Monday, October 29, 2012

Inflation, deflation, and the iPad mini

The debate over inflation—which ranges all the way from those who see the imminent risk of deflation to those who see hyperinflation just around the corner—continues, and with good reason. Inflation is alive and well in the services and nondurable sectors of the economy, while deflation is the "new normal" in the durable sector of the economy. Some prices are going up, but others are going down; on average, the government is telling us that inflation is only about 2%. That's a calm surface on a body of water that is roiling underneath.

The first of these two charts shows the average price level for each major sector. Service sector prices have risen about 60% over the past 18 years, while the price of nondurables are up a little over 50%. But durable goods prices have fallen steadily, and are now down a total of 28%. In the entire history of these series, there has never been a sustained period of declining prices except for the past 18 years in the durables sector. Not coincidentally, that period corresponds to the emergence of China as a powerhouse producer of durable goods (e.g., computers and TVs). Memo to Romney and Obama: China has done us a great service by producing products so cheaply.

If we make the assumption that the price of services is a proxy for wages and salaries, then what we see here is arguably the most incredible increase in workers' purchasing power in the history of the world. Do the math: over the past 18 years, services are up 161% and durables are down 28%. 161/.72 = 223.9. Salaries have more than doubled relative to durable goods. Put another way, an hours' worth of work now buys more than twice as much in the way of durable goods as it did 18 years ago—it takes 55% less work today to buy the typical durable good than it did 18 years ago. Bottom line, labor has become a whole lot more valuable and more expensive than things, especially very sophisticated and powerful things like computers.

Which leaves me puzzled as to the brouhaha over whether the iPad mini—the newest durable good to be offered to the public—is a whole lot more expensive, at a price of $329, than the Amazon Kindle Fire HD at $199. As the link demonstrates, there are some significant differences in features between the two devices. My point is whether the price of those differences—$130—is a huge amount. Is a 35% larger screen + a 5 mp camera + greater video compatibility + hundreds of thousands of extra apps + aluminum construction (vs. plastic) worth an extra $130? Consider what $130 gets you these days: a dinner for two with a bottle of wine at an upscale restaurant; a pair of jeans at Nordstrom; two tanks of gasoline; admission for one to Disneyland; a bottle of Dom Perignon; a small basket of groceries.

The average person now has available to him or her gadgets that 18 years ago would have been considered magical, if not impossible. With only one week's worth of minimum wages in California ($8/hr), you can buy yourself an iPad mini: a device that connects you to all information in the world; that holds and displays and edits and takes thousands of videos and photos; that holds your entire music library; that lets you read millions of books; that holds and displays maps of the entire world; that lets you explore the cosmos by simply pointing at the stars at night; that lets you read hundreds of newspapers; that lets you plan and reserve flights and hotels all over the world for free; that let's you play and record all kinds of music; that gives you access to thousands of video games that never before existed; that let's you correspond with people instantly all over the world; that's lets you fly dozens of planes realistically. I could go on, but I hope my point is clear. 18 years ago a device like the iPad mini would have been inconceivable no matter how much it cost. Today, in contrast, we are quibbling about whether such a device should cost $200, $250 or $330, when the difference is almost insignificant for the vast majority of people.

It is undeniably deflationary when a week's worth of work at minimum wage buys you things that only 18 years ago would have been unavailable to even the richest person on the planet. But at the same time, it costs an employer 2.2 times as much to hire that minimum wage worker, and it costs us all 5 times more to fill our tanks with gasoline. That's a lot of inflation. Or is it?

No wonder the debate rages.

Friday, October 26, 2012

Money demand continues to rise

We know this has been a miserable recovery—arguably the weakest ever—but exactly why is still a question that has not been answered to everyone's satisfaction. What follows is an attempt at a technical explanation based on the growth of the money supply and the nominal economy.

As the first of these two charts show, the M2 measure of money supply has grown at a fairly steady pace of about 6% per year for the past 17 years. As the second chart shows, the pace has picked up a bit since the Eurozone panic of last summer: since May '11, M2 is up at a 8.5% annualized pace. If all you knew were these two charts, you would guess that whatever has happened to the economy since the onset of the Great Recession hasn't involved any shortage of money.

Of course we all know that the Fed has been trying very hard to inject money into the economy for the past four years, and they have achieved a measure of success: since Sept. '08, the M2 money supply is up $2.2 billion, with $300 billion of that coming from additional currency in circulation and the rest from an increase in bank savings deposits. Banks now hold $6.5 trillion of savings deposits, and that represents almost two-thirds of M2. But so far, all this extra money hasn't had much impact on either the economy or inflation. The economy has only managed a bit more than 2% growth over the past three years, and inflation has only been about 2%; nominal GDP is growing only 4%, far less than the 8.3% annualized pace of the past 30 years. 

What's happened to all the money is that almost $1 trillion of the money that the Fed has succeeded in injecting into the economy over the past several years hasn't actually gone anywhere. People are holding on to it in bank savings accounts, and the banks in turn have invested the money in bank reserves that are sitting on the Fed's balance sheet. Most of the bank reserves that the Fed created to purchase notes and bonds have been willingly held by cautious savers and banks. The Fed has succeeded mainly in swapping bank reserves—essentially equivalent to T-bills since they pay about the same amount of interest and have an implicit government guarantee—for notes and bonds. 

As the chart above shows, there has been a huge increase in the world's demand for M2 money (M2 growth has been much faster than nominal GDP growth). Like corporations that are reluctant to reinvest their profits (which are at record levels in terms of GDP), individuals are reluctant to spend the money they have instead been stashing in their savings accounts. (For more detail, see my series on The Reluctant Recovery starting here.) Everyone wants to be more conservative, pay down debt, and build up their cash reserves. Why? Because there are too many uncertainties looming: the fiscal cliff, the trillion dollar deficits that portend a huge increase in tax burdens, the regulatory uncertainties created by things like ObamaCare, the Eurozone sovereign debt crisis, and the Fed's massive balance sheet expansion which could theoretically ignite a huge burst of inflation, to name just a few.

If money demand keeps increasing, then the Fed will not be able to achieve much in the way of real or nominal GDP growth. What's needed is a change in the fiscal policy outlook, more than anything. But if confidence in the future increases (or the uncertainties about the future lessen), then the demand for M2 would likely begin to decline, and there could therefore be a tidal wave of liquidity attempting to exit bank savings accounts in order to relocate in nominal GDP. In addition to that, we have the possibility that banks might decide to use some or all of their current $1.4 trillion of excess reserves in order to expand their lending activities. Either way there is enough money in the system to boost nominal GDP significantly in the years to come, if conditions are ripe. How and when that might happen is still uncertain, as is the issue of how much of the additional nominal GDP would would be attributable to real growth. 

But that is the essence of the problem today: there are some huge uncertainties out there, and that has simply dampened the animal spirits of nearly everyone. The November elections have the potential to create a great deal of change on the margin.  

Quick thoughts on GDP: more stagflation

Third quarter real GDP growth was a bit stronger than expected (2.0% vs. 1.8%), but to me that was not the big news of the day. The more significant "beat" in the data was the GDP deflator, which came in at 2.9% vs. expectations of 2.1%. The combination of the two pushed nominal growth (on a quarterly annualized basis) up from 2.8% in the second quarter to 5.0% in the third quarter. With the exception of only 3 of the 13 quarters since the recovery began, nominal GDP growth has been 4% or better. We are a long way from facing any threat of deflation, and it should be abundantly clear that there is no shortage of money.

From a long-term perspective, this continues to be the weakest recovery ever. As the chart above suggests, the economy is about 13% smaller than it could have been absent the deep recession and the very meager recovery. That is equivalent to a little over $2 trillion of national income that has gone missing, and that accounts for at least half the size of the current federal deficit. In other words, the tax base on which current tax rates are applied is a lot smaller than it could have been. 

The chart above shows the quarterly annualized rate of inflation according to the GDP deflator. The economy flirted only briefly with inflation late last year and in the second quarter of 2009, but other than that it looks like inflation is on track to be 2-3% going forward. This casts further doubt on the Fed's commitment to keep inflation low, since currently they are pursuing an obviously reflationary strategy at a time when inflation is at or above their target. It's not difficult to conclude that they are giving much greater weight to their full employment target at the expense of their inflation target.

This new inflation reality also clashes head-on with the yields on Treasuries. 5-yr yields are a measly 0.8%, 10-yr yields are a paltry 1.8%, and 30-yr yields are 2.9%. Negative real yields on everything out to 10 years mean that savers are being cheated and borrowers and speculators are being rewarded. The incentive to save is low and the incentive to speculate is high, and that is not a prescription for healthy economic growth. Erratic and inflationary monetary policy thus gets some of the blame for the slow growth of recent years. I worry that if the Fed keeps short-term rates close to zero for the next few years, as they promise, we could face a serious inflation problem in the next 3-5 years.

Thursday, October 25, 2012

Romney's wrong on China

I've said it before, and I'll say it again: Romney is dead wrong when he criticizes China for allegedly selling us stuff at a discount. Mark Perry does an excellent job explaining why we should be thrilled if indeed China is selling us stuff at artificially low prices. But as I explained last summer, there is no reason to think that China is undervaluing its currency in the first place.

This is such an important issue that it bears repeating. I've updated some charts to make my point clear.

As the chart above shows, the Chinese yuan has been rising against the dollar ever since 1994. The Chinese are demonstrably not undervaluing their currency, they are continuous revaluing it. They have been forced to do this because of the tremendous inflow of capital to the country, which in turn has been driven by the world's desire to invest in this rapidly growing and dynamic economy. Since China's monetary policy is geared towards pegging its currency against the dollar, a net inflow of dollars and other currencies to the country obliges the central bank to buy the extra currency, thus adding to its forex reserves and expanding its monetary base. This is the way that capital inflows get turned into yuan and help the economy grow. But as the chart also shows, forex reserves swelled to over $3 trillion by last year, way more than enough to credibly back China's currency and its money supply. 

For the past year, there has been no net addition to China's reserves, which means that there is no longer a net inflow of capital to China. This could be one sign that the currency is properly valued, and/or it could be a sign of a diminished desire on the part of foreigners to invest in China, and/or diminished investment opportunities in China, and/or a greater desire on the part of Chinese to invest abroad. Whatever the case, the central bank is no longer buying foreign currency to keep the yuan from rising, but they are still allowing the yuan to appreciate. This is not the behavior you would expect from a currency manipulator. If anything, the Chinese seem to be "manipulating" their currency higher against the dollar, not lower. And they might be doing this in order to proactively deflect criticism from misinformed and misguided politicians in the US.

This next chart shows the real value of the yuan against a large basket of currencies, as calculated by the BIS. Since it was first pegged to the dollar in 1994, the yuan has appreciated in real terms by 64%! Even supposing the yuan was purposefully undervalued in 1994, it is hard to believe that it is still undervalued today. 

By pegging the yuan to the dollar, China effectively outsourced its monetary policy to the Federal Reserve. On the surface, both countries have the same monetary policy, so both should have the same inflation rate, and that is indeed what has happened, as the chart above shows. China has been living under a US-influenced monetary regime for almost 20 years now, and its economy has had plenty of time to adjust. If the yuan were still undervalued, as Romney and even Obama claim, then Chinese inflation should be higher than US inflation, but it's not.

Anecdotal evidence suggests that on the margin more companies are finding it cheaper to produce goods in the US than in China, and that's part of the reason for the stability of China's reserves over the past year. It all adds up to evidence of a sort of equilibrium having been attained between the value of the yuan, the relative price levels in China and the US. The yuan has successfully compensated for the different level of productivity and specialization in each country.

There is nothing here to worry about, with one big exception: if the US tries to start a trade war with China to force it to revalue its currency even more, then we are all going to be in big trouble. The US could suffer from rising inflation (demanding a stronger yuan is equivalent to wanting a weaker dollar), while the Chinese could suffer from deflation. It's the politicians, not the Chinese, that pose the biggest threat to the US economy.

Big changes in the labor market

The weekly unemployment claims data is among the most timely indicators available to track the economy's progress, which is why I post on this subject almost every week. In fact, the only thing timelier is market-based data, which is real-time. 

Claims last week came in as expected, and they were almost identical to the average so far this year (370K vs. 369K). So there hasn't been much change this year in the underlying health of the jobs market, according to this measure.

But there has been a great deal of change, to judge by the 2.4 million decline in the number of people receiving unemployment compensation year to date. There are still an unusually large number of people receiving unemployment insurance given that we are three years into a recovery, but at least the number is declining steadily: it's down over 20% in the past 12 months, and down by one-third so far this year.

The chart above shows how different this recession has been from other recent recessions: at the peak, the percentage of the labor force receiving unemployment compensation was 67% more than at the peak of the 1981-82 recession. This goes a long way to explaining why this recovery has been so tepid. It's been the weakest recovery ever, in part because we've never paid so many people for so long not to work. And the main cause of that huge increase was Congress' decision in July 2008 to create a program called "Emergency Claims," which went on to double the number of people receiving benefits by early 2010. Congress' "compassion" for the unemployed had the unintended consequence of slowing and drawing out the recovery for everyone.

These charts document the single biggest change on the margin that is happening to the U.S. economy these days. Fortunately, it is a positive change on the margin, since it results in increased incentives to find and accept a new job, even if it doesn't pay very much. In the end, the only way a true recovery can take place is if unwanted labor is able to relocate and reprice itself so as to be attractive to new employers. That process is clearly underway, and it is one very good reason why the economy should continue to grow.

Wednesday, October 24, 2012

The Reluctant Recovery: Conclusions

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post discusses the investment implications of the presentation. This is the fifth and final part in a series (see Part 1 here, Part 2 here,  Part 3 here, and Part 4 here).

If there is one unifying theme to my presentation, it starts with the title. I argue that the recovery has been a reluctant one, because the market has from the very beginning been reluctant to embrace the notion that the recovery was real and durable, much less robust. There are plenty of good reasons for the market to be concerned, of course: unprecedented changes in monetary policy, misguided fiscal stimulus, the deep-seated problems in the Eurozone, the housing disaster, and the huge federal deficit, among others. 

In Part 1, I show how key market-based indicators reflect a significant improvement in economic and financial fundamentals (e.g., swap spreads, real short-term interest rates, the slope of the yield curve, corporate profits), but other indicators show that the market remains very pessimistic about the future (e.g., TIPS yields, credit spreads, PE ratios, equity yields). The fundamentals have improved, but market sentiment remains pessimistic. This creates an interesting environment for investors, since it means that the bar for economic performance has been set very low: the economy only needs to avoid a recession for markets to react positively.

In Part 2, I argue that monetary policy has correctly responded to a huge increase in the demand for safe-haven dollar liquidity that followed in the wake of the Great Recession. But since the Fed's response was not only unprecedented but gigantic by historical standards, this has created tremendous uncertainty. Will the Fed be able to reverse its Quantitative Easing in a timely fashion? Should we be bracing for a significant increase in inflation? Will the dollar, already very near its weakest level ever, go down further?

In Part 3, I point out that although the federal budget is in miserable shape, there have been encouraging signs of progress. Spending as a % of GDP has declined, thanks to Congressional gridlock. Revenues as a % of GDP have increased, thanks to slow but steady growth in jobs and incomes. As a result, the budget deficit has dropped from a threatening 10.5% of GDP to now only 7%. This points to a relatively simple solution for the future: maintain spending restraint, avoid increasing tax rates, reduce tax rates as much as possible, and pay for lower rates by broadening the tax base (e.g., eliminating or limitation tax deductions and loopholes). In other words, there is a growth-oriented solution to our fiscal problem that needn't be difficult to implement. 

In Part 4, I find that although this is the weakest recovery ever, there are a number of areas in the economy that are improving, and only a few that point to further weakness. Households have undergone tremendous deleveraging, and are much more financially healthy than before. Corporations have cut costs to the bone and are now more profitable than ever. The housing market is turning up. Banks are lending more. The main obstacles to progress are the uncertainty created by misguided fiscal policy, unprecedented monetary policy, and the looming fiscal cliff.

So, the market has dreadful expectations for the economy, but the economy is displaying many classic signs of an ongoing recovery, albeit a very tepid and disappointing one. The bar of expectations has been set very low. If the economy avoids a recession and continues to recover, even very slowly, this likely would be a positive shock to the market. Investors willing to bet that we do in fact avoid a recession can therefore expect to profit by buying risk assets that are relatively cheap by historical standards.

What follows are general guidelines for investing in different asset classes.

Equities are relatively cheap, in my view, because corporate profits are very high, both nominally and relative to GDP, but PE ratios are below average. Moreover, equity yields are significantly higher than corporate bond yields (the earnings yield on the S&P 500 is currently about 7% vs. a yield of 4.5% on the average BAA-rated corporate bond), and both are orders of magnitude higher than the yield on cash, which is another way of seeing that the market expects profits to decline significantly. If profits merely stagnate, equity yields would still be very attractive compared to corporate bond yields and unbelievably attractive relative to cash. It might take an outright recession or worse to shock the equity market.

Real estate, particularly residential real estate, has fallen significantly in price, while at the same time the cost of buying real estate using extremely low mortgage rates is very cheap—historically cheap—relative to household incomes. In other words, the affordability of housing has almost never been so attractive. That's because the majority of people still expect real estate prices to decline, despite growing signs of a housing market recovery and rising prices. It's also likely that demand for housing is being suppressed because banks' lending standards are still much tougher than they were before the Great Recession. Undoubtedly there are many young homeowners who would like to buy a house but find that they lack the necessary down payment or job history. Nevertheless, "everyone knows" that there is a ton of foreclosed properties sitting on banks' balance sheets waiting to be sold, and there are millions of homeowners still underwater on their mortgages. The real estate market is still in the grips of caution, rather than exuberance.

Real estate is also potentially very attractive because it has traditionally been an excellent inflation hedge. If the Fed fails to reverse its Quantitative Easing in a timely fashion, inflation could rise significantly. Incomes would also rise in that case, and the demand for housing could rise hugely. We all learned in the 1970s that real estate (and any hard asset, for that matter) is a great thing to own, especially with leverage, when inflation is rising. Today, however, both real estate and mortgage rates are priced to the expectation that inflation will remain relatively low for as far as the eye can see.

What about other inflation hedges? Gold prices are extremely high, both in nominal and real terms, and commodity prices have risen substantially. These markets arguably are priced (by speculators) to the expectation that the Fed will make a big inflationary mistake. Maybe they will, but if they don't, gold in particular could tumble much as it did in the 1980s when tight monetary policy caused inflation to fall way below everyone's expectations. It's late in the game to load up on gold, because the world has been loading up on gold for the past decade, in the expectation that inflation will rise, the dollar will collapse, and/or the global financial system will collapse. Barring any of these disasters, gold might have very limited upside but a lot of downside potential.

Treasury yields, meanwhile, are extraordinarily low, making Treasury bills, notes and bonds extraoridinarily expensive. Investors everywhere are willing to hold Treasuries at historically low levels of yield because they are very fearful of the future. With real yields on TIPS deep in negative territory, this is one more sign that expectations for future investment returns, and for real economic growth, are dismal. Thus, holding Treasuries today only makes sense if you worry about an outright depression. If the economy picks up even just a little, and/or inflation rises by even a few percentage points, Treasury yields could rise (and their prices fall) by enough to wipe out many years' worth of income.

Corporate and emerging market debt have performed very well in the past several years, because spreads to Treasuries have narrowed from very high levels and default rates have fallen thanks to an improving economy. Investment grade spreads are still somewhat wide by historic standards, but their yields have never been so low (3-3.5% currently). High quality corporate bonds still offer yields that are a few points higher than Treasuries, but if Treasury yields rise, investment grade corporate debt is going to face challenging conditions (i.e., rising yields and falling prices). In other words, current yields offer very little protection from a rising interest rate environment should the economy improve. High-yield corporate bonds offer more protection against rising yields, since their spreads to Treasuries are still relatively generous and their yields are in the range of 6-7%, but high-yield debt is no longer the slam-dunk it used to be. The current appeal of high-yield debt is that if nothing changes it offers much higher yields than Treasuries, and if yields rise, then the negative impact of rising yields would likely be offset to some degree by declining default rates and by declining spreads to Treasuries. That's because higher yields would only occur if the economy improves and/or inflation rises, and both of those conditions would make high-yield debt more attractive.

New homes sales jump 27%

New homes in September sold at a seasonally adjusted, annualized pace of 389K. That's a miserable pace of sales compared to the last 20 years, when sales averaged 770K. But the important thing to note is that sales have risen by a very impressive 27% in just the past year. That is a huge change on the margin, and it is the reason that housing starts are up 35% in the past year. The residential construction industry is realizing that the six year slump in the housing market is over; excess inventories have been worked off and new demand is materializing. This is a housing recovery, and it's still in the early stages.

Monday, October 22, 2012

The Reluctant Recovery: Part 4

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes some of the key points of the presentation, and is the fourth in a series (see Part 1 here, Part 2 here, and Part 3 here.). In this fourth part, the main focus is the state of the economy. I argue that although this is the weakest recovery in generations, with a few exceptions the economy has undergone some significant adjustments and is continuing to expand, although growth is likely to continue to be rather slow and disappointing until and unless we get significant improvement in fiscal and monetary policy.

This chart is plotted with a logarithmic y-axis (as are many of my charts) in order to highlight the trend rate of growth of the economy, which for most of the past 50 years has been about 3% per year. Recessions throw the economy off track, but it usually comes back to trend after a few years. I discuss this in more detail here. This recovery, however, has been miserable. This chart suggests the economy is about 12% smaller than it otherwise could have been if the recovery were "normal." That translates to almost $2 trillion in lost output or income. This very likely the weakest recovery ever, and I think it's due to the tremendous amount of fiscal and monetary "stimulus" that has been applied in the past several years. Fiscal "stimulus" that consists of a massive increase in transfer payments only weakens growth. In the same vein, monetary "stimulus" that consists of a promise to keep rates close to zero for years, and a commitment to keep banks flush with reserves, only stimulates speculative activity while also depressing savings. In addition, it creates tremendous uncertainty about the future value of the dollar. This all combines to weaken growth because it saps the confidence and the wherewithal to make major investment decisions. 

The Eurozone has taken a big hit, but industrial production there appears to be recovering in recent months, as predicted by the huge decline in Eurozone swap spreads so far this year. U.S. industrial production has been relatively stagnant this year, but there is no sign here of any collapse. 

The above chart suggests that the recovery in the stock market has tracked the improvement in the underlying fundamentals of the labor market. As the pace of layoffs has dropped, equities have risen. This is my general thesis: the equity market has not been driven by rising optimism, but rather by declining pessimism. Equities have rallied reluctantly, since the economy has improved—albeit very slowly—in contrast to the very pessimistic assumptions embodied in equity prices and bond yields as I discussed in Part 1. The market's expectations, in other words, have consistently been for the economy to be in worse shape than it has actually been. The future, in other words, has turned out to be somewhat better than expected, and that is what has forced equity prices to rise, reluctantly.

The growth in jobs has been generally disappointing, but nevertheless the economy is still creating additional jobs, and there is no sign in this chart of the decline in jobs that traditionally marks a recession. We are still in the recovery phase of the business cycle, no matter how disappointing the recovery may be. With markets still braced for another recession (or worse), a continuation of modest growth should have a positive impact on equity valuations.

The chart above compares households' monthly financial payment obligations to disposable income. Thanks to rising incomes, higher savings, deleveraging, and mortgage defaults, households have significantly reduced their financial burdens in the past several years. Financial burdens today are about as low as they have been at any time in the past 40 years, in fact. Recessions are all about negative surprises and the adjustments they force. By this measure there has been a significant amount of adjustment, and that in turn lays the foundation for healthier growth in the future. All that's lacking at this point is confidence. People are still reluctant to believe that the future is bright.

The delinquency rate on credit cards and consumer loans in general has dropped considerably since the end of the recession, another sign that households are in much better financial shape these days. 

In contrast to the general private sector deleveraging that has been underway in recent years, student loans are expanding at a rapid pace. This is the only category of consumer credit that has grown since the recession, in fact—consumer credit excluding student loans has actually declined by $240 billion since its peak in 2008. Student loans now account for 18% of consumer credit, whereas they were only 4% at the end of 2008. What accounts for this counterintuitive growth? The rapid growth started in early 2009, right around the time that the federal government essentially took over the student loan market. Virtually all of the increase in loans since that time has come from and is held by government agencies that have no qualms about suffering losses, since they are passed on to taxpayers. Like the housing market, which was force-fed with unaffordable loans that eventually went bust, the student loan market is a bubble in the making. The rapid growth in government-backed student loans is helping higher educational institutions to keep inflating their costs and their prices. This will likely end in tears (and defaults), with colleges and universities eventually forced to undergo the painful restructuring already experienced by the residential construction industry. The increase in student loan borrowing is not a portent of a stronger economy. There are still problems out there, and that's why everyone is reluctant to be optimistic about the future.

Auto sales are the very picture of a V-shaped recovery. Sales have increased at a 14.5% annualized pace since their recession low. Sales are still below "normal" levels, of course, but this kind of outsized growth has ripple effects throughout the economy. Sales have consistently exceeded forecasts, and this means that factories have no choice but to ramp up production and increase hiring. Real change happens when the unexpected occurs, and that is what is driving the auto industry.

Residential construction is now in the midst of a V-shaped recovery. Since early last year, housing starts have jumped by 60%, vastly exceeding virtually everyone's expectations. This also has positive ripple effects throughout the economy, and is a good sign that the housing bubble has burst. The necessary adjustments have been made (e.g., a significant decline in the inventory of new homes) to permit a return to growth. Residential construction could add as much as 1% per year to GDP growth over the next several years. It matters little that starts are still extremely low; what matters the most is the change on the margin, and that is very encouraging.

With construction rebounding, it's not surprising that housing prices are firming and even beginning to rise in many areas. The Radar Logic survey of housing prices shows they rose 5% in August compared to a year earlier. Housing today is more affordable than ever, thanks to extremely low mortgage rates and a 35% average decline in housing prices across the country in the past six years. But of course the consensus of opinion still appears to be dominated by a reluctance to believe that housing has really turned the corner—after all, there are still so many homeowners with underwater mortgages and so many foreclosed homes waiting to be sold. What the worriers ignore, however, is that while the supply of homes could increase, the demand for homes could increase as well, if confidence in the future were to increase.

The chart above shows that bank lending to small and medium-sized businesses is up over 22% in the past two years. Lending standards are still relatively strict, but banks are nevertheless lending more and relaxing lending standards on the margin. This is very encouraging because it reflects increased confidence on the part of both banks and businesses. Banks are more willing to lend, businesses in aggregate are more willing to borrow.

The chart above shows the fairly reliable relationship between the ISM manufacturing index and quarterly GDP growth. Manufacturing was one of the key sources of growth early in the recession, and although it is now less strong, the most recent index reading of 51.5 is still consistent with GDP growth of about 2%. The service sector version of this same index is currently at 55, and that too points to continued, albeit relatively slow, growth. Slow growth is disappointing, and there are many millions still out of work, but growing is better than not growing, and there is no sign at all in these key surveys of a recession. 

Capital goods orders are a good proxy for business investment, which is the seed corn of future growth. Growth which produces rising living standards requires that we produce more with a given number of inputs. Productivity, in other words, is the source of real growth, and it requires investment in new plant and equipment, new computers, and new technology. The slowdown in business investment in recent months is disappointing, because it means growth in the future is likely to remain weak or weaken further. I think business investment has declined because of the growing uncertainty surrounding the "fiscal cliff" which is scheduled to arrive in just over two months; I don't think this is a harbinger of recession as it typically would be. Everyone knows that tax rates could soar in few months, and a drastic cut in defense spending could have negative ripple effects throughout many industries. No one knows at this point how this problem is going to be resolved; it could end up being very bad for growth or very good. This kind of binary uncertainty is likely inhibiting all sorts of decisions right now, contributing to the reluctance of investors and businessmen to embrace the equity rally and the economic recovery.

I'm optimistic that Washington and the electorate will arrive at a reasonable solution, but I can't be sure. Still, if I'm right and the markets are still braced for a recession, it's possible that even a suboptimal resolution of the fiscal cliff would fail to be unexpectedly bad news. 

Next installment: conclusions.

Friday, October 19, 2012

Housing update

Just a few updated charts to chronicle the ongoing improvement in the housing market:

Although September sales were down a bit from August levels, the above chart shows that the uptrend in sales is still intact. Sales are up 11% in the past year.

Despite all the talk about the great shadow inventory of foreclosed properties that have yet to hit the market, the inventory of homes for sale has fallen to 5.9 months' worth of sales. This is much lower than the levels that prevailed in the 1980s, and is only marginally higher than what we saw in the boom years of the early 2000s. Bloomberg's story on the subject contains these choice tidbits: "sales of previously owned U.S. homes decreased in September ... restrained by a lack of supply," and ""the median price from a year earlier jumped by the most since 2005 as inventories dwindled." If home-buying enthusiasm picks up, we could see some real shortages—and higher prices—in the coming year or two.

This last chart illustrates the degree to which prices have rebounded over the past year.

Sales are down and prices are up because of restrained supply: quite an amazing development.

Thursday, October 18, 2012

36 more reasons why industrial policy is a bad idea

Heritage has done us all a favor by compiling a list of 36 "green energy" companies that have received federal support and have either gone bankrupt or are laying off workers and headed for bankruptcy. Even with millions and billions of federal help, these companies could not compete in the real world, because green energy is still way too expensive to compete with existing forms of energy, and politicians are foolish if they think that federal largesse is the only way to change this reality. (I won't even get into the fact that most of these same companies were big contributors to Obama's campaign, since crony capitalism and corruption are to be expected whenever politicians—of whatever stripe—shower taxpayer money on favored industries.) Throwing money down the "green" drain just takes away money from more promising technologies and more promising ways to improve our lives through gains in efficiency and productivity. When someone finally does come up with a "green" energy technology that really makes economic sense, the world's capital markets will be there, ready and willing to provide all the funds necessary.

See the list here.

HT: Instapundit, my choice for MVB (most valuable blog)

The Reluctant Recovery: Part 3

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the third in a series (see Part 1 here and Part 2 here). In this third part, the main focus is fiscal policy. I argue that Congressional deadlock has allowed the growth in federal spending to slow significantly, with the result that there has been a welcome decline in spending relative to the economy; and that economic growth has increased federal revenues without any increase in tax rates. This has combined to reduce the burden of the deficit substantially. From this it is easy to see a simple and straightforward solution to our trillion-dollar deficit nightmare: continue to exercise spending restraint, avoid increasing taxes, and broaden the tax base by reducing deductions and loopholes.

To begin with, it's important to understand that we are indeed in the midst of a fiscal debt crisis. As the chart above shows, the burden of the federal debt (measured by comparing outstanding federal debt held by the public to nominal GDP) has increased by much more during the Obama administration than it has during any previous post-war administration. By early next year the federal debt burden will be over 70% of GDP, having risen from 46% in early 2009. The impact of the rapidly increasing debt burden has been muted by the fortuitous fact Treasury yields have fallen to their lowest levels in history. This could change dramatically for the worse, of course, if the economy and/or inflation picks up in coming years, since higher interest rates combined with the relatively short maturity of existing federal debt could make federal debt service payments soar even if deficits were to decline meaningfully.

The first chart above shows federal spending and revenues as a % of GDP, while the second shows the nominal level of each. Government spending has declined relative to GDP mainly because the growth in spending has slowed sharply as the economy has grown. Slower growth in spending owes much to a gridlocked Congress, and also to improvement in the labor market, since 6.8 million people have dropped off the unemployment insurance rolls since early 2010. Revenues have increased much more than spending has declined, thanks mainly to the growth of the economy, which in turn has generated more jobs and more corporate profits. We didn't need to raise tax rates to increase tax revenues, because economic growth caused the tax base to expand. In fact, tax revenues have risen even though social security contribution rates have been reduced for most of the past two years (i.e., the "payroll tax holiday"). Unfortunately, liberals seem to be dug in on the need for higher tax rates on the rich and more income redistribution, both of which could weaken the economy and aggravate the budget problem. 

Thanks to slower growth in spending and a moderate increase in the size of the economy, the federal deficit has shrunk rather dramatically from a high of 10.5% in late 2009 to about 7% today. The 2012 fiscal year deficit came in at $1.089 trillion, however, which is still mind-boggling. The bad news is that the deficit is still very large; the good news is that it's declining. 

Tax revenues are likely to rise further if the economy continues to grow, so that side of the ledger will likely take care of itself. But on the spending side we have two looming problems: payments to individuals and net interest expense. Both are likely to rise meaningfully if and when Obamacare is implemented and if and when Treasury yields rise. Payments to individuals (aka transfer payments) already consume a huge portion of the budget (over 70%), and this category has been growing like Topsy for the past 50 years. Social security, medicare, medicaid, food stamps, etc.; are all non discretionary items that could continue to expand without practical limit unless Congress reforms the underlying programs and their eligibility requirements. As for net interest expense, it is very hard to see how this won't increase significantly; only a continuation of painfully slow growth could keep interest rates from rising, and the deficit is going to be very large no matter what for at least the next several years.

So although the budget picture has definitely improved in the past few years, we are not yet out of the woods. The deficit is still very large, as is the burden of federal debt. But the most important part of the budget, as Milton Friedman taught us, is spending. Spending is the best measure of the burden of government, and it is still at very high levels relative to the economy. Government at the federal, state, and local levels still consumes a huge share of our nation's output, and that is like a ball and chain to economic progress, because government simply can't spend money as efficiently as the private sector can. The only hope for stronger growth and rising prosperity in the years to come is a substantial shrinkage in government spending, and that can come only from fundamental reforms to our many entitlement programs.

In the meantime, it is easy to see how investors and corporations are reluctant to believe that there won't be a big increase in future tax burdens, and reluctant to believe that there will be significant relief from the overall burden of government. Fiscal policy is like a big storm cloud on the horizon. There is still time to avoid disaster, but there are many obstacles on the road to prosperity.

Next installment: the economy

Labor market update

The weekly claims data has been exceptionally volatile of late, which strongly suggests that seasonal factors are at work, distorting the reported numbers. This is when you look at the 4-week average of the data for clarity. As the chart above shows, not much is going on beneath the surface noise—claims are about flat so far this year.

The one area of the labor market that is not receiving the attention it deserves is the number of people receiving unemployment insurance. This has been steadily declining since early 2010: in fact, 6.8 million people have stopped receiving unemployment insurance since the peak in early 2010. Just over 2.3 million so far this year have dropped off the unemployment insurance rolls. Compare that to the 4.2 million new jobs since early 2010, and the 1.3 million new jobs so far this year, and you realize that this represents a significant change on the margin, since it means that there are millions of people out there who now have a stronger incentive to look for and accept a job offer, and who are now much more interested in the health of the economy and the size of the jobs market.

Wednesday, October 17, 2012

The unattractiveness of Treasuries

CPI data for September were unsurprising. Although the headline number was higher than expected (0.6% vs. 0.5%), the core number was lower than expected (0.1% vs. 0.2%). On a year over year basis, both headline and core inflation are running at 2.0%. Over the past 10 years, prices ex-food and -energy have risen at an annualized pace of 1.9%, while the total consumer price index has risen at 2.5%, with the difference being attributable almost entirely to rising energy prices (crude oil was $20/bbl 10 years ago, and is now $90/bbl). As the chart above shows, while there have been some deviations from the long-term trend, 2.5% per year on average for the CPI is still the norm. Ho-hum. Nothing to see here, move on.

But as this chart shows, Treasury yields are very low relative to inflation. The chart is set up to reflect the long-term difference between 30-yr bond yields and core inflation, which has been about 2.5%: the right-hand y-axis is offset by 2.5% relative to the left-hand y-axis. Note how yields were very high relative to inflation throughout the 1990s, a period in which the Fed was for the most part actively fighting inflation. That period culminated in falling commodity and gold prices—and the Feds' first panic over the possibility of deflation—when the core CPI hit a low of just 1% in 2003. Since then, bond yields have tended to follow inflation with the customary 2.5% difference, up until, that is, the past year, when bond yields have plunged while inflation has risen.

The difference between bond yields and inflation is now as low as at any time since the 1970s, when low real yields helped boost inflation. 30-yr T-bonds now offer only a 3% yield, at a time when inflation is running 2-2.5%. That's a very small premium to insure against the possibility that inflation could outstrip bond yields at some point over the next 30 years. 10-yr Treasury yields are even more unappealing, since at 1.8% they are already below the current rate of inflation. Thus, TIPS real yields (which are negative out to 20 years' maturity) and Treasury yields out to 10-years offer investors either a risk-free, U.S. government-guaranteed loss of purchasing power (in the case of TIPS), or the strong likelihood of a loss of purchasing power (in the case of Treasuries) over the next decade. Wow, what a deal!

It only makes sense to hold TIPS and Treasuries at current yields if a) one is obligated by organizational mandates to invest in risk-free notes and bonds, or b) one is so afraid of suffering losses in alternative investments (e.g., MBS, corporate bonds) that a guaranteed loss of up to 1% of one's purchasing power every year for the next decade sounds terrific. It doesn't even matter if you think that inflation will decline, because negative real yields on TIPS guarantee that you will lose purchasing power even if the rate of inflation declines significantly. (Technicality: If TIPS are held to maturity, investors are protected from negative rates of inflation, but not against receiving a zero inflation adjustment. This is comforting to some degree, but it doesn't help the investor who owns 10-yr TIPS if and when there is a bout of deflation that hits in the next several years.)

But isn't this all the result of Fed meddling in the bond market? Aren't yields artificially low because of QE? I don't believe so. The Fed may be buying a relatively large share of the new issuance of Treasuries (the current Quantitative Easing program only involves the purchase of $40 billion of Treasuries per month, which is a bit less than half the current $90 billion/mo. financing needs of Treasury), but Treasury yields are not set by marginal buying; they are set by the world's demand to hold the existing stock of Treasuries. After all, low yields on newly-issue debt must equal the yields on existing debt, since Treasuries are fungible.

Fed purchases of Treasuries these days are only a small fraction (less than 10%) of the non-Fed-held federal debt held by the public, which is almost $10 trillion. It strains credibility to think that $40 billion in purchases of new debt can massively distort the value and the current yields on $10 trillion of outstanding debt which is owned by individuals, corporations, and large institutional investors all over the world. And let's not forget that many tens of trillions of bonds all over the world are priced off of Treasuries (i.e., their yields are quoted in terms of a spread off Treasuries of similar maturity). Distorting the price on Treasuries means distorting the price on almost all of the bonds in the world. Yet there is no evidence that spreads on non-Treasury debt are unusually or irrationally wide. As an example, the chart below shows how tightly the yield on 5-yr Industrial bonds tracks the yield on 5-yr Treasuries over time. The current spread of 66 bps is actually lower than the average (89) over this same period.

From this I think it is clear that QE is not the driver of low Treasury yields. The real driver is deep-seated pessimism over the outlook for economic growth. The market believes the Fed when it says that it will keep rates very low for a very long time, because the market does not believe that there is much chance of enough growth or inflation in the next several years to sway the Fed from delivering on its promise.

If you agree with the Fed or are even more pessimistic, then you think Treasury yields are attractive at current levels. But if you think the Fed and the market are being too pessimistic about what the future holds, then, like me, you think Treasury yields are very unattractive.

Still more signs of a housing recovery

There likely are plenty of people in the world who still doubt that the U.S. housing market is on the mend. They are for the most part fixated on the huge "shadow inventory" of foreclosed properties and the millions of homeowners who are still underwater on their mortgages. But this group doesn't include homebuilders, who last month started work on 872K new homes (seasonally adjusted annual rate). That was 13% more than expected by analysts, and it was fully 60% more than the level of starts early last year. Even just a cursory glance at these charts makes it clear that the residential construction industry has turned the corner, and decisively. This is for real.

The stock market figured out this was coming years ago. The stocks of major home builders are up 56% from June of last year, and up 240% from their recession low. When I predicted in July 2009 that "it's highly likely that if we haven't seen the bottom in residential construction, we are getting very close," I was almost laughed out of town. The bottom had indeed already occurred, but it took two years before the upturn became established.

As Calculated Risk notes, "the US will probably add around 12 million households this decade, and assuming no excess supply, total housing starts would be 1.2 million per year, plus demolitions and 2nd home purchases. So housing starts could come close to doubling the 2012 level over the next several years." Housing is now adding to GDP—after subtracting for most of the past six years—and the process is just getting started. Over the next 3-5 years, residential construction could almost one percentage point a year to real GDP growth.

Tuesday, October 16, 2012

Industrial production is flat this year

U.S. industrial production has not expanded this year, but neither has it collapsed. Eurozone industrial production took a hit beginning last September, but has managed to eke out some gains this year. Not a picture of growth, but not one of global recession either. If the worst that happens is that the U.S. and Eurozone economies remain stagnant for another year, that wouldn't be the end of the world. 5- and 10-yr sovereign yields in the U.S., Eurozone, and Japan are priced to the expectation that growth will be stagnant at best, in my view.

Monday, October 15, 2012

The Reluctant Recovery: Part 2

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the second in a series (see the first here). In this second part, the main focus is monetary policy. I argue that the Fed has correctly responded to the huge increase in the demand for safe-haven dollar liquidity that was caused by the Great Recession and the Eurozone debt crisis. However, the measures they have taken are so unprecedented and so potentially inflationary that they have introduced a significant amount of uncertainty to the market, and this in turn has contributed to the market being reluctant to believe that the current recovery is sustainable.

Quantitative easing has been accomplished so far by the Fed purchasing $1.6 trillion of Treasuries and MBS, in three stages. QE3 has only recently begun, and it is still relatively modest in size, with purchases scheduled to be about $40 billion per month. These purchases have been paid for not with cash, but with bank reserves. Since the Fed decided to pay interest on bank reserves early on in the quantitative easing process, bank reserves are functionally equivalent to T-bills since they are almost as risk-free and yield a little more (currently the Fed pays 0.25% on reserves, which is a bit more than the 0.09% yield on 3-mo. T-bills). This is very different from how things worked in the past, when reserves paid no interest and banks therefore had a strong incentive to use additional reserves to expand lending. In effect, the Fed has swapped $1.6 trillion of T-bill equivalents for $1.6 trillion of notes and bonds. The Fed has not "printed money" in massive quantities as so many have been led to believe. The Fed has merely supplied an asset to the market that was in very high demand (i.e., T-bill equivalents whose price was so high they yielded almost nothing) in exchange for an asset that was in less demand (i.e., notes and bonds with lower prices and higher yields). 

Quantitative easing was necessary to accommodate increased money demand. When analyzing monetary policy, it is critical to establish whether the Fed's willingness to supply money is greater, lesser, or equal to the world's demand for money. If money supply exceeds money demand, the result is inflation (e.g., too much money chasing too few goods and services). If money supply is less than money demand, the result is deflation (e.g., a shortage of money relative to goods and services). If supply and demand are in balance, the result is monetary nirvana—low and stable inflation. As the chart above shows, the demand for money (M2 is the best proxy for "money" that I am aware of, and comparing M2 to GDP is a good way to see how much money people want to hold relative to their incomes and their spending) skyrocketed beginning with the collapse of Lehman Bros. in late 2008. In effect, the world's demand for money soared; people wanted to save more, spend less, increase their cash balances, and reduce their debt.

In the chart above, the increase in the ratio of M2 to GDP from September '08 through today is the equivalent of approximately $1.5 trillion in additional M2 growth. It is not a coincidence that the world's extra demand for money, sparked by fears of a global financial collapse and/or a global economic meltdown, was of the same order of magnitude as the Fed's injection of $1.6 trillion of bank reserves. The Fed bought $1.6 trillion of notes and bonds and paid for them by crediting banks with bank reserves; a portion of those reserves were eventually exchanged for currency, which has increased by about $300 billion; about $100 billion of those reserves were used by banks to back up increased deposits; and the rest of the reserves found their way back to the banks, who were content to just hold on to them in the form of "excess reserves." Banks were risk-averse too, after all, and reserves were a safe asset that paid at least some interest.

Most M2 growth went to deposits. The chart above shows the different components of the M2 measure of money, with the largest by far being savings deposits. It is not a coincidence that savings deposits account for virtually all of the increase in M2 since the Lehman Bros. collapse. Savings deposits have increased by about $2.5 trillion over the past four years, with $1.5 trillion of that increase going towards satisfying the public's hugely increased demand for money. In short, all of the extra "money" that the Fed created in the form of bank reserves ended up in the banking system. It never made it into the economy.

Money growth has not been excessive by past standards. As the chart above shows, M2 in the past four years has grown only marginally faster than it has on average over the past 17 years. Accelerations and decelerations in M2 growth happen all the time, and the last two—driven by increased money demand—don't appear unusual at all. When inflation was rising in the 1970s, M2 growth was averaging close to 10% per year. M2 growth over the past four years has been an annualized 6.4%, and that is just not enough to fuel a significant rise in inflation.

Benign inflation confirms this. Both the headline and the core version of the Personal Consumption Deflator are within the Fed's target of 1-2%. Although inflation has been unusually volatile in the past decade or so, on average it has not been problematic. This strongly suggests that the Fed's efforts to expand the money supply have been matched by the market's increased demand for money. If the Fed had not launched Quantitative Easing, we would probably have seen deflation by now.

However, inflation expectations are rising. The above chart shows the forward-looking inflation expectations that are embedded in the pricing of TIPS and Treasuries. Inflation expectations have been rising in recent months, but they are still only moderately elevated compared to historical experience. I think this reflects emerging fears on the part of the bond market that the Fed is likely to make an inflation mistake in the future, and that is a very legitimate concern.

The dollar is extremely weak. The above chart shows the value of the dollar against large baskets of other currencies, adjusted for differences in the inflation rate between the U.S. and those other countries. It is arguably the best measure of the dollar's value vis a vis other currencies. That the dollar is very close to its all-time low suggests that the currency market also is feeling uneasy about the Fed's stewardship of the dollar. At the very least it suggests a serious lack of confidence in the future of the U.S. economy. The Fed may have done an excellent job accommodating the world's demand for safe-haven dollars to date, but in the process they may have undermined the world's confidence in the value of the dollar going forward.

Gold and commodities are very strong. Gold and commodity prices have risen significantly in the past 10 years, beginning with the Fed's initial efforts to ease in response to weak recovery that followed the 2001 recession. This is basically the flip side of the dollar's general weakness following its peak in 2002. The world's demand for dollars has been eclipsed by an increased demand for physical assets, which in turn is symptomatic of the beginnings of a rotation out of financial assets that could fuel future inflation. Recall that the sharp rise in inflation in the late 1970s followed a sharp rise in gold and commodity prices in the first half of the 1970s. Gold, which is up strongly relative to every currency, is sending a strong signal that the world is concerned that inflation is going to rise.

Inflation has not risen yet, but that is mainly due to the fact that the demand for dollars has been very strong, and that increased demand has been driven by fears, uncertainty, doubt, and a general lack of confidence in fiat currencies. If confidence in the future increases, the demand for dollars is likely to decline. Will the Fed be able to reverse its quantitative easing and/or increase the interest rate paid on reserves in a timely fashion, enough so as to prevent an excess of dollars—and a significant rise in inflation—from occurring? That is the biggest question lurking beneath the surface today. If the demand for M2 should decline, there is the potential for a $1.5 trillion—or more—excess of dollars to develop. Looked at another way, there is $1.5 trillion sitting in bank savings deposits that could be spent, and banks' excess reserves could be used to make new loans and expand the money supply almost without limit. If the world just attempted to reduce its holdings of savings, $1.5 trillion could find its way into higher prices for goods and services, and that could fuel some significant inflation, and perhaps some additional growth, in the years to come.

In short, it's understandable that markets are reluctant to believe that things will continue to improve.

Next installment: fiscal policy