Wednesday, December 23, 2015

The absence of bad news is good news

Over the past 5 years or so, the price of oil has tumbled by two-thirds, gold is down over 40%, non-energy commodity prices are down 40%, and industrial commodity prices have fallen by one-third. Over the same period, Chinese economic growth has slowed from 12% to less than 7%, most industrialized economies have experienced persistently weak growth, and inflation has been relatively low and curiously resistant to central banks' efforts to boost it. 

Many have looked at these facts and have concluded that the world is caught up in a deflationary death spiral. Bearish fever is alive and well, but it is countered by evidence that the economy continues to grow. As I've said many times before, when sentiment is braced for deflation and recession, all that matters is avoiding recession. This line of inquiry isn't very exciting, however, and that's one reason blogging on this site has been light of late. Nothing much has changed: the economy shows every sign of continuing to grow at a relatively disappointingly slow pace. The important thing nevertheless is that there is no sign of recession, deterioration, or deflation, and that's good news.


If ever it made sense to pay more attention to core inflation rather than headline inflation, it's now, given the magnitude of the collapse of oil prices over the past year or so. Headline inflation has been hugging zero for most of the past year, but core inflation has been averaging 1.6 - 2.0% for the past 10 years. In the 12 months ended November, PCE Core inflation was 1.33%, while CPI Core inflation was 2.02%. As the chart above shows, these two measures of inflation closely track each other over time, with the PCE Core tending to be about 40-50 bps lower than the CPI. The message here is that inflation has been relatively low and stable for a long time, with not even a hint of deflation in recent years or months. The fact that the Core PCE deflator measure of inflation is somewhat lower than the Fed's current 2% target is not troubling in the least, in my opinion. 


The chart above focuses on non-energy commodity prices, in both real and nominal terms. In real terms, non-energy commodity prices today are about 27% below their long-term average, but 50% above their all-time lows of late 2001. Commodity prices have fluctuated significantly over the past several decades, and their recent "plunge" is hardly unprecedented. In nominal terms, commodity prices today are still double what they were in late 2001. Message: business as usual. Plus, the recent downturn in commodity prices likely has much more to do with increased supplies than with any deflationary error on the part of the Fed. As such, lower commodity prices are good news for commodity consumers, since they free up money for other expenditures.


The commodity markets may be struggling, but the bond market is more sanguine. Real yields on 5-yr TIPS—arguably a good proxy for the market's perception of the economy's underlying growth potential—have risen from a low of -1.8% in early 2013 to almost 0.5% today. I note that this increase in real yields has tended to track an improvement in the economy's growth rate over the same period. Growth expectations are still modest, but they are improving on the margin, and not deteriorating. 


As for oil prices, in real terms (see chart above) they are only about 30% below their long term average. In real terms, oil prices today are about the same order of magnitude as they were in the 80s and 90s, when the economy enjoyed generally robust growth. Thank goodness for a return to relatively cheap energy.


As the chart above shows, when we compare oil to gold, oil looks very cheap today. It's rarely been this cheap compared to gold.


The chart above compares the real price of oil (inverted) to a measure of consumer confidence. Cheaper oil in the past year has helped boost consumer confidence considerably.


Today saw further proof that the housing market continues to firm: new applications for mortgages are now 35% above what they averaged in the latter half of last year. (This also confirms that the unexpected weakness in existing home sales reported yesterday was another artifact of a change in regulatory requirements that lengthened the closing process, not actual weakness.)


November capital goods orders confirmed that business investment remains lackluster, and this is a good reason why the economy continues to grow at a sluggish pace. But while the news was not optimistic, neither did it show any sign of deterioration. That's the important news.


And so the market continues to climb walls of worry. Worries abound (e.g., deflation, commodity collapse, Fed tightening, China weakness), but they amount to nothing: the economy keeps growing at a modest pace. Stocks are reasonably priced, and absent a deterioration in the outlook, are attractive, if only because earnings yields are significantly higher than the yield on cash.

19 comments:

Galactic said...

Light blogging or not-- this site is ranked atop my list for Quality insights and commentary.
Thanks Scott.

Merry Christmas, Happy Holidays and New Year everyone!

Burton Rothberg said...

Hi Scott. Great job as always.

If your readers are interested in similar graphs for individual commodities, go to my blog https://thecommoditystrategist.blogspot.com/
Click on the link on the right that says: "Ten Year Forward Graphs". I've done it for every commodity in the IMF database, although in a different format.

Merry Christmas to everyone!

Cabodog said...

Scott, as always, thank you so much for taking the time to share your thoughts and research. Always, ALWAYS appreciated.

Merry Christmas to you and your family.

Alain said...

Yes this is my top site as well for financial reading. Thanks Scott for taking the time to give us your insight. I've been reading your blog for the past 3 years now. Keep it up!

Benjamin Cole said...

Great wrap-up, although I think the world's major central banks could be much more aggressive in seeking growth.

We may see another flat year on US stock markets. If the dollar continues to appreciate, then reported earnings will continue to contract, and, of course, export and tourism will be hurt. BTW, Japan has 50% more tourists in 2015 YOY.

The risk in forecasting is always this: one expects more of the same. I expect 2016 to look like 2015. (Another risk is to forecast rising inflation and interest rates. That has been the forecast since 1982 in some circles.)

But global markets have a way of not living up to expectations. The secular trend in inflation and interest rates still appears down.

Good luck everybody!

steve said...

Took the leap yesterday: long high yield bonds. Not sure how long I'll be there (I'm a trader and this could be a very short term trade) BUT they have caught a bid and they are trading as if we're heading into recession. Barring that, HY works at some point in the near future and outperforms the market.

Excellent work by Scott as usual and I wish all a very Merry Christmas!

Burton Rothberg said...

Hey Steve I did the same thing, on the same day!
I bought DSU
It's Black Rock's high yield closed end fund.

discount to NAV 13.5%
% of port in oil 6%
in metals 2.5%
current yield 8.7%

This is obviously a bottom pick, but a pretty decent one I think.

minnesota nice said...

Merry Christmas Scott. Thanks for all your work. I have been reading for many years. I appreciate your deep knowledge of markets/economics as well as your common sense applications.

Burton - FYI DSU is the corporate loan fund, HYT is the corporate bond fund. Either way, they both are attractive right now.

Tom L said...

Thank you Scott for great commentary and insights! Happy holiday and happy new year!!

marcusbalbus said...

why is only oil and commodities worthy of praise for being "cheaper". let's reduce all prices and really party.

zumbador said...

THANK YOU….for ALL of the excellent data and commentary you provide. I have been reading your reports now for a number of years and feel very fortunate to receive the information you provide. Your commentary from 12/23 to me seems to be spot on!

I hope YOU and ALL YOU FAMILY have a very good Xmas Holiday and all have an excellent New Year in 2016! Take Care!

marcusbalbus said...

and earnings yield is the last refuge of the sophist

FactsAreFriendly said...

Is there any reason to believe that the GDP reports from China? Or Russia? Or any other dictatorship?

Scott Grannis said...

Facts: As a general rule, all GDP and related reports are suspect, if only because it is practically impossible for any government to accurately measure all the transactions that take place in an economy. Moreover, it is a fact that GDP stats are revised—and sometimes significantly—after the fact. In my experience, the GDP stats from developed countries are generally reliable, but only in the fullness of time, which might take as much as two years. I consider the U.S. GDP report to be a ballpark figure, for example, which is not refined until much time has passed. It is foolish to place too much trust in an initial GDP report, even from the U.S. government. However, in looking at GDP stats from developed economies that have been fully revised and refined, they do paint a picture that is generally consistent with other facts that are known.

In the case of lesser-developed economies and dictatorships, it makes sense to be highly skeptical of GDP reports. Argentina is arguably the most well-known case of a country willfully manipulating its inflation statistics, so much so as to almost laughable.

The best indicators, of course, are the ones generated in real-time by market forces (i.e., prices).

Oeconomicus said...

Another hearty thank you from a long time reader. Happy Holidays Scott.

William McKibbin said...

Sadly, the news is all bad for the US economy. I invite everyone's attention to the charts linked below.

https://twitter.com/McKibbinUSA/status/681145810147409920

To state that we have an "absence of bad news" is simply to admit callous indifference to the measures in the charts linked above.

Supply-side economics is a failed policy of old people from the last century. The only good news is that advocates of supply-side economics are being to pass away.

William McKibbin said...

being -> beginning

Charlie Howardrocco said...

WM - how's your gold investment working out for you?

William said...
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