health insurance provided by the government (actually provided by you and your neighbors). They claim this "public option" can co-exist fairly alongside private health insurance, increasing competition and keeping the private system "honest," and not deteriorate to a single payer (socialized medicine) system. They are wrong, or very dishonest, as in unguarded moments they admit that the single payer socialized system is what they really want.
By their logic the government must be a major player in every industry. Ah, just when you think you have them, you remember, they are socialists … dismantling liberty piece by piece.
The government does not co-exist or compete fairly with private enterprise. It does not play well with others. The regulator cannot be a competitor at the same time. Finally, it cannot be a fair competitor if when the "public option" screws up (can't pay its bills), the government implicitly or explicitly guarantees its debts.
Perhaps the best example of the destructive "public option" is our nation's schools. Here we clearly have a government provided "public option" competing with (and in fact dominating in size) private schooling. But, is it fair? Does it work well? Not by a long-shot.
With a "public option" things inevitably would go the horrific way of our public schools. It will be like looking in a funhouse mirror and seeing a doctor where you used to see a teacher.
Finally, let's worry a bit about the end game. We are not here yet, but in a world where the "public option" replaced all private options, would we still be allowed, if we had the resources, to pursue private medical alternatives? Some socialized countries say yes, some say no. Imagine the answer is no in this country, where freedom is valued more than anywhere else in the world. Imagine a person is to be prevented from spending their hard earned money on their or their children's health care, or a doctor was prevented from earning what he could in a parallel free system after all his training and work.
It takes literally seconds to realize that this "public option" cannot co-exist with liberty and thus will indeed lead to full-on socialization. Since the simplest answer is usually best, and the President has already declared his preference for a "single-payer" system, and since this "public option" leads there with near certainty, might I be forgiven for assuming he knows this and is lying, and has a socialized medicine end-game in mind?
Myth #5 We Can Have Health Care Without Rationing
Rationing has to occur. This sounds cold and cruel, but it is reality. If you have a material good or service, like health care, that is ever increasing in quality, and therefore cost, there is no way everyone on Earth can have the best at all times (actually the quality increases are not necessary for rationing to be needed, it just makes the example clearer). It's going to be rationed by some means. The alternatives come down to the marketplace or the government. To choose between those alternatives you judge on morality and efficacy.
It is an uncomfortable truth that tough choices will have to be made. There is no system that provides for unlimited wants with limited resources. Our choice is whether it should be rationed by free people making their own economic calculations or by a bureaucracy run by Congressional committee (whose members, like the Russian commissars, will, I guarantee you, still get the best health care the gulag hospitaligo can provide). Free people making their own choices only consume what they value above price, using funds they have earned or been given voluntarily. With socialized medicine health care is rationed by committees of politicians trying to get re-elected and increase their own power, and people consume as much of it as the commissars deem permissible. I do not find these tough alternatives to choose between.
Myth #6 Health Care is A Right
Nope, it's not.
This is more philosophy than economics, and I'm not a philosopher. But, luckily it doesn't take a superb philosopher to understand that health care simply is not a "right" in the sense we normally use that word. Listing rights generally involves enumerating things you may do without interference (the right to free speech) or may not be done to you without your permission (illegal search and seizure, loud boy-band music in public spaces). They are protections, not gifts of material goods. Material goods and services must be taken from others, or provided by their labor, so if you believe you have an absolute right to them, and others don't choose to provide it to you, you then have a "right" to steal from them. But what about their far more fundamental right not to be robbed?
So why do people scream health care is a "right" if it so obviously is not? If not a right it can still be willingly provided as charity by society.
So, Why Are These Crazy Things Believed (Or, Pretended to Be Believed)?
Lots of politicians understand that the simple free system leaves them out in the cold. No power for them. No committees to sit on to decide people's lives. No lies to tell their constituents how they (the government) brought them the health care they so desperately need. No fat checks from lobbyists as the crony capitalists pay dearly to make the only profits possible under this system, those bestowed by the government.
Finally, if the above is not enough, the rush to pass a huge expansion of government now, and limit debate and discussion, is indicative of a group that knows it is wrong, and if people have time to think they will refuse to go along, but is attempting an exercise of naked power, to impose dictatorship before the people wake up. Paraphrasing Mark Twain, a lie can travel halfway around the world while the truth puts on its shoes. They are counting on this, and they don't want to give the truth time to be shod.
And In Conclusion
We do not need a single payer (socialized medicine) system to cut confusion and inefficiency. On the contrary we need unfettered competition and clear legal standards. Another major concern is provision of basic healthcare to the needy. This is an important issue, but not an expensive one in the scheme of things, and not one that should drive the trillion-dollar healthcare debate. You do not reorganize the entire housing industry and tax policy around the need for homeless shelters, you just build enough shelters and let the market take care of, and discipline, the people who can pay for their own housing.
Finally there is the concern that healthcare costs make US workers too expensive to compete in global markets. As long as workers get full value for their healthcare dollars, it shouldn't matter whether companies pay in cash or in health benefits.
This chart illustrates what could be a very important and bullish development for the economy: the coming decline of money demand.
Background: Dollars in circulation (most of which are held overseas) surged beginning in mid-September of last year, as fears of a financial market collapse caused people all over the world to stuff money under their mattresses (figuratively speaking, of course, but I do know a person in Argentina who sold all of his portfolio holdings last year, converted everything to $100 dollar bills, and then hid them in his house). The demand for dollar cash and dollars in general (as a safe haven and to pay down debt) was so intense that the Fed had to resort to a massive expansion of the monetary base to avoid a sudden onset of deflation. This surge in the demand for dollars also meant that instead of spending money, people simply held onto it and at the same time wanted more of it. Economists call this a plunge in money velocity, and it resulted in a sudden and massive decline in retail sales. That in turn caused a huge rise in inventories, and manufacturers were then forced to respond by slashing production.
With the benefit of hindsight, it now looks as if the fear of collapse started to decline last March. People began to decide they didn't need to accumulate more dollar cash. On the margin, the demand for dollars stopped rising. Which is another way of saying that the velocity of money stopped falling. Currency in circulation has been flat since mid-April, but there are still lots of dollars sitting under mattresses.
The next shoe to fall is the key. Dollar demand will likely start falling, and money velocity will likely start rising. All the extra money that was stuffed under mattresses will either get returned to the bank, or it will get spent. Consumer demand will return, powered by precautionary holdings of money that are no longer needed.
It's not unreasonable at all to expect this to happen. Indeed, the demand for dollars in the world currency market has been falling since mid-March; the dollar is down over 10% against major currencies. The next chart shows a very strong correlation between the equity market and the changing demand for dollars (a weaker dollar goes hand in hand with a stronger equity market, and vice-versa). Declining dollar demand today means that precautionary balances are likely to be spent, and that is lifting the economy and brightening the prospects for the future.
Housing starts in June rose to the highest level in 7 months, after falling for 3 1/2 years to the lowest levels since records were first kept in 1959. Residential construction as a percent of GDP also fell to its lowest levels ever. After languishing for 9 months, the stocks of major home builders are now beginning to rise. It would appear that we have finally seen the bottom in the housing construction market.
This is good news for housing in general, since it means that the inventory of excess homes has been cut substantially, and will likely fall further unless construction starts ramping up soon. This will help put a floor under housing prices. And to the extent we can feel better about housing prices no longer falling, that should provide a huge boost to the financial market, since it eliminates a big source of the uncertainty underlying the valuation of subprime mortgages and the institutions that hold them.
Thursday, July 16, 2009
The 1,018-page House bill (HR 3200) is a decidedly mixed bag, reflecting the difficulty of making large-scale repairs while preserving the healthcare options people have today. The measure would make some important changes in the way healthcare is delivered and financed, yet it falls short of some goals and overshoots others.
The bill ... doesn't move as aggressively as it should to reduce the incentives for wasteful, inefficient or unnecessary procedures. It would extend coverage to millions of the uninsured but would pay for that expansion in too narrow a way. Part would be covered by a hefty tax on employers that don't provide insurance, a burden that would fall hardest on businesses with thin profits and low-wage workers. And part would be borne just by the wealthiest 2 million Americans, even though the benefits of the program would be spread broadly.
Ideally, lawmakers would finance those changes in ways that would increase consumers' sensitivity to healthcare costs without eliminating jobs and slowing economic growth. The House bill fails that test for a couple of reasons: It suggests to most Americans that they're getting a better healthcare system for free, and it makes one small group pay for improvements that benefit everyone. Taxes on the wealthy and businesses can help, but the middle class should contribute too, not only because it's the right thing to do but also to make the funding less vulnerable to economic downturns.
For starters, lawmakers should consider rolling back the tax exemption for employee healthcare benefits. The exemption is worth $3.5 trillion over 10 years, so even a modest reduction could raise a significant amount. Such a move would face stiff resistance from unions and President Obama, who promised not to raise taxes on the middle class. But it would send the valuable message that everyone pays for this reform because everyone benefits.
Here's an update of a post from about two months ago. These charts come from the folks at Markit and they track the performance of various asset-backed and mortgage-backed securities. The first chart shows the price of a representative sampling of home equity-backed securities initially rated AAA, while the second chart shows a sampling of commercial mortgage-backed securities rated AAA that were originally issued around the end of 2007, the year when CMBS issuance reached an all-time high.
Note how the prices of these securities—issued typically at a price of 100—had absolutely cratered around the same time that the stock market hit its lows in March. In the past several months these securities have experienced a significant rally, presumably because the market has sharply revised downwards its expectations of defaults. This reflects a) the return of confidence, and b) improving prospects for economic growth and incomes.
I noted back then that while these securities still reflected the expectation that default rates would be much higher than normal in both markets, they also showed significant improvement on the margin, which in turn meant that the likelihood of the economy falling down a black hole had declined dramatically, and that confidence was returning. That still looks to be the case. Confidence is returning to a lot of markets, and prices are improving.
This chart plots the 6-mo. annualized change in the 4-week moving average of weekly unemployment claims. The Labor Board notes that the numbers have been distorted because automaker shutdowns occurred earlier than normal. Seasonal factors expected layoffs to occur now that in fact happened several weeks or months ago; to that extent seasonally adjusted claims today are lower than they otherwise would have been. But if that's true, then claims were distorted on the high side for the past several weeks and months, right? And even those upwardly-distorted claims numbers showed significant slowing from earlier in the year.
Despite the problem of earlier-than-usual automaker shutdowns, it should be clear that the pace of unemployment claims has moderated significantly. We have almost certainly seen the worst of this recession, and most likely the end.
Wednesday, July 15, 2009
NEW YORK (AP) — Two major credit card providers reported more improvements in delinquency rates in June on Wednesday, an encouraging sign that borrowers are not in as bad shape as many had feared.
American Express Co. said in a regulatory filing that accounts at least 30 days past due shrunk to 4.4 percent of total loans during the month ended June 30, after falling to 4.7 percent in May and 4.9 percent in April.
Capital One Financial Corp., a major credit card issuer based in McLean, Va., said its delinquency rate among U.S. cards improved for a fourth straight month, falling to 4.77 percent from 4.9 percent in May.
This is consistent with the improvements I have been seeing for the past several months.
After a brief correction (10-yr T-bond yields fell from a high of 3.95% on June 10th, to a low of 3.30% on July 10th, and the S&P 500 fell 6.4% over the same period) driven by doubts about the economy's ability to recover, we're now back in bullish mode: T-bond yields are up 28 bps and stocks are up almost 6%.
The news has been better than expected (or perhaps better than feared). Companies like Goldman Sachs, Intel, and Apple are making lots of money. The economy is beginning to turn up. Housing is probably bottoming (the Bloomberg Home Builders Index has been flat for nine months now, and is up 70% from its November low). Deflation is dead. Manufacturing conditions are improving.
Higher interest rates are a sign of economic health, not a threat to the economy. They are also signaling that the Fed should start raising short-term interest rates before inflation becomes a problem.
All of this bureacracy in order to replace what would otherwise be a simple transaction between two people: the patient and his or her healthcare provider.
The "solution" to healthcare is to get government out, not give government total control. Government has distorted the healthcare market just as they distorted the housing market, by handing out subsidies (tax-free healthcare benefits) and by directly intervening in the market (medicare, medicaid).
If Congress simply eliminated the tax subsidy distortion, by either doing away with the employer-only tax deduction or by allowing everyone to deduct healthcare costs, and if they also eliminated artificial restrictions on the market such as mandated coverage and barriers to entry, we could probably solve 80% of the healthcare "problem" without creating so much as one bureaucracy. Just let the free market work, and it would fix things just as it has in countless industries every day. How hard is this to understand?
UPDATE: Keith Hennessey has written an excellent explanation of how the new healthcare mandate would end up shafting about 8 million people. "For those who do not or cannot comply with the mandate, they end up in the worst of all worlds – uninsured and paying higher taxes." This is simply outrageous, and it is one more illustration of how the government can't possibly "fix" healthcare by increasing regulations and imposing mandates. The subject is so complex that it can only be handled rationally at the individual level.
ONE LAST UPDATE: As this article explains, a healthcare mandate is unconstitutional.
As was the case with producer prices yesterday, deflation was nowhere to be seen in the June CPI report. The headline CPI, heavily influenced by surging gasoline prices, was up at a 2.7% annualized rate in the first six months of this year, but the core rate (see above chart) was up at a 2.3% rate, almost as much. Both measures dipped in the final months of last year as commodity prices collapsed and the economy hit an air pocket. But so far this year things are back on track. If there was a deflation threat, as the market feared in late 2008, it hasn't materialized. For that we can thank the Federal Reserve for taking aggressive action to accommodate the surge in money demand that came in response to the credit and banking crisis, which in turn helped cause last year's air-pocket decline in the economy.
Even though the economy is most likely in the early stages of growing once again, there is by all accounts plenty of "slack," or idle resources. Yet this slack has had no visible impact on inflation this year. That reinforces my belief that inflation is not determined by the strength or weakness of the economy, but by the actions of the central bank.
The Fed should be taking note of this and raising interest rates. For months the evidence has been building that the economy was on the mend, that monetary policy had more than met the challenge of surging money demand, and that money demand was beginning to soften. We see the evidence in rising commodity prices, in gold prices trading at $940, in the dollar trading near the low end of its historic range, in a steep yield curve, and in rising breakeven spreads on TIPS.
To date there is little or no objective evidence that the Fed has committed any huge error. But the clock is already ticking on reversing the monetary expansion they so boldly engineered last year. They can't wait too much longer. Higher rates are not going to kill the expansion, they are going to instill confidence in the dollar and confidence is what is needed to power the economy right now.
Tuesday, July 14, 2009
Inflation: headline inflation has gone down, but core inflation hasn't; once oil prices bottom (which I think is happening), all measures of inflation will head higher; I don't see a hyperinflation yet, but I do see inflation that is significantly higher than what is priced into the bond market. The main driver of higher inflation will be the Fed's inability to withdraw its massive liquidity injections in a timely fashion; they will prefer to err on the side of inflation rather than risk a weaker economy.Inflation has definitely come in above expectations, as detailed in my previous post. The economy has probably bottomed recently, and is on track for a sub-par recovery. Housing looks very close to a bottom. Treasury yields are up significantly. TIPS yields are relatively unchanged. Spreads have come down signficantly. Equities are about unchanged, but have recovered significantly from the lows of early March (lows that I didn't expect). Commodities are up across the board. The dollar is slightly weaker overall, and significantly weaker relative to emerging market currencies.
Growth: the economy is going to recover sooner than the market expects, with the bottom in activity coming before mid-2009; the recovery will be sub-par however, due to the drag of increased fiscal spending and slowly rising inflation.
Housing: the bottom in construction activity has essentially arrived; whether construction drops another 10% or not is at this point immaterial; housing prices are rapidly approaching a bottom, which should come well before June '09; mortgage rates are now low enough to make a huge difference.
Interest rates: Treasury yields are essentially at their lows and will be significantly higher by the end of next year. TIPS yields will hold steady or fall as nominal yields rise.
Spreads: Spreads have seen their highs and will continue to narrow.
Equities: We have seen the lows in equity prices; equity prices will lag other risk asset prices, but they will be significantly higher by the end of next year.
Commodities: Prices are essentially at their lows; whether they drop another 10% is immaterial; prices are beginning a bottoming process; oil prices are unlikely to drop below $35; commodities may take awhile to move higher, but they will be higher within 2 years.
Dollar: The dollar is unlikely to make further gains against most major currencies, given the Fed's hyper-easy stance, and is likely to fall against emerging market currencies as commodity prices rise.