Wednesday, February 29, 2012

Great day at Telluride

After almost one foot of fresh powder yesterday, today we had a beautiful morning skiing. This shot, taken with my iPhone 4S, was taken at the top of the Plunge lift. Magnificent views all over the mountain:

Federal debt burden by president

While relaxing after several hard days of skiing in Telluride, my brother Dick suggested a change to the chart I featured in a post earlier this month. I liked his suggestion, which was to add color to the bars in order to distinguish between periods of rising (red) and falling (green) debt burdens. And I like the chart even more now—though it has been highly controversial, generating more positive and negative comments than almost any post I can remember. Since this is a very important issue, I think it bears repeating. What follows is adapted from the original post, with additions meant to clarify some of the issues that came up in the comments.

The chart above addresses the issue of how much federal debt was accumulated during past presidencies. There are many ways of calculating this, and it is of course difficult to lay the blame on any president for increasing the national debt, since only Congress can spend money. But the president sets the tone of the national debate, and like any chief executive, he must bear the ultimate responsibility for what happens during his watch.

I think there is only one correct way to calculate the burden of our national debt, and that is to compare the debt owed to our national income (GDP). The nominal size of our economy is a critical variable, since it is one thing to owe a million dollars if your income is 10 million, and it is quite another to owe a million dollars if your income is only one million. Using this method, if GDP grows by a nominal 10% and our debt grows by the same amount, then there has been no net increase in the debt burden. Some might argue that the average interest cost of the outstanding debt should be factored in, since it is one thing to owe a trillion dollars when interest rates are 1%, and quite another to owe a trillion dollars if interest rates are 10%. But interest rates tend to track inflation over time, so while higher interest rates increase debt service costs, they don't necessarily increase the overall burden of the debt, since the economy tends to grow by at least the rate of inflation over time. Debt service costs are quite low right now because interest rates are exceptionally low, but this could change dramatically once the Federal Reserve starts raising short-term interest rates, and if inflation starts to pick up. On average, and over time, the effect of inflation tends to cancel out the effect of interest rate costs.

Each bar in the chart above represents the Federal debt burden at the beginning and end of each presidency. In his first four years of office, Obama will have added considerably more to our federal debt burden that any post-war president. (The Federal debt burden reached an all-time high of more than 100% of GDP at the height of WW II, then declined steadily through the early 1970s.)

Furthermore, I note that Obama's contribution to our debt burden during his first term is likely to be about 25% of GDP, while the next biggest post-war contribution came during two terms of Bush II (15.3%). If Obama wins a second term and the economy and fiscal policies evolve along the lines currently projected by OMB, Obama could end up adding more to our debt burden that all past presidents combined. I don't think there is any way to escape the conclusion that fiscal policy under Obama has been conducted in reckless and unprecedented (with the exception of WW II) fashion, especially since all that deficit spending has done practically nothing to improve the economy—indeed, as I have been arguing for the past three years, "stimulus" spending has only weakened the economy, since it has consisted mainly of transfer payments which create perverse incentives.


For Federal debt I use the amount of debt held by the public, not total debt (which includes debt the federal government owes to itself, e.g., to social security). If I included all debt, then the current debt burden would be more than 100% of GDP. I think it's reasonable and conservative to use debt held by the public, since debt that the government owes itself is not necessarily an inescapable obligation; social security benefits are not cast in stone, and they are not an individual's property, whereas Treasury debt held by an individual is sacrosanct. Social security obligations can change at the whim of politicians (e.g., by raising the retirement age), and the tweaking of benefit formulas—for example, adjusting future payments by the rate of inflation instead of by the rate of wage inflation (which includes a real and an inflation component) would cause the future liabilities of social security to decline dramatically. 

For the amount of debt incurred during each presidency, I have compared federal debt outstanding to nominal GDP at the end of each calendar quarter immediately following a president's assumption of office. Thus, Bush II starts in Mar. '01 and ends in Mar. '09. For one, this allows me to use GDP data which is only available on a quarterly basis. I also think it makes sense to give a new president a month or two to get his feet on the ground, and to credit outgoing presidents with the policies they set in motion before they left. I recognize that a new president may find it difficult to immediately and significantly change the policies he inherits, but he has at least four years to get things right. In this regard, I note that there have been several sizable reversals in the chart above (e.g., Clinton inherited a rising debt burden but managed to reverse that in significant fashion, while Bush II did just the opposite).

In order to project the federal debt burden as of Mar. '13, I assume that the federal deficit in the 15 months prior will be an annualized $1.2 trillion, and that nominal GDP will grow by an annualized 5%. I believe these are conservative assumptions for the purpose of this analysis, since the OMB is projecting a higher deficit and there are many analysts projecting slower GDP growth. A bigger deficit and slower GDP growth would result in a larger increase in the debt burden than shown here.

US equities trounce Eurozone equities

The top chart compares the level of the S&P 500 to the level of its Eurozone counterpart, the Euro Stoxx index, while the bottom chart shows the ratio of the two. U.S. equities have massively outperformed Eurozone equities over the past five years—by over 60%. This could be likened to the price that the Eurozone is paying for its debt-financed bloated government spending.

Tuesday, February 28, 2012

Housing prices were still weak late last year

By these two measures, housing prices were still weakening in the fourth quarter of last year (these indicators lag reality by at least several months). In real terms, the Case Shiller home price index is down 40% from its early 2006 high. This has been a really ugly housing market, no question. But that's what happens when the government goes all out to promote home ownership—subsidizing mortgage interest, directing Fannie and Freddie to buy mortgages made to people who couldn't afford traditional financing—and the Fed keeps real interest rates very low for years: prices rise to unaffordable heights, too many homes get built. Prices and new construction have to fall in order to clear the market.

Are they getting ready to plunge to new, disastrous lows, or are we close to a bottom in real estate? I've been thinking we're close enough to a bottom that it makes more sense to look ahead to improvement than to worry about further declines, and I continue to feel that way.

Weak January capex probably not a real problem

January capital goods orders were quite weak, weaker than weak expectations. The first month of every quarter is always weak, and this one was no exception. January '11 orders actually fell a bit more than they did this year. On a year over year basis, orders are up 5.9%, but over the past six months they are up only 1.3%. Is this a sign of an economy about to enter a recession? It could be, but a) it's too early to tell, and b) it doesn't jibe with so many other indicators of strength (e.g., a pickup in jobs growth, falling unemployment claims, strong car sales, strong corporate profits, an upturn in residential construction, good ISM service and manufacturing reports, an upturn in commodity prices). The January weakness was predicted by many analysts on the basis of the expiration at the end of last year of a tax incentive allowing full depreciation of equipment purchases, so that needs to be factored in as well.

While noting the recent—and largely explainable—weakness in business investment, the unusual strength in this indicator in recent years is still very impressive, so I'm willing to refrain from drawing any meaningful conclusions at this point.

Monday, February 27, 2012

Consumers get control of their finances

Consumers' financial health continues to improve, as delinquency rates on credit cards and consumer loans in general continue to decline (latest data available is 12/31/11, so it is quite likely that current rates are even lower). Credit card delinquency rates are now at their lowest level since 1991. Mark Perry has some related comments on business loan delinquency rates, which have also fallen impressively. All of this suggests that the economy is much less vulnerable to unforeseen difficulties or slowdowns.

Blogging will be light this week

Blogging will be light this week since this is my annual Guys Ski Week. We're at Telluride this year, and as the photo above shows (taken with my iPhone 4S of course), the views are spectacular. We're expecting snow tonight and tomorrow, so this should be a great week of skiing. Yesterday the snow was good packed powder, and it seemed like the mountain was practically deserted.

Friday, February 24, 2012

Bank loans continue to accelerate

Bank lending to small and medium-sized businesses continues to accelerate. C&I Loans outstanding are up at a 15.2% annualized rate in the past 3 months, and have risen 12.3% over the past year. Since the recent low in Oct. '10, C&I Loans have grown by $174 billion, or about $2.5 billion per week on average; in the past 3 months the pace has picked up to $3.7 billion per week on average.

M2 growth has also been robust, fueled in part by increased bank lending. I think it's rather astonishing, actually, to see in this chart that the M2 measure of our money supply has risen by almost $3 trillion in the past 5 years. The increase since early 2007 works out to $10 billion per week on average. Surely there is no shortage of liquidity in this economy. In fact, M2 has grown over 20% more than nominal GDP since the end of 2006. So far, it would appear that the major driver for M2 expansion has been increased money demand: people simply want to have more "cash" on hand because they are worried about the economy. Savings deposits now represent about 63% of M2, and they have contributed the lion's share of M2 growth in recent years.

One of the biggest changes we should expect to see in the economy and the markets over the next year or two will likely come from the unwinding of all this demand for cash. I seriously doubt whether the Fed will be able to soak up all the money that may be unleashed by a public that is no longer willing to hold a mountain of zero-interest-bearing cash, and wishes instead to exchange that cash for all manner of more interesting things. Stepped-up bank lending and a reversal of cash hoarding could unleash a wave of liquidity into the market and the economy, boosting nominal GDP, boosting corporate cash flows, boosting commodity prices, and yes, likely boosting inflation.

Income taxes are now bailing out Social Security

I'll wager that the vast majority of taxpayers are completely unaware (as I was until today) of the fact that the payroll tax cut "stimulus" that was enacted in December '10 and extended through this year was financed by income tax revenues. This represents an ominous milestone in the history of Social Security, since it marks the first time that the program has ceased to be a government-run annuity program and now operates at least partially as a pure income redistribution scheme. Charles Blahous lays out the facts and the implications in an excellent article, The Dark Side of the Payroll Tax Cut, which I have excerpted here:

In December 2010, President Obama and Congress reached an agreement whereby the Social Security payroll tax would be cut by two percentage points in 2011—from 12.4 percent to 10.4 percent—as a temporary stimulus measure. The president later proposed that the cut be extended and expanded in 2012. Before Congress went home at the end of 2011, it passed a 60-day extension of the two-point tax cut. The payroll tax cut has now been further extended to last throughout 2012 at least.
Most public discussion of the payroll tax cut has pertained to its efficacy (or lack thereof) as economic stimulus. Its greater policy significance, however, lies in another provision tucked into the same law. This provision is now transferring more than $215 billion in general tax revenues (e.g., income taxes) into the Social Security Trust Fund to make up for the reduction in payroll tax revenue.
In other words, the payroll tax cut is not really reducing the amount of tax revenues committed to Social Security. All that it actually does is to shift the Social Security financing burden from covered workers to others—most notably, to those Americans who pay income taxes. This is a transformative change to Social Security, reflecting goals for broader income redistribution now ascendant on the left end of the American political spectrum.
The new policy ends the longstanding requirement that Social Security expenditures be limited to the total amount of its tax collections (plus interest). And, by subsidizing payments with income taxes, it ends the idea that the Social Security benefits are fully “earned” by recipients.
The recent shift to income-tax-financing embodied in President Obama’s payroll tax cut policy cannot be said to represent a bipartisan agreement with this new policy view. Instead, the payroll tax cut was first proposed on the basis that it was necessary for economic stimulus, and later extended with the argument that doing otherwise would impose a painful tax increase on working Americans. The fact that the law also contained a provision to begin significant subsidization of Social Security with income taxes only belatedly gained the notice of the press, and not yet of the general public.
A critical milestone has nevertheless been passed. Beginning in December 2010, and continuing through to the present time, the federal government has embraced the policy of committing income taxes to subsidize benefits beyond those that Social Security itself can finance. Unless this policy is rapidly reversed, readers of this article who pay income taxes should brace themselves for the substantial new taxes they will soon be paying to bail out Social Security.

This is a very important article that deserves your attention. It's a "camel's nose under the tent" story of how and why our federal government's primary function these days is to redistribute income—60% of federal spending now consists of transfer payments—and how income redistribution will continue to expand unless it is forcibly rejected by the voters. Taking money from the more productive members of our society and handing it out to the less productive members can only result in the impoverishment of all, since it creates terribly perverse incentives to work less.

HT: Glenn Reynolds, one of America's MVPs.

P.S. Oh, and by the way, the payroll tax cut is one of the worst ways to use the tax code to stimulate the economy, since it does nothing to reward more work and risk-taking. So this whole "stimulus" program has not only harmed the economy, it's been used as a way to sneak greater income redistribution into our already bloated, redistributionist government. 

Thursday, February 23, 2012

Update on the bursting of the housing price bubble

I last posted a version of this chart in early January, citing it as evidence that the housing price bubble had definitely burst. With January data now available, here's an update. According to the National Association of Realtors, and adjusted for inflation, real median home prices of existing single-family homes are now back down to where they were in the mid-1970s. That's a monster correction. Prices could go lower—I'm not saying they won't—but I think investors and potential homebuyers should be looking at this as a sign that the next big thing to happen to the housing market is more likely to be significantly higher prices rather than significantly lower prices.

I received several critical comments about my post yesterday (More progress in the housing market) from readers who assert that data from the NAR is not to be trusted. That could well be true, and is probably good advice, but the same goes for just about any data source that is not based on real-time, liquid market prices (e.g., data on jobs, which can be skewed by faulty seasonal adjustment factors, and are based on surveys and estimates, and which are likely to be revised in the future). Regardless, while the NAR may have a bias to make home sales look stronger than they really are, I doubt that they have an interest in making home prices look weaker than they really are.

In any event, this chart of housing affordability (which shows that a family earning the median income has 195% of the income needed to purchase a median-price resale home using conventional financing) does reinforce my larger point, which is that housing likely has never been more affordable for the average family than it is today, thanks to the combination of sharply lower home prices, record-low mortgage rates, and rising real incomes. (The chart above also comes from the NAR, but affordability is so high that it's doubtful they can be completely fudging the numbers.) This is a time to be excited about buying, not fearful.

Still more improvement in the labor market

It should now be quite obvious to all that there has been some significant improvement in the labor market over the past several months, since first-time claims for unemployment have been consistently lower than expectations. At the current rate of improvement, claims could very soon be about as low as we might expect them to get if the economy were healthy (approximately 300K per week). But of course what is still missing from the picture is a significant increase in new hiring. Businesses have done almost all the cost-cutting that they need to, but they have not yet made a serious effort to grow.

The reluctance to expand and hire more aggressively is very likely due to a number of factors commonly cited, such as increased regulatory burdens, increased healthcare costs, and uncertainty about the future level of tax rates. In other words, businesses are reluctant to hire because the cost of labor has increased substantially, and the cost of labor and overall tax burdens might increase even more in the future. This is what happens when government spending ratchets higher, as it has over the past 3-4 years; a higher level of public-sector spending relative to the economy must eventually require a higher level of taxation, and a state-managed healthcare industry must eventually become more expensive and less efficient (government bureaucrats cannot possibly run the healthcare industry better than free markets can). The slow-growth fundamentals which frustrate us all—and which boil down to government crowding out the private sector—are unlikely to change in the near term, but the outlook for spending and taxation could change significantly (for the better, I hope) as the presidential election debate kicks into high gear this summer.

PE ratios are still substantially below average and profits are at record levels, which means the market is priced to a substantial deterioration in the fundamentals and is probably resigned to some increase in future tax burdens. But with the ongoing improvement in the labor market, equity prices have little choice but to drift higher, as the chart above suggests. As I've been suggesting for years now, this market is being driven not by optimism, but by the realization that the economy has not proven to be as bad as was expected. Three years ago the market thought we would still be in a deflationary depression today, but instead we're in a slow-growth expansion, climbing walls of worry.

Wednesday, February 22, 2012

Japan gets serious about fighting deflation

This chart shows the Japanese Yen/US Dollar exchange rate since the beginning of last year. What stands out this past month is the sharp depreciation of the yen, which has dropped 5.1% against the dollar in the past three weeks. It's the result of the Bank of Japan undertaking serious intervention steps to weaken the yen, which reached an all-time high of 75.8 against the dollar last October.

Typically, forex intervention is not very effective at changing a currency's value, since most intervention is "sterilized" by monetary authorities. For example, one arm of the government sells its currency for dollars in order to weaken it, thus increasing the supply of its currency, but then another arm sells bonds in order to mop up the extra supply of the currency. With no net change in the supply of its currency, the intervention leads to only a temporary change in the currency's underlying supply/demand fundamentals.

But as the chart above shows, this time the Bank of Japan is working hard to make the increase in the supply of yen permanent, by dramatically increasing its bond purchases and paying for them with bank reserves. In the upper right hand corner of the chart you can see where this latest version of quantitative easing has caused bank reserves to jump by 76% in the year ending Jan. '12. Not only is the BoJ intervening to weaken the currency and pumping up the supply of bank reserves to expand the money supply, but the BoJ has also announced a formal inflation target of 1%. They are working hard to stop the yen from appreciating further—since that leads directly to increased deflationary pressures—and they are actively trying to get inflation to rise at least modestly, from the current zero to 1%. These efforts stand a good chance of working, since they have worked in the past.

The above chart also shows how the BoJ pursued its first round of quantitative easing by greatly expanding the supply of bank reserves from mid 2001 to early 2006. During this time the yen averaged 115 against the dollar, which is about 30% weaker than it is today. In addition, inflation rose from a low of -1.6% in early 2002 to a high of 2.3% in 2008 (a lagged response to easy money in prior years). In other words, that round of quantitative easing produced results. But then the BoJ reversed its quantitative easing, slashing bank reserves by 75% over the course of 2006. This tightening set in motion the yen's record-breaking 60% rise against the dollar, from a low of 124 in mid-2007 to an all-time high of 76 in late October '11.

The chart also shows the origin of the deflation that has plagued the Japanese economy for so long. That's in the middle portion of the chart where I've highlighted the fact that the BoJ allowed zero net expansion of bank reserves from 1990 through 2001. With policy so tight, it is no wonder that the yen rose from a low of 160 in 1990 to 110 by the end of 2000—an appreciation of 45%.

Bottom line: Japanese monetary policy has tilted decisively in favor of at least some mild inflation, and decisively against further deflation. This may improve the outlook for the economy—and I note in that regard that the Nikkei 225 index is up 12% in the past month—if only because it will likely result in a pickup in aggregate demand as money velocity rises. The yen is likely to depreciate further against the dollar, thus providing some support to a dollar that has suffered from significant weakness against most currencies in recent years.

More progress in the housing market

January data released today on existing home sales continues to support my contention that the housing sector is in recovery mode. In the top chart we see that misbegotten government efforts to stimulate housing sales (e.g., rebates) only made sales more volatile—pushing sales up in late 2009 only to depress them in 2010—but not any stronger. Over the past year we have seen some genuine improvement, with sales up about 10% from last February. As the second chart shows, with the pickup in sales activity and a modest decline in homes being put up for sale we have seen the months supply of unsold homes drop to a new post-recession low. The situation today looks better even than it did in the mini housing bust of the early 1980s. The housing market is making real progress, even though it is still in bad shape. It's not the level of home sales that counts, it's the change on the margin, and that is positive.

Tuesday, February 21, 2012

Charting the recovery

I've put together a fairly random selection of charts that I think provide some valuable insight into the nature of the economic and financial market recovery that began about 32 months ago. Two major themes stand out: 1) although the economy is still quite weak, there is noticeable improvement on the margin in a number of key areas, and 2) markets are still priced to very pessimistic assumptions about the future. Although there are many things to worry about (e.g., huge federal budget deficits, excessive monetary accommodation, sovereign debt defaults), the market is fully aware of the problems and only reluctantly accepting the fact that things are improving on the margin. 

The economic recovery has been very modest—quite weak in fact. I estimate the economy is operating about 13% below its potential, which is why there are 6 million fewer jobs today than there were at the peak of the previous business cycle. The economy is still struggling to grow, most likely because the Fed and the Congress have been trying so hard to "stimulate" it. Yet despite the economy's dismal state, there are numerous indicators that show substantial improvement on the margin. Things could be a lot better, to be sure, but things are nevertheless getting better.

Bank lending to small and medium-sized businesses continues to expand, and at an accelerating pace: C&I Loans are up at a 13.4% annualized pace over the past 3 months, and up 12.1% over the past year. This reflects increased confidence on the part of businesses and banks, and is an excellent sign that underlying financial and economic fundamentals are improving.

The ongoing improvement in the stock market tracks the ongoing improvement in the health of the labor market, in the form of declining claims for unemployment. This rally is based on improving fundamentals, not excessive optimism.

Rising equity prices are being driven in large part by declining fear. The Vix index is still somewhat elevated from an historical perspective (12-15 would be considered "normal"). 10-yr Treasury yields are still very low, and the ratio of the two is a good measure of the degree to which panic and pessimistic views of the future are driving market sentiment. Bottom line, the market is still fearful of the risk of Eurozone defaults, central bank accommodation, and very pessimistic regarding the ability of the U.S. economy to grow, because 10-yr yields are still trading a depression-era levels.

The market is still trading at PE ratios that are below the long-term average, yet corporate profits are at all-time highs, both nominally and in terms of GDP. This is a good sign that the market is still priced to pessimistic assumptions (e.g., profits are expected to decline significantly).

The banking industry is still in miserable shape, but technology and even consumer staples have staged impressive recoveries. Technology is leading the way, and that is good because that's a significant source of improved productivity for workers all over the world, and that, in turn, augurs very well for future economic growth.

Swap spreads in the U.S. are back down to levels that reflect little if any unusual systemic risk in the financial system. Eurozone swap spreads are still quite elevated, however, but do show some recent improvement. The Greek "bailout" announced today does little to improve confidence in Greece's ability to service its debt (a default is still highly likely), but the Eurozone financial system has pulled back from the brink of the abyss thanks to the ECB's efforts to expand liquidity, since this has bought time for the market to digest the huge losses that are priced into Greek debt (trading today at 20 cents on the dollar) and for risk-takers to take on more of the risk of future Eurozone defaults. Given time and and liquidity, free markets can solve almost any problem.

Sunday, February 19, 2012

Putting Obama's deficits in perspective

I offer this chart in the hope of clarifying the ongoing controversy over how much federal debt was accumulated during past presidencies. Each bar represents the Federal debt burden at the beginning and end of each presidency, and the bars are added together in cumulative fashion. As should be readily apparent, in his first four years of office Obama will have added considerably more to our federal debt burden that any post-war president. (The Federal debt burden reached an all-time high of more than 100% of GDP at the height of WW II, then declined steadily through the early 1970s.)

Lest I be criticized as too partisan, I note that Clinton achieved the largest reduction in our debt burden of any president since the 1950s.

My assumptions: For Federal debt I use the amount of debt held by the public, not total debt (which includes debt the federal government owes to itself, e.g., to social security). I have compared federal debt outstanding to nominal GDP at the end of each calendar quarter immediately following a president's assumption of office: thus, Bush II starts in Mar. '01 and ends in Mar. '09. I do this in order to give a new president a month or two to get his feet on the ground, and to credit outgoing presidents with the policies they set in motion before they left. Also, this allows me to use data which is only available on a quarterly basis. I reject the notion that an incoming president must necessarily shoulder the policy burdens of the outgoing president, and in this regard I note that there have been several sizable reversals in the chart above (e.g., Clinton inherited a rising debt burden but managed to reverse that in significant fashion, while Bush II did just the opposite). Finally, I consider debt outstanding as a % of GDP to be the best measure of our national debt burden, since it adjusts for growth in the economy and inflation.

In order to project the federal debt burden as of Mar. '13, I assume that the federal deficit in the 15 months prior will be an annualized $1.2 trillion, and that nominal GDP will grow by an annualized 5%. I believe these are conservative assumptions for the purpose of this analysis; the OMB is projecting a higher deficit and there are many analysts projecting slower GDP growth. A bigger deficit and slower GDP growth would obviously result in a much larger increase in the debt burden than shown here.

Finally, I note that Obama's contribution to our debt burden during his first term is likely to be about 25.6% of GDP, while the next biggest post-war contribution came during two terms of Bush II (15.3%). If Obama wins a second term and the economy and fiscal policies evolve along the lines currently projected by OMB, Obama could end up adding more to our debt burden that all past presidents combined, and almost as much as was taken on to fight WW II—a highly dubious distinction, needless to say.

The chart above gives some long-term perspective on debt burdens and interest rates. Note how there is no evidence at all that higher debt burdens lead to higher interest rates, or vice versa (if anything, the correlation appears to be negative). The same can be said for Japan, where the government's debt burden is well in excess of 100% of GDP, yet interest rates are even lower than in the U.S.

Friday, February 17, 2012

The problem with Treasury yields

I'm always on the lookout for valuation discrepancies, and these two charts highlight the biggest potential discrepancy that I'm aware of today: Treasury yields are very low given the strength of the economy and the level of inflation. Stock prices are rising because the economy is proving to be somewhat stronger than expected. Inflation is not dead—it's been rising for the past year—and it now is close to where it's been for the past decade, around 2-3%. Yet bond yields are near all-time lows and are priced to the expectation that the economy will be chronically weak and inflation will move towards zero. 

There are of course three valid explanations for why Treasury yields are so low despite the improvement in the economy and the outlook for 2-3% inflation (i.e., the market is not entirely crazy): 1) the Fed keeps insisting that it will keep short-term rates near zero for the next three years, 2) the Fed, via its "Operation Twist," is actively attempting to keep Treasury note and bond yields low, and 3) the world is willing to pay very high prices for the safety of Treasuries given the threat of Eurozone sovereign defaults and the potential demise of the Euro. 

However, those rationales could evaporate very quickly, if a) the Fed becomes convinced that the economy is doing better than expected and there is little risk of inflation being too low, and b) the Eurozone survives a Greek default without any significant collateral damage. I think there is a reasonable chance we could see both of those developments within a reasonable time frame. Thus I view Treasuries as very risky investments, while equities remain relatively attractive, underpinned by relatively low PEs and strong corporate profits.

UPDATE: There appears to be some confusion regarding the market's expectation of future inflation, and I should have made that clear in my initial post. The best measure of expected inflation that I know of is that which is derived from the pricing of TIPS and Treasuries. And the Fed agrees, having annointed the 5-yr, 5-yr forward inflation expectation implied in TIPS and Treasury prices as the "best" measure of the market's inflation expectations. I show that in the chart below, with the current reading being about 2.5%. On a longer-term basis, the expectation for average CPI inflation over the next 10 years is about 2.25%. Both of these expectations are very close to what inflation has averaged in the past 5 and 10 years, so there is nothing unusual in today's expectations for the future. 

You can see the same pattern in this chart as in the charts above: 10-yr yields are trading substantially below the level that has prevailed in the past, given current inflation expectations. No matter how you look at it, Treasury yields appear to be artificially depressed. And from my perspective, the pressures for higher yields are building daily. 

Thursday, February 16, 2012

PPI inflation of 3.5% points to higher yields ahead

January Producer Price Inflation was lower than expected, but the core version was higher than expected. Nothing scary here, thank goodness, but on balance, inflation at the producer level is running at a rate around 3.5% per year. As the second chart shows, this is roughly the level of inflation that we have seen for the past 8 years, and it is about twice the rate that we enjoyed throughout most of the 80s and 90s. We likely are still in a somewhat higher, more volatile inflation environment than we saw during the Greenspan era. Given the weakness in the dollar and the strength of gold and commodity prices, and the Bernanke Fed's continued emphasis on being accommodative, I still believe that the risks to inflation in coming years are on the high side.

Treasury yields remain very low relative to the current level of PPI inflation. This creates incentives for firms to borrow and invest in raw materials, since the after-tax cost of borrowing has been much lower than the rate by which commodity prices have risen over time. It also makes it less likely that the Fed is going to be able to keep Treasury yields as low as they would like. With the economy showing clear signs of picking up, and inflation still alive and well, there is increasing pressure on Treasury yields to rise. I find it very difficult to believe that the Fed will be able to keep its "promise" to keep short-term rates close to zero for the next three years. When the Fed backs off of that promise, that should provide a further boost to confidence as yields rise to more normal levels.

Housing starts are up 46% from their low

It would be hard to argue that residential construction, measured by housing starts, is not in full recovery mode. January starts were much higher than expected (699K vs. 675K), and December starts were revised up almost 5%. From the low in April '09, starts are now up by 46%. This is a recovery, and it started almost a year ago, though it has somehow managed to fly under the radar of the consensus view that the economy is very weak. The level of starts is still miserably low, of course, but we are seeing very impressive changes on the margin in this indicator. This is very good news, because it shows that builders are more confident in the future because they see a looming shortage of housing after years of extremely deep construction cutbacks. This further suggests that the underlying fundamentals of the housing market are much sounder than most believe have been led to believe. On the margin, the problem is no longer a glut of homes for sale, but a shortage of homes relative to the number of households in a position to buy them. This is very good news.

Still more improvement in the labor market

First-time claims for unemployment continued their descent last week, dropping to a mere 348K. It is now absolutely clear that there has been substantial improvement in the labor market. At last week's level, the ratio of claims to payrolls (what I term "workforce disruption" is now lower than at any time prior to 1997. We've rarely seen claims at such a low level relative to the size of the workforce. This must mean that firms have done just about all the cost-cutting that they are going to do. If firms have to change course because of something unexpected, it is much more likely to be in the direction of more hiring, not less, because they are already prepared for bad news. In other words, they are now vulnerable to an unexpected improvement in the economy. This is good.

Wednesday, February 15, 2012

Paul Ryan for President

I don't know that there is any politician in Washington that has a better grasp of the facts and  what is going on in this country than Paul Ryan. It's a real shame he declined entreaties to run for President, because we really need someone like him, someone who appreciates why government must be scaled back, not only because it is spending and redistributing way too much, but also because it is encroaching on our precious liberties as individuals. This is not just partisan politics—I'm a fiscal conservative and a social liberal and don't fit the traditional mold of either Republicans or Democrats—it's about what's best for freedom, free markets, and prosperity for all. I don't know of any other way that is more conducive to a strong and prosperous economy, one that provides the highest standard of living to the most people.

There are way too many politicians of both parties that are guilty of pursuing policies that threaten our future, and I'm compelled to make that case on this blog, since I cherish free markets and individual liberty. I'm also compelled to criticize Obama's attempts to divide this country into have and have-nots, which I view as nothing but a transparent attempt to divide and conquer in the name of Big Government, which in the end is the biggest threat we face today.

Following are some excerpts from Ryan's opening statement today, as Chairman of the House Budget Committee introducing testimony from Acting OMB Director Jeff Zients regarding President Obama's recent budget proposal. To my knowledge Ryan makes not a single error or misrepresentation of the facts. We have a serious problem with deficit spending and runaway entitlement programs that can't be fixed by higher taxes, and Obama, the Senate Democrats and too many Republicans are studiously avoiding any meaningful solutions.

I’d like to thank our witness today, Mr. Zients. Unfortunately, you are in the position of having to defend a budget that essentially dodges the most difficult challenges our country faces.
The New York Times has reported that this budget is, quote, “more a platform for the president’s re-election campaign than a legislative proposal.” After a careful review, it’s hard to disagree. The Associated Press has reported – accurately in my view – that this budget, quote, “[takes] a pass on reining in government growth.” Instead, it leaves the drivers of our debt – namely, the unsustainable growth of entitlement spending – quote, “largely unchecked.” It takes a pass on real reform, even though the looming bankruptcy of these programs threatens to end the guarantee of security they provide for our nation’s seniors.
Jack Lew, your former boss, claimed that the reason Senate Democrats haven’t passed a budget in over 1,000 days is that the Republicans have threatened to filibuster. This is simply false. As Mr. Lew surely knows, budget resolutions cannot be filibustered. They can be passed with a simple majority.
The real source of dysfunction in the Senate comes from members of the President’s own party, who have been unwilling – for almost three years now – to go on record in support of his budgets, or to pass budgets of their own.
More to the point, it wasn’t so long ago that the President’s party held total control of the White House and both branches of Congress – during which time his agenda was enacted in near totality:
* massive new spending and taxes
* the creation of new, open-ended entitlements
* a regulatory onslaught that hurt the economy
* and trillions of dollars in new debt.
We were – and we remain – eager to work with the President to stop spending money we don’t have… to reform government programs that aren’t delivering on their promises… and to enact pro-growth policies that raise revenue by getting our economy moving again.
Yet, instead of working with us, the President has demonized our ideas to save and strengthen health and retirement security programs. And he continues to insist on taking more money from hardworking Americans – not to reduce the debt, but to fuel his ever-higher spending.

$4 gasoline isn't a big threat to the economy

As the top two charts show, oil and gasoline prices are very close to all-time highs. Arab Light crude is closing in on $120/bbl, driven by increasing mideast tensions, and that's only $26 off its all-time high of mid-2008. As the bottom chart shows, the nationwide average price of regular gasoline is now over $3.50/gallon, and it could be headed once again to its all-time high of $4.00. (Here in So. California, we're already paying over $4/gallon at most stations, and I've seen prices as high as $4.50.) Gasoline prices at the pump are just following the pattern of crude oil and wholesale gasoline prices.

Do rising oil and gasoline prices pose a threat to the economy? I know it's painful for many folks to have to shell out upwards of $100 to fill up the tank, but I doubt this will bring the economy to its knees.

This next chart is one reason why $4 gasoline is not a big threat. Thanks to conservation and technology, the U.S. economy today requires less than half as much oil to generate a unit of output than it did in the 1970s.

Despite the fact that the U.S. economy has more than doubled in size since 1979, our oil consumption has hardly risen at all. Cars are much more efficient these days, and more and more of our economy gets transacted through the internet, where marginal costs are almost nil.

As this chart shows, the average consumer today spends only about 6% of his income on energy (most of which comes from petroleum products), and that is almost 30% less than what he spent at the end of 1983, when the economy had just finished its first of what would prove to be seven years of very rapid growth and oil was very close to its (then) all-time highs. Simply put, we use a lot less energy today to power our economy, so the fact that energy is relatively expensive is much less important. (Actually, it's because energy is so expensive that we use a lot less of it.)

Meanwhile, plunging natural gas prices (thanks to new drilling technologies) help take the sting out of rising crude oil prices.

So, even though gasoline pump prices are making headlines and causing much irritation among consumers, there is little reason to think that this puts the economy at risk.

The U.S. economy is definitely picking up

Today was a solid "good news" day for the U.S. economy: more evidence that the housing market has turned up, strong manufacturing production, and a strong NY manufacturing survey. With numbers like this and upside momentum building, the economy is very likely to post stronger growth numbers this year. We'll still be struggling with a gigantic output gap, but the gap should be closing. The public will likely perceive some improvement by the time of the November elections, but I suspect it won't be enough to make a significant difference to the outcome. We are on the road to recovery, but policy blunders along the way have amounted to significant headwinds—we could have been in far better shape if things had been done differently. It's a testament to the inherent dynamism of the US economy that we are doing as well as we are. In my decades of experience, I've learned that one should never underestimate the ability of the U.S. economy to grow, even when faced with significant hurdles.

This index of homebuilders' sentiment is still at miserably low levels, but the improvement in recent months is striking. Things have really improved on the margin, and that is what is most important—not the level, but the change on the margin. This also suggests that housing starts, which rose 25% last year, are likely to continue to pick up.

I know there are still plenty of analysts reminding us that banks have a huge supply of REO that they are going to dump on the market any day now, warning that this will lead to another housing slump. But as this chart shows, the supply of unsold homes has declined significantly in the past year. It's a combination of sales picking up and slower growth in new homes being put up for sale. I see this as a strong sign that the market is clearing; in fact, it's been clearing for several years now (we're over 5 years into this housing downturn) and there isn't a person alive in the U.S. that doesn't know that housing prices have been weak and there are still plenty of foreclosures in the pipeline. Buyers are responding to lower prices, even as there are many still sitting on the sidelines waiting for things to pick up. Problem is, the pickup is usually not visible to most folks until it's well underway. Once it makes headlines, you get a buying stampede as prices and interest rates start to rise. In any event, if sentiment starts to improve, then new buying can easily outweigh whatever new supply the banks might dump on the market. The ingredients for improving sentiment are out there: incredibly low mortgage rates, prices that are an order of magnitude lower than they were 5 years ago, and an improving economy.

There are still lots of vacant homes for sale, and I'm sure everyone has seen several in his or her neighborhood. But on the margin, there are fewer and fewer. That's real improvement.

Since early October, when stocks slumped over fears that a Eurozone financial meltdown would trigger a double-dip recession in the U.S., this index of the stocks of major homebuilders is up 67%. (The S&P homebuilders' index is at a new post-recession high.) Altogether, this is substantial improvement on the margin and there is plenty of upside left.

January industrial production was up by less than expected, but revisions to prior months boosted the index to a new high, and weakness was concentrated in the utility sector, where good weather reduced the demand for electricity. As this chart shows, industrial output in the U.S. economy has diverged substantially from that of the Eurozone economy. We are not dependent on Europe for our growth, and despite all their financial misery and fears, the fundamentals of the U.S. economy have continued to improve. No reason this can't continue. Rather than us fearing that Europe might drag us down in the future, the Europeans are likely cheering the fact that a stronger U.S. economy will provide fundamental support for their own economy. Growth is infectious.

Abstracting from utility output, U.S. manufacturing production—led by the auto sector—has been very strong: up at a 8.6% annualized rate in the past three months, and up at a 6.7% annualized rate in the past six months. (Mark Perry has a nice table showing the breakdown by sector.) It doesn't get much better than this.

Finally, the February Empire State Manufacturing Survey came in very strong, reinforcing the message of the January manufacturing production number.

I haven't seen any news lately from the folks at ECRI, but I imagine they must have abandoned by now their September '11 call for an imminent and inevitable recession.