Tuesday, January 31, 2012

Home prices are still weak, but very affordable

As these charts show, both nominal and real housing prices have declined to new post-recession lows, though the decline since the end of the recession in mid-2009 has been modest: between -3% and -7%. These price indices may well slip a bit more, but I don't think that is inconsistent with my view that we have seen the worst of the housing and residential construction bust, and that a slow recovery is now underway. Note that the prices reflected in these charts are an average of prices during the months of September, October and November, so they are rather old news. Plus, I think it's important to add that homebuilders' stock prices have jumped some 50% since the end of September, the National Assoc. of Home Builders' Market Index rose from 14 last September to a 4-year high of 25 in January, and housing starts rose 25% last year. Housing price indices such as these are most likely a lagging indicator of the underlying dynamics in the housing market; real-time data suggests we are seeing improvement on the margin. Furthermore, mortgage rates are now at rock-bottom levels (the nationwide average of 30-yr fixed conforming mortgage rates is only 4.07%), making housing more affordable to the average buyer than ever before.

Sunday, January 29, 2012

Commodity prices are turning up

This index of non-energy industrial commodities (mundane things such as burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, and zinc) began to weaken last summer as the Eurozone sovereign debt crisis was heating up and fears of another financial crisis caused sparked a wave of risk-aversion and de-risking: swap spreads rose, equities declined, Treasury yields plunged, and credit spreads widened as investors feared a double-dip recession. Yet so far this year, we have seen just the reverse: swap spreads, particularly in the U.S., have declined, equities are up, credit spreads have tightened, and now—as the above chart shows—commodity prices are turning up (as of Friday, the CRB Spot index had exceeded both its 50- and 100-day moving average). Moreover, copper prices have jumped 27% since October, and the JOC metals index is up almost 16% since December. All of this suggests that global growth fundamentals are improving.

As this chart of credit default swap spreads shows, there has been a substantial improvement in spreads since late November '11. Spreads are still relatively high, but there's been important improvement on the margin. 

I note again that Treasury yields remain terribly depressed, despite all the stirrings of activity going on. How much longer can the bond market remain terrified of growth?

Friday, January 27, 2012

The 13% GDP gap

This chart nicely illustrates just how weak the current recovery has been—it's actually unprecedented. According to my calculations, there is a 13% "gap" between the current size of the economy and where it would be if it were following its long-term trend growth rate (3.07% compound annual growth, which breaks down on average into 1% annual growth in the workforce and 2% annual increases in productivity). The current output gap is equivalent to lost income of $1.75 trillion, and that's inextricably bound up with the fact that there ought to be at least 10 million more jobs today if the economy were on its long-term trend growth track.

The precise cause of this huge output gap will be the subject of discussion among economists for years, but most of the evidence I see points to the highly unusual expansion of government spending (mostly in the form of transfer payments) over this same period as the leading culprit. Since 2008, federal payments to individuals as a % of GDP have increased by at least one-third, to their highest level ever. Income redistribution on a massive scale like this can not only fail to create growth, it can stymie growth by creating perverse incentives (e.g., rewarding the lack of work and punishing success).

One thing about today's fourth quarter GDP report that caught my eye was the relatively weak growth (3.2%) in nominal GDP, which was entirely due to sharply lower inflation. This can be traced to the same decline in inflation that shows up in the CPI and the PCE deflator over the same period, and which, in turn, was mostly a function of a decline in energy prices, which have since stabilized. As the chart above shows, real growth has been accelerating for the past three quarters, so it's not unreasonable to think that nominal GDP will accelerate in the current quarter, as I suspect it will. Faster nominal GDP growth would also be consistent with a decline in money demand, a phenomenon which I think will be driven by the lessening of concerns over the Eurozone financial crisis. Of course, even if we do get an acceleration in nominal GDP this year, the output gap will likely remain large. Faster nominal GDP is good for corporate cash flows and debtors, but it is not necessarily a big job-creator. For more jobs we need less government and better and permanent after-tax incentives to work and invest (e.g.,  a simpler and flatter tax code) for individuals as well as corporations.

Today's GDP report also amounted to one more shot across the bow of the Phillips Curve theory of inflation: an output gap this large and this persistent should have resulted in years of deflation, according to standard thinking. Instead, the GDP deflator (the broadest and arguably best measure of overall inflation) has risen a total of 6.5% since the peak of the last business cycle.

Brian Wesbury also makes an interesting point, which is that a reduction in public sector spending was one of the sources of weakness in Q4: "Excluding government, real GDP grew at a robust 4.5% annual rate in Q4 and was up 2.6% for 2011 as a whole." In other words, cutbacks in local, state, and federal spending reduced the growth in GDP last year by 1 percentage point. That's not surprising, since we know that public sector payrolls have been declining for the past three years, and we know that our military presence in the Middle East has been winding down of late. But it's not exactly bad news, since our public sector had grown like topsy in the years preceding. A smaller government footprint on the economy means more room for the more-efficient private sector to grow.

So even though today's GDP report was bit weaker than expected, it's not necessarily bad news at all.

Thursday, January 26, 2012

The Eurozone crisis is slowly fading away

Eurozone swap spreads are still elevated, but they have come off their highs and as such are no longer signaling an imminent disaster. U.S. swap spreads have moderated substantially, having returned to the low 30s, well within the range that is considered "normal." The Eurozone banking system has avoided a meltdown, and banks' access to dollar liquidity (blue line in second chart above) continues to improve, suggesting further declines in euro swap spreads are likely. Meanwhile, from the perspective of U.S. markets, contagion risk has declined considerably.

If anything sums things up, it's this chart of the ratio of the Vix index (a measure of fear and uncertainty) to the 10-yr Treasury yield (a proxy for the economy's growth prospects). We are still far from optimum conditions, of course, but the worst of the panic and gloom-and-doom is a thing of the past. There is definitely light at the end of the tunnel.

Three PIIGS are looking much better

Here's an updated chart of the short-term yields on sovereign debt in the questionable countries of the Eurozone. I haven't included Greece, since Greek 2-yr yields are off the chart (over 180%), and Greece is a lost cause anyway: most Greek notes and bonds are priced at 21 cents on the dollar.

Spain has made excellent progress. 2-yr Spanish yields haven't been this low since Nov. '10, and Italian yields are not far behind. Ireland gets credit for the most dramatic improvement of any of the PIIGS, with 2-yr yields having plunged from a high of 23% to just 5.2% today. The big decline in yields on the bonds of these three countries is one reason our Vix index has fallen from the 40s to now below 20; markets are breathing a big sigh of relief.

Bear in mind that Greek losses of $360 billion have already been priced in, as have Portuguese losses of some $110 billion, and the Eurozone sky has not fallen. The ECB gave the Eurozone banking system a liquidity reprieve with its recent loan facilities, and with liquidity conditions restored, the banking system has continued to function even as sovereign debt losses are likely to be on the order of half a trillion or so. There's no reason this can't continue.

As I've been pointing out since last July, the consequences of debt defaults have been greatly exaggerated because most people apparently don't understand that debt is a zero-sum game. The defaulting debtor wins, and the creditor loses. Debt is simply a promise to redistribute cash flows in the future, and if the debtor can't generate those cash flows, he can't redistribute them. The over-spending and over-borrowing that has been the bane of the PIIGS long ago resulted in economic losses, because the money they borrowed was not spent on productive activities. The Eurozone economy's scarce resources have already been wasted, and that's water under the bridge. All the gnashing of teeth and pulling of hair since last summer has just been about who will have to take the losses on his balance sheet. The economic losses have been incurred, now it's just about who will have to account for them.

Even if PIIGS debt losses were to reach $1 trillion, that would only be a drop in the global stock and bond market bucket, which is worth over $100 trillion.

Wednesday, January 25, 2012

More fiscal and monetary stimulus means more slo-flation

The Law of Unintended Consequences, coupled with a contrarian mindset, is often the best way to understand the impact of government policies on the economy: whatever the government is trying hardest to do, expect the opposite. At the very least, remain very skeptical.

Today the FOMC reminded us that they are trying really, really hard to stimulate the economy by keeping short-term interest rates very, very low, "at least through late 2014." Notably missing in today's FOMC statement was boilerplate which promises that the FOMC will keep its eye on the evolution of inflation and inflation expectations. The Fed is trying to be bold, but even they realize that "a highly accommodative stance for monetary policy" is only likely to foster more inflation rather than more growth. Rising inflation expectations sap some of the economy's vitality by steering resources to speculative activities (e.g., buying gold and stockpiling commodities, buying other currencies), rather than taking on real risk by investing in new plant and equipment and creating new jobs.

Last night, in his SOTU speech, Obama reminded us that he is willing to do just about anything to help the economy grow—except to give the private sector more room to work its growth magic. That would expose the fatal conceit of those, like him, who believe that nothing good can come if it does not originate in Washington. It's not enough to just lower the corporate tax rate to a more competitive level and eliminate loopholes and tax subsidies. He'd rather punish corporations that "export" jobs overseas, and reward those who bring them back, as if the federal government or mere politicians knew better how to manage a business like Apple than Tim Cook. Unfortunately, the more changes to the tax code designed to create politically-favored outcomes, the more distortions this introduces to the economy and the less growth we are likely to get.

Today's market reaction to the SOTU speech and today's FOMC news was consistent with this interpretation: thanks to myopic fiscal and monetary policies, we're likely to see somewhat more inflation, and only modest real growth. Call it slo-flation, rather than stagflation.

The 10-30 Treasury spread is the only part of the yield curve that is more or less immune to Fed ministrations. By pledging to keep short-term rates very low for years, the Fed can dominate interest rates out to the 10-yr maturity area. But they have very little control over interest rates beyond 10 years. The 10-30 spread has been widening since last October, in line with the rise in forward-looking inflation expectations, as shown in the above chart. Both jumped today because the bond market is getting nervous about the prospects for inflation.

Gold shot up by $43 in the wake of the FOMC announcement. This makes perfect sense, since extremely low borrowing costs locked in for a long time make it easier and safer for speculators to bet on rising gold prices, and extremely accommodative monetary policy promised for as far as the eye can see only undermines the outlook for the dollar's purchasing power, thus boosting the demand for tangible assets.

The S&P 500 inched higher, up only 0.5% as of this writing. The trailing PE ratio of the S&P 500 is still less than 14, substantially lower than its long-term average of 16.6, and Apple's trailing PE of 12.75 and expected PE of 11.21 is hardly what one would expect to see for a rapidly-growing company. Low PE ratios—especially in today's environment of super-low interest rates—can only mean that the market is highly skeptical about the prospects for future growth.

Equity and high-yield debt prices are rising—reluctantly—mainly because the risk of deflation is disappearing, and rising inflation means faster nominal growth and that is good for corporate cash flows. But PE ratios remain depressed, since the promise of true growth remains elusive.

Tuesday, January 24, 2012

Apple is simply amazing

Apple today announced earnings and revenues that far exceeded expectations—once again. As the above chart from MacRumors shows (HT: John Gruber), the biggest source of revenue gains was iPhone sales, which totaled over 37 million units in the latest quarter. And as Matt Richman notes (HT also to John Gruber):

In 2009, Apple sold more iPhones than it did in 2007 and 2008 combined. In 2010, Apple sold more iPhones than it did in 2007, 2008, and 2009 combined. Last year, Apple sold 93.1 million iPhones, slightly more than it did in in 2007, 2008, 2009, and 2010 combined. The pattern continued.

The pattern: "iPhone sales double with every new model."

Here's the history of Apple's share price, including today's after-hours gain of (only) 8%. It's amazing to me that a company that has more than doubled its revenues and its profits in the past year can trade at this morning's PE of 12, with an expected PE of only 12. Moreover, as Bloomberg notes, "per-share profit for the quarter was more than the company earned in any fiscal year before 2010." Is this the greatest American growth story ever, or what?

If you focus on the almost $100 billion that Apple now has in cash, and subtract the taxes necessary to bring the offshore portion of that money back to the U.S., Apple shares ex-cash are trading in after-hours right now for a PE of only 10.5.

Conclusion: this is a very pessimistic market.

P.S. Alert readers may note that my "favicon" is a miniature graph of Apple's stock price. Long-time readers will know I've been an Apple fan for more than three years.

Truck tonnage is very impressive

Truck tonnage (Calculated Risk has lots of details here) is a great way to track the real, physical improvement in the economy. It can be volatile from month to month, but there's no denying that this index is reflecting some very impressive growth in the economy in recent years. The December reading was an all-time high, and was up fully 10.5% from Dec. 2010, the strongest year-over-year showing since 1998.

This chart compares the truck tonnage index with the S&P 500, and clearly it is suggesting that equity prices have plenty of room to rise just to keep up with the physical expansion of the U.S. economy. It's hard to argue with truck tonnage: there's been a lot of improvement going on out there. Meanwhile, equities are still priced to the expectation that corporate profits are going to collapse in coming years. Good news for contrarians like me.

Dollar review: still very weak

By almost any measure, the U.S. dollar is at or near its weakest levels ever, whether nominally or in real terms. This is in part a reflection of the fact that U.S. inflation has tended to be higher than that of other countries, but perhaps more importantly, it shows that the market's outlook for and confidence in the U.S. economy is dismal.

This first chart is the most common measure of the dollar's value (DXY) as compared to a relatively small, trade-weighted basket of six major currencies (EUR, JPY, GBP, CAD, SEK, CHF). The dollar is bouncing along the bottom, today about 10% above its all-time low, and it has lost 50% of what it was worth at its peak in 1985.

This next chart is arguably the best measure of the dollar's value against other currencies. Calculated by the Fed, it shows the dollar's value on a trade-weighted and inflation-adjusted basis against a very broad basket of currencies (over 100), and against a smaller basket of major currencies. Again we see that today the dollar is only marginally above it's all-time lows and has lost one-third of its all-time high value in 1985, when the economy was booming and the Fed had conquered double-digit inflation. Since early 2002 it has lost 25% of its purchasing power against other currencies.

The chart above shows the dollar vs. the yen (blue line), and my calculation of the dollar's Purchasing Power Parity exchange rate against the yen. The idea of PPP is to start with a base value of an exchange rate, preferably chosen from a time when trade and capital flows were in rough balance and inflation differentials were minimal, and then adjust that value for inflation differentials. If country A has less inflation than country B, then country A's PPP exchange rate will rise against B's currency, as it must in order to keep prices equal in the two economies. (In all the charts here, an upward sloping line means that U.S. inflation has on balance between greater than the inflation rate of each individual country.) If a currency trades above its PPP, then it can be considered "overvalued" relative to the dollar, since prices in that country will be higher than in the other country, and a currency trading below its PPP is consequently undervalued relative to the dollar.

If a PPP calculation is done correctly (caution: it's more art than science), then if a currency tracks its PPP over time, tourists from each country traveling in the other should find that prices are roughly the same as what they pay at home for similar goods and services. In the case of Europe, my calculation of PPP suggests that prices in Europe today are roughly 13% higher than prices in the U.S. In other words, the Euro is about 13% overvalued against the dollar.

As this next chart shows, Japan has experienced significantly less inflation than the U.S. since the late 1970s, and that is reflected in the sharply upward-sloping PPP line for the yen. Not surprisingly, the yen has appreciated tremendously against the dollar since 1970 (100 yen buys 4.6 times more dollars today than it did then), as purchasing power parity theory would predict. By my calculations, the yen currently is about 50% overvalued against the dollar, meaning that for a U.S. tourist, traveling in Japan is very expensive.

In contrast to the ever-appreciating yen, the long-term trend of the the pound vis a vis the dollar has been down, as this next chart shows, because U.K. inflation has been higher than U.S. inflation. I was unfortunate to have my youngest daughter studying in London some 5 years ago, when the pound was at its strongest level ever relative to dollar. Today, prices in the U.K. are still more expensive than in the U.S., but not by much—only about 17% by my calculations.

The Canadian dollar today is almost as strong relative to the U.S. dollar as it has ever been, and on a par with the strength of the yen. What a contrast from its weakest level, back in 2002! With Canadian inflation being very similar to U.S. inflation over the past two decades, I doubt that the loonie is going to appreciate further. Canada likely has benefited as much as it ever will from the global commodity price boom. With the loonie trading at close to parity to the dollar, Canadians are finding U.S. prices irresistibly cheap, and on the margin this could put upward pressure on U.S. prices and downward pressure on Canadian prices. For that matter, tourists from almost all parts of the world are finding that U.S. vacations are cheap thanks to the weak dollar.

The story in Australia is very similar to the one in Canada. Like Canada, Australia's economy is heavily influenced by its bounty of natural resources, and commodity prices today are still very near their all-time highs. The commodity boom has been great for the Australian economy, and by extension great for the Aussie dollar. But given the current degree of overvaluation (over 50%), I doubt the Aussie dollar has much upside left. 

I haven't calculated the PPP value of the Chinese yuan, but this chart shows the real value of the yuan relative to a basket of currencies on an inflation-adjusted basis, as calculated by the BIS. What it shows is that since pegging its currency to the dollar at the beginning of 1994, the yuan has appreciated 68% in real terms against the currencies of its trading partners. That puts the yuan right up there with the yen in the ranks of strong and appreciating currencies in recent decades. Over this same 18 year period, the dollar (DXY) index has fallen 16%, and the Real Broad Dollar Index has dropped 6%, so the yuan has unmistakably appreciated in every sense, and significantly, against not only the dollar but against most other currencies. Protectionists in the U.S. should stop complaining about the supposed "unfair advantage" that a supposedly cheap yuan confers on Chinese exports. And anyway, if the Chinese want to sell us cheap stuff, why should we complain? Cheap Chinese goods only hurt a small segment of our economy (i.e., those few that have to compete with Chinese imports, which comprise less than 3% of what U.S. consumers spend every year), but they greatly benefit everyone else. And of course, the strong yuan is the flip side of a weak dollar. Why would we want to cheapen the dollar, since that can only make imported goods more expensive for everyone?

The dollar is worth only marginally less relative to gold than ever before. If the price of gold says anything about a currency's value, the 10-yr surge in gold prices is a gigantic vote of no confidence in the dollar, and an implicit bet by the market that the dollar will lose even more of its value against other things and other currencies in the future.

Non-energy, raw industrial commodity prices are only 16% off their all-time highs, but way above their average in the 1980s and 1990s. This also reflects poorly on the dollar's purchasing power, and it is no coincidence that the rise in gold and commodity prices started at almost the same time as the dollar's decline (relative to other currencies) from its early 2002 highs. Gold and commodity prices act like canaries in the monetary gold mine, warning of dollar debasement.

Crude oil prices are about one-third less than their 2008 highs, but orders of magnitude higher than they were 10 years ago, which not coincidentally was the latest high-water mark for the dollar. It's worth remembering that crude oil, commodity, and gold prices all began soaring very soon after Nixon decided to break the dollar's tie to gold in the early 1970s.

Real estate stands out as one of the very few tangible assets that are not even close to an all-time high. Commercial real estate, for example, is worth about the same today as it was when the dollar reached its peak in early 2002, and residential real estate, according to the Case Shiller property index, is worth only 15% more (though the cost of financing real estate is at an all-time low). In other words, the dollar is worth a lot more relative to real estate than it is relative to other currencies and commodities. That in turn suggests that real estate is the cheapest hedge against further dollar weakness.

Finally, corporate profits aren't worth very much in terms of dollars. Considering that PE ratios are 17% below their long-term average and the dollar is very close to its all-time lows, U.S. equities are practically on a fire sale in the eyes of foreign investors. A dollar of earnings has almost never been so cheap for the rest of the world, yet after-tax corporate profits today are at all-time highs, both nominally and relative to GDP. This has only one meaning: the market has almost no faith that the outlook for the U.S. economy will be anything but dismal. This reflects poorly on our monetary policy, which has the potential to greatly increase future inflation, and on our fiscal policy, since trillion-dollar-plus annual deficits and massive unfunded entitlement liabilities have the potential to significantly increase future tax burdens.

All of the above adds up to a very depressing message: the market thinks the U.S. sucks. However, it also confirms my repeated assertions that valuations are still extremely depressed. Conditions are terrible, even grim, but lots of bad news is priced into just about everything. If U.S. monetary and fiscal policy can move even modestly in a more positive/less negative direction in coming years, there is plenty of upside for equity prices.

Monday, January 23, 2012

Bank lending still accelerating

Commercial & Industrial Loans (a good proxy for bank lending to small and medium-sized businesses) have been expanding at an accelerating rate for more than a year now, having grown by $154 billion since their low in October 2010. Over the past six months, C&I Loans have risen at a 13.4% annualized pace. This is a rather remarkable development that has been way under-appreciated, in my view. It is now very clear that not only are banks increasingly willing to lend, but that businesses are increasingly willing to borrow. I view this as convincing evidence of returning confidence. The deleveraging and general risk-aversion that dominated the private sector's financial decisions since the financial panic of late 2008 has now been replaced by a renewed willingness to take on risk.

Banks are required to hold "bank reserves" at the Fed to support their deposits. Required reserves, shown in the chart above, are thus an excellent indicator of the net impact of bank lending. The fact that required reserves (above chart) have more than doubled since the beginning of the Fed's first Quantitative Easing program in late 2008 is convincing evidence that banks are expanding the money supply by making net new loans. And by an amount that is unprecedented: the M2 measure of the money supply has increased by over $1.9 trillion over this same period, or by 25% in just over 3 years. It's hard to imagine how anyone could think that the Fed's efforts to add liquidity to the economy have failed. At the very least, it can be argued that the Fed's massive attempts at accommodation have been sufficient to satisfy the world's voracious demand for extra dollar liquidity, since inflation has been positive and ongoing, the dollar is roughly unchanged against other major currencies since QE began, gold prices have doubled, industrial commodity prices have risen 14%, and the inflation expectations embedded in TIPS and Treasury prices have risen from almost zero in late 2008 to levels now that approximate what inflation has averaged over the past two decades. If the Fed had been stingy with money, we would most likely have seen convincing signs of deflation in these same indicators. Instead, these indicators strongly suggest that the Fed's efforts to be accommodative have succeeded in adding at least some inflationary impulse to the global economy.

If the economy is suffering from a lack of anything these days, it is most certainly not a shortage of money.

Consequently, I continue to believe that the economy will continue to grow, albeit at a sub-par pace given how far it fell in the last recession. Moreover, I have every reason to think that the pace of nominal GDP growth will likely accelerate at least somewhat over the next few years. If that is the case, faster nominal GDP growth will support growth in corporate cash flows and profits, and help keep default rates low, thus auguring well for the outlook for equities and corporate bonds, particularly those rated below investment grade, where implied default rates are still relatively high.

Friday, January 20, 2012

Panic is slowly fading.

The first chart above is a closeup look at the Vix/10-yr ratio, and the second chart shows the longer-term picture of the same. The market is still nervous (the Vix is still substantially above where it would be in normal times) and holds out little hope for a healthy economy (the 10-yr yield is still at levels that were associated with the Depression), but those sentiments are slowly giving way to the fact that the financial fundamentals in Europe are improving and there are quite a few indicators that show the U.S. economy is improving as well.

The Vix/10-yr ratio was priced to a global catastrophe at its peak in early October, and markets are breathing a tentative sigh of relief that so far nothing all that bad has happened. This year is off to a good start, if only because it's not proving to be as terrible as expected.

The bond/equity disconnect

Over the past several years, bond yields have correlated pretty well with equity prices—yields rise and fall along with the ups and downs of the stock market. Higher stock prices reflect increased optimism (or less pessimism) about the future, and bond yields move in synch because a more healthy economy increases the odds of higher inflation and a tighter Fed. Most of the time the correlation between stocks and bond yields has been 0.6 to 0.8, interrupted with a few relatively brief periods of negative correlation, as can be seen in the two charts below. Over the past few months, we have once again entered one of those periods where the correlation has gone to zero. Equity prices are up, but bond yields remain very low and relatively stable. As the above chart suggests, either bond yields should be at least 100 bps higher, or equity prices should be a lot lower.

In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

I can think of an alternate explanation, but it's not very convincing. Maybe bond yields are low because the market is absolutely convinced that no matter what happens to the economy, inflation is going to be very low for a very long time, and central banks, and particularly the Fed, are going to remain at or close to their "zero bound" for as far as the eye can see. To counter this explanation, I note that break-even spreads on TIPS reflect inflation expectations to be in a 2.0- 2.7% range, which is pretty close to the average rate of CPI inflation over the past two decades (2.5%), and during that time 30-yr bond yields have averaged 5.5%. In other words, I find no evidence to suggest that bond yields today are priced to deflationary concerns, so their low levels therefore more likely reflect an intense risk aversion on the part of investors.

In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to.

My money is on bonds catching up to stocks—bond yields are more likely to rise than stock prices are to fall. What could trigger this? Maybe the Fed bows to the same realities that are driving equity prices higher, and informs us that with the economy doing better on the margin, the Fed mostly likely won't have to keep yields at zero for the next several years as the market currently believes it will. Or maybe Greece finally executes its default, but the world does not come to an end (after all, a huge default has been fully priced in for a very long time, so it should not prove surprising or disruptive when it finally happens). Or maybe the simple passage of time without anything disastrous occurring will do the trick—markets can't stay priced to disaster forever if a disaster doesn't occur.

Meaningful improvement in Eurozone fundamentals

Here's a quick recap of important indicators of financial market health, which all register substantial improvement, especially in the Eurozone. Even though a Greek default is a virtual certainty (Greek 2-yr yields today are 180%), these indicators suggest that the risk of contagion to other countries has dropped significantly, and the Eurozone financial system is not destined to collapse any time soon. 

2-yr swap spreads are an excellent indicator of financial market liquidity and systemic risk. Spreads are down meaningfully in the Eurozone, albeit still quite elevated. U.S. spreads are now back to a level that is consistent with "normal" conditions.

Euro basis swaps reflect the difficulty that Eurozone banks are having in obtaining dollar liquidity. Funding pressures have eased significantly in the past month, leading the way to reduced swap spreads, also a measure of counterparty risk. Eurozone financial markets are exiting the danger zone when liquidity dries up and trading freezes.

2-yr yields on sovereign debt are a good measure of the market's estimation of default probabilities. Greek yields have soared, but all other countries have seen meaningful declines in the past few months. Italian 2-yr yields have fallen by half since their peak in late November. This is rather impressive.

The cost of obtaining insurance against Eurozone defaults has not declined as much as 2-yr yields, but the CDS contracts represented here cover a 5-yr period. The combination of only marginal improvement in CDS plus significant improvement in 2-yr yields means that while the market realizes that defaults are not likely in the near term, they remain a risk over a longer time horizon. Efforts to restore liquidity and confidence to Eurozone markets have been reasonably successful, but investors have yet to see any meaningful steps on the part of the PIIGS governments to address their fundamental problem, which is bloated, deficit-financed government spending.

The decline in systemic risk in the Eurozone is one reason that the U.S. equity market has been able to move higher in recent weeks, and the implied volatility of equity options has dropped to a 5 1/2 month low. As risk declines, risky asset prices rise.

Thursday, January 19, 2012

Effective tax rates are highly progressive

There's a lot of chatter these days about whether the rich pay a high enough tax rate. Warren Buffett comes to mind, as do the recent attempts to shame Mitt Romney for paying only 15% of his AGI in tax.

Confusion arises only if we look at part of the picture. For example, everyone who is employed pays social security tax and personal income tax. But only those with investment income pay capital gains and dividends tax. And in order for investors to receive capital gains and dividend income, the companies they have invested in—with after-tax dollars—need to pay a corporate income tax. Consider, for example (and I'm simplifying), a worst-case scenario person who is self-employed, whose income puts him in the top Federal and California income tax bracket, and who has substantial income from investments. He pays 35% federal income tax, 9% state income tax, a 15% social security tax, and a 2% medicare tax. Any income he receives from his investments—which were originally made with after-tax dollars—is effectively what the companies he owns have earned after paying a 35% corporate income tax, and on top of that he must pay 15% of what is distributed to him—he might be paying an effective tax on his total investment income of as much as 45%. Depending on how the numbers stack up, this unfortunate person could be paying an enormous effective tax rate—well over 50%—on his total income.

When Warren Buffet says he only pays a 15% effective tax on his income, that's because his income mainly comes from capital gains and dividends, and he is completely ignoring the fact that the companies he owns must pay a corporate income tax of as much as 35% before he can receive those gains and dividends.

Fortunately, we do have access to facts that do not distort or color the picture. The chart below uses the numbers as crunched by the Congressional Budget Office. The effective total tax rate shown is the ratio of total federal taxes (income, social security, corporate, excise) divided by comprehensive household income. As Greg Mankiw notes, our tax system is highly progressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way.

Greg Mankiw also has a nice summary of how progressive our tax system actually is:

1. The U.S. personal income tax is generally progressive, and substantially so. Click here to see the numbers. The average tax rate for tax returns with over $1 million in income is 25 percent. The average tax rate for returns with income between $50,000 and $75,000 is 7 percent.
2. It is arguably better to use an average tax rate that is all-inclusive. That is, we should include not only personal income taxes but also payroll and corporate income taxes. CBO analysts regularly do that. They find a substantially progressive tax system, as I have pointed out before.
3. If we added transfer payments (which are essentially negative taxes), we would find an even more progressive fiscal system. Those data are harder to come by, as data on transfers are rarely integrated with data on taxes.
4. It make little sense to aggregate payroll taxes with personal income taxes and ignore corporate income taxes.

Inflation remains relatively tame

The headline Consumer Price Index in December was flat, compared to expectations of a 0.1% increase. On a year-over-year basis, the CPI has fallen from a high of 3.9% to 2.4% in the past three months. As this chart shows, all of that decline was due to energy prices, which have been relatively flat to down for the past three months (oil was up but gasoline prices have fallen and natural gas prices have dropped significantly). The CPI ex-energy has continued to pick up.

Inflation is not dead, deflation is not a threat, and so far inflation has not been the problem I thought it would be. Thank goodness.

Housing starts rose 25% last year

December housing starts were less than expected (657K vs. 680K), and were 70% below their early-2006 peak; a pessimist would say that's pretty grim. But an optimist like me is quick to note that last year housing starts rose by a very impressive 25%. The big housing bust that began in early 2006 likely ended about a year ago—5 long years of terrible destruction for the residential construction industry. But it's over, finally.

For all those who have been saying that we'll never get a decent recovery until the housing market starts improving, your time to turn optimistic about the future has come.

For all those who say that those on the right of the political spectrum are hoping for a lousy economy so that Obama can be forced out, I want to emphasize once again that I think the economy is improving not because of anything Washington is doing but rather in spite of all the things that Washington has been doing to try to help. As I said in my forecast for 2012, "Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue." This is an organic recovery, if you will. The U.S. economy is by nature dynamic; it never pays to underestimate it. The economy will probably be doing a little better come November, but I suspect that Obama will find it difficult to turn that to his advantage. Unemployment is still going to be high, the deficit will still be gigantic, gasoline prices will be high, the dollar will still be relatively weak, and government's presence in our midst will still be oppressive.

Claims continue to fall

First-time claims for unemployment last week fell by a surprisingly large amount, and were significantly less than expected (352K vs. 384K). Nevertheless, at this time of the year, when layoffs are just coming off their annual peak, the seasonal factors are very large so we have to take this news with a few grains of salt. Still, it's clear that employers by now have done the bulk of the cost-cutting and cutbacks that they needed to do, so the next phase of the economy's expansion will see more emphasis on new jobs rather than getting rid of jobs. That process is underway, but only gradually. Things could improve more convincingly as the year wears on and employers get more comfortable with the likely future direction of fiscal and monetary policy.

Wednesday, January 18, 2012

Thoughts on producer inflation

Once again the headline measure of Producer Price Inflation came in below expectations (-0.1% vs. +0.1%), with the result that on a year-over-year basis, this measure of inflation has been declining for the past 5 months. Unfortunately, that good news is fully offset by higher-than-expected core PPI inflation. And unless oil prices spike again, these trends are likely to continue. I note, for example, that the headline PPI is up a cumulative 40% over the past 10 years, while the core PPI is up only 20%; this divergence is bound to narrow over time, with the core measure catching up to the headline measure as higher energy prices slowly filter down to other prices.

One thing that should stand out here is that PPI inflation over the past 10 years (with a compound growth rate of 3.4% per year) has been and continues to be higher than it was in the previous 10 years (when the compound growth rate was 1.2% per year). And what has changed in the past decade? Monetary policy was undeniably tight in the 1990s, but the Fed has been working overtime to be accommodative for most of the past 10 years. That same message can be found in the dollar, which rose throughout the 1990s and early 2000s and has been falling for the past 10 years. It works like this: monetary policy impacts the value of a currency, and a declining currency eventually results in higher inflation.

Another thing that doesn't receive as much attention as it should is that Treasury yields have been lower than the rate of PPI inflation for most of the past four years. We haven't seen such low real interest rates since the highly inflationary 1970s, when the Fed was chronically "behind the curve," repeatedly failing to raise interest rates enough to constrain the high inflation that was triggered by the collapse of the dollar early in the decade.

Low real interest rates, a weak dollar, and an accommodative Fed are a combination that augurs for inflation that continues to surprise on the upside for the foreseeable future. In fact, that's been the case (higher than expected inflation) ever since the end of the last recession. Recall that at the end of 2008 the expected 5-yr, 5-yr forward annual CPI inflation rate embedded in TIPS prices was 0.5%. Instead, the CPI has averaged 2.1% a year over the past 3 years.

When inflation exceeds expectations and real interest rates are uncommonly low for several years running, this has distorting effects on economic activity. Since borrowing costs have been unexpectedly low and the returns to commodity investing have been unexpectedly high, it's not surprising that the mining and related sectors have been on fire, and commodity producers like Australia and Canada are at the top of their game. I wish I knew how much longer this will go on, but one thing is for sure: central banks are setting up the global economy for an inevitable and sharp correction in commodity prices and a return to rising borrowing costs.