The weakest recovery continues

First quarter GDP growth was miserably weak, as expected. The economy grew at a 0.5% annualized pace, which means an expansion of only $22 billion in the past three months—equivalent to a rounding error. In the past six years, we've seen miserably slow growth in the first quarter four times now, which suggests that a statistical problem may be the culprit. Whatever the case, the economy grew 2.0% in the past year, which is only slightly less than the 2.1% annualized growth rate that has been sustained since the recovery got underway in mid-2009. So it's not unreasonable to think that nothing much has changed and that we will see stronger growth numbers for the remainder of this year.

The chart above shows the real and nominal annualized growth rates of the U.S. economy by quarter. Note the green circles which highlight unusually weak growth rates in the first quarter. When four of the past six first quarters show a similar pattern it suggests there is something wacky going on with the seasonal adjustment factors. 

The chart above shows the year over year growth rate of the U.S. economy. By this measure the past year was very much in line with previous years. Since the recovery began in mid-2009 the economy has growth at an annualized pace of 2.1%.

The chart above plots real GDP on a semi-log scale in order to better appreciate how the economy has underperformed relative to its long-term trend growth rate. By failing to bounce back to its trend growth path, and by growing only 2.1% a year instead of 3.1%, the economy is now almost $3 trillion smaller than it might have been had this been a typical recovery. We've never seen such miserably slow growth following a recovery, and the problem has persisted for almost seven years now.

What explains the persistence of slow growth? The two charts below suggest that the economy suffers from a failure to thrive because of a lack of investment. Risk aversion has held back entrepreneurship and risk-taking in general. For years I've explained that this has been a risk-averse recovery.

Capital goods orders, shown in the chart above, are a good proxy for business investment. In nominal terms, capital goods orders are no stronger today than they were prior to the last two recessions. In real terms, capital goods orders today are the same as they were in 1995. But of course the economy has grown by over 60% since then. Simply put, there has been a huge shortfall of business investment, especially if you consider that corporate profits today are about 9% of GDP, which is substantially higher than the 6.5% average of the past 57 years. 

The chart above, which shows fixed private domestic investment as a percent of GDP, tells the same story: investment has been unusually weak. 

Strong profits, weak investment: its a conundrum that is difficult to explain with confidence. But it's probably not a coincidence that for the duration of this unusually weak recovery we've seen a huge accumulation of public debt, a huge increase in regulatory burdens (e.g., Obamacare, Dodd-Frank), generally high and rising marginal tax rates, and a punitively high corporate tax rate. The rewards to risk-taking, and the burdens of running a business and complying with increased regulatory mandates have depressed the economy's animal spirits. The government is slowly smothering the private sector.

Chart updates

This has been a slow-blogging month so far, mainly because I haven't seen much change in the economic and financial environment. The market remains worried about slow growth and weaker corporate profits, but less so than a few months ago, thanks to rising oil prices and signs of stability in China. Meanwhile, it's quite likely that the U.S. economy is still growing, albeit slowly, as jobs growth and the labor market both look healthy. There is plenty of upside potential in the future, but much depends on the future direction of fiscal policy, and that in turn depends on the November elections—with the outcome still very much up in the air.

So here are some updated charts that I find interesting, in no particular order, with some brief commentary below each one:

Industrial commodity prices are up 15% since last December. At the very least this suggests that global economic activity is strengthening on the margin. The Chinese yuan has been stable over this same period, suggesting further that conditions in China are not deteriorating as many had feared.

Commodities have risen in price in all major currencies since December. This is not just a dollar-driven phenomenon, and that reinforces the notion that rising commodity prices reflect improving economic conditions.

Oil prices have been much more volatile than other commodity prices (note the difference in magnitudes of the two y-axes). However, both have tended to move together. Oil prices are up an astounding 70% since their mid-February low.

The dollar has been relatively flat since early last year, and this appears to have provided some important support to commodity prices of all types.

Housing prices have been rising for the past four years. In real terms, prices have tended to rise about 1.4% per year on average. Prices today do not seem to be out of line with historical trends. In the past four years, home prices on average have risen by an annualized 8%.

Fear has been an important source of stock market volatility in recent years. Fears have subsided of late, and that has allowed stock prices to rise.

Credit spreads have subsided as well as fear in general. Most of the fear was concentrated in the oil patch, and rising oil prices have brought a sigh of relief to the entire corporate bond market. 

The number of active drilling rigs in the U.S. has plunged by almost 80% since late 2014, in direct response to lower oil prices. This illustrates the power of market prices, since lower prices have worked to discourage oil exploration and production while at the same time encouraging more oil consumption. Crude oil production in the U.S. has declined by7% since last June, after almost doubling in the previous six years.

Fixed mortgage rates are within inches of all-time record lows. There may never be a better time to refinance a mortgage or take out a new mortgage.

Applications for new mortgages have surged by almost 50% since late 2014, largely in response to low and declining mortgage rates. This reflects a significant improvement in housing market fundamentals.

The spread between the yield on MBS collateral and the 10-yr Treasury has been remarkably stable (70-80 bps) for the past several years. This stability suggests that the appetite for MBS has been relatively strong even as the demand for new mortgages has surged of late: borrowers are more willing to borrow, and lenders are more willing to lend.

According to Bloomberg's Financial Conditions Index, conditions are relatively healthy, though still shy of what they have been during earlier periods when markets were optimistic and economic growth was stronger.

U.S. equities have outperformed Eurozone equities by a significant and perhaps unprecedented margin over the past seven years. Eurozone equities have made no progress on balance since 1999, in contrast to the U.S. equity market which has attained new highs.

10-yr Treasury yields today are only 45 bps above their all-time record lows of mid-2012. Relative to core inflation, 10-yr Treasury yields are negative. Yes, negative yields exist in the U.S. The real yield on 2-yr Treasuries is now -1.4%! Yields are very low and even negative relative to inflation, relative to rising home prices, and relative to rising commodity prices. This encourages borrowing and speculation. In the late 1970s, negative real yields contributed to rising inflation. Some central banks have resorted to negative interest rates in an attempt to boost inflation. Since negative interest rates strongly discourage holding cash, they are inflationary since they weaken the demand for money at a time when there is an abundant supply of money, effectively creating an over-supply of money. To the central banks that are paying people to borrow money, I say "be careful of what you wish."

The chart above compares the price of gold with the price of TIPS (with the inverse of the real yield on TIPS being a proxy for their price). Both have been in a declining trend for the past several years. I've argued that this reflects a declining demand for safe assets and a gradual return of the confidence that was lost in the wake of the 2008 financial crisis. I think it also reflects less concern regarding the potential for QE to boost inflation. But the recent upturn in both prices could be an early sign that negative interest rates are beginning to bite: the market is now willing to pay more for the protection these two assets offer from rising inflation and general uncertainty. This may be the canary in the coal mine of rising inflation.

Even though 10- and 30-yr Treasury yields are very close to all-time record lows, the spread between the two is relatively high and rising from an historical perspective. This is the bond market's way of saying that short-term interest rates are quite likely to rise in the future, and it is also a sign that the economy is not on the verge of another recession (the yield curve typically flattens in advance of recessions).

Pessimism recedes

Not much has changed in the past few months since I posted A review of key charts: no recession, no deflation, lots of pessimism, except that things have played out more or less as expected. As I observed last week, there have been some encouraging developments that have thrown cold water on fears that China would collapse and oil prices would go to zero. Here are just three of the more important charts that are worth updating:

Commodity prices continue to rebound from their lows of several months ago. Oil prices are up much more than 50%, and as the chart above shows, industrial metals prices are up over 25% in just the past 3 months. At the very least this rules out the threat of a global economic collapse; more importantly, it hints strongly that economies around the world are beginning to improve on the margin. Later this month we'll hear that first quarter growth was miserably slow, but that's definitely old news at this point. What matters is what's happening now.

Credit spreads continue to fall, thanks to rising commodity prices. And of course 2-yr swap spreads, my favorite leading indicator of economic and financial market health, continue to be very low and thus very encouraging.

Equities continue to rally as fears are gradually allayed. I can't say the market is optimistic, however, since 10-yr Treasury yields continue to be extremely low (~1.8%). There's still a lot of pessimism priced into Treasury bonds these days, and PE ratios are only moderately above average, despite the fact that corporate profits are very strong relative to GDP.

What's driving the market higher is not optimism but receding pessimism.

More encouraging developments

Ten days ago I wrote about a few encouraging developments amidst a sea of negativity. I'm happy to report that the list of encouraging developments is expanding. At root, the good news is the growing perception that China is not collapsing and oil prices are not going to zero. In fact, China seems to be on firmer footing these days, albeit with less rapid growth, and oil prices have rebounded over 50% from their recent lows. Meanwhile, the outlook for the U.S. service sector has improved, commodity prices continue to rally, credit spreads continue to narrow, and bank lending continues to surge. First quarter GDP growth may prove to be miserably slow (Bloomberg's consensus is for 0.6% growth), but that's old news by now and is trumped by a range of market-based prices that reflect improving economic fundamentals on the margin.

China's foreign exchange reserves (the red line in the chart above) are best thought of as a measure of net capital flows, given the central bank's exchange-rate policy.  Since the central bank relies on a managed peg regime, whenever more money comes into China than leaves, the central bank must buy any net inflows, which in turn increases forex reserves; by the same logic, net capital outflows show up as declining forex reserves because the central bank must sell reserves to keep the yuan from declining. 

The fact that reserves have been relatively stable for the past two months, while the yuan has actually risen a bit suggests that the central bank has been successfully managing the changing dynamics of the Chinese economy. The market had worried about a deluge of capital outflows and a weaker yuan and a weaker economy, but those fears appear to have been largely put to rest. In other words, the much-feared panic exit from China has not materialized, and markets seem to be finding a new equilibrium.

The stabilization of the yuan (it needn't fall further if there are no net capital outflows) has, unsurprisingly, coincided with the restoration of some confidence to the Chinese equity market, which has firmed up in recent months as shown in the chart above. Investors are still smarting from the equity market collapse in June of last year (which now looks increasingly like a speculative bubble that was doomed to burst), but prices today are still 50% above the levels that prevailed prior to the yuan's devaluation and prior to the loss of forex reserves. On the margin, the outlook for Chinese growth is improving (now 6-7% a good deal less than the 10% annual average over the past two decades, but still impressive), to judge from the stabilization of reserves and the yuan, and the rising stock market.

With the dollar no longer appreciating, commodity prices have found new support. Industrial metals prices, shown in the chart above, are up over 20% in the past 3-4 months. At the very least this dispels any notion of a global economic collapse or slump, and hints instead at improvement on the margin.

Most important is the fact that oil prices are up over 50% in since mid-February, as cutbacks in oil production have restored some balance to the oil market (see chart above). For example, the number of active drilling rigs in the U.S. has plunged by a staggering 78% in the past 18 months. Meanwhile, oil consumption has undoubtedly risen in response to very low prices.

5-yr Credit Default Swap spreads have narrowed meaningfully since mid-February, as investors infer that rising commodity prices reflect an improvement in global economic fundamentals. CDS spreads are now only modestly elevated relative to prior lows. 2-yr swap spreads remain very low, and continue to suggest that liquidity conditions are excellent and systemic risk is low. In short, markets are dealing successfully with, and overcoming, the oil price and China slowdown shocks.

Spreads on high-yield energy bonds soared to almost 2000 bps in mid-February, but have since dropped back to 1200 bps. The stench of panic is rapidly dissipating.

The March ISM service sector business activity index, shown in the chart above, rebounded strongly from its February low. This is the functional equivalent of a big sigh of relief, as a much-feared deterioration failed to materialize. February's very weak reading was likely influenced by the panic that had infected some areas of the market. Confidence, in other words, is returning.

Bank lending to small and medium-sized businesses, shown in the chart above, continues to surge, rising at a 16.6% annualized pace in the past three months and 10.3% in the past year.

Not surprisingly, as the market's fears have been allayed, equity prices have risen:

We're still not out of the proverbial woods yet, to be sure. The Vix index remains somewhat elevated (14), 10-yr Treasury yields are very low (1.76%), real yields on TIPS are very low (flat to negative), and the earnings yield on stocks is still unusually high, especially relative to the yield on Treasuries (5.3% vs. 1.75%). These market-based indicators all reflect the presence of caution and concern. If markets were confident and optimistic, Treasury yields would be higher (3-4%), the earnings yield on stocks would be lower (i.e., PE ratios would be higher), and the Vix index would be 10-12.

To top it all off, we have the great uncertainty surrounding this year's presidential elections and what the result holds for the direction of fiscal policy, since that holds the key to the future health of the U.S. economy. We've been muddling along with 2 - 2 ½% growth for the past seven years, thanks mainly to the economy's inherent dynamism which has managed to overcome rising tax and regulatory burdens. The economy has a lot of untapped potential if fiscal policies were to become more growth-friendly (e.g., tax reform, lower tax rates, reduced regulatory burdens). But a replay of the faux "stimulus" policies of 2009, coupled with higher taxes (as both Democratic candidates are advocating) could deliver more years of disappointingly slow growth—or even no growth.

To judge from the degree of caution and concern still priced into the market, I think the consensus of investors is that the fiscal policy headwinds are more likely to strengthen than weaken (i.e., bad news is priced in). But if the outlook for China and the global economy continues to improve, this could go a long way towards offsetting the negatives that might surface in November. Regardless, it's hard to develop strong convictions about where policy is headed next year given all the variables still in play (e.g., a Hillary indictment, Trump vs. Cruz, who controls the Congress). I'm inclined to believe that things will improve, if only because in the past 8 years we have tried so much of what doesn't work.

The bad news is why I'm optimistic

In the seven and a half years that I've been doing this blog, I've been accused by many readers of being relentlessly and even dangerously optimistic (e.g., "do you ever seen any negatives?"). It's true that I have been reliably optimistic, even in the face of a series of selloffs and corrections. However, I've explained that my optimism is not optimism per se, but optimism relative to a market that has been generally pessimistic. Ever since early 2009 I've predicted that, while the economy was likely to grow, it would be a disappointingly sub-par recovery, mainly because of headwinds like high marginal tax rates, "stimulus" spending, increasing regulatory burdens, Obamacare, anti-business sentiment, and uncertainty surrounding the Fed's monetary policies. Even though I foresaw sub-par growth, I thought that it made sense to be bullish because the market expected even less (remember all the "double-dip recession" calls and ECRI's recession call in 2012?). So far, my optimism has been warranted.

Now, let me be specific about all the negatives I see out there, especially the relatively new ones. There are LOTS of negatives, but I'll try to be brief.

The biggest negative of them all is that the US economy is not nearly as large and as healthy as it could or should have been, had policies been better designed. This has been the weakest recovery in post-war history, and by a lot. If the economy had rebounded from the Great Recession with the same vigor it displayed in every post-war recovery, national income would be almost $3 trillion higher than it is today, as the chart above illustrates. Per capita income would be almost $9000 higher, and a family of four would be making $35K more every year. That's real money, and it explains why the electorate is so upset these days with the establishment.

As I noted some years ago, all the spending and borrowing that was supposed to "stimulate" the economy was essentially flushed down the toilet. Since 2009 we've conducted a laboratory experiment in the power of government spending to grow the economy by stimulating demand, and the result is proof that Keynesian theories are destructive, not stimulative. Neither government spending nor easy money has the power to create growth out of thin air, but politicians want to convince you that they do. The economy is weak today because we have wasted many trillions of dollars on transfer payments that only create perverse incentives to work less.

A few days ago, Treasury Secretary Jack Lew unleashed a regulatory broadside against large corporations seeking to become more competitive in an economy with an absurdly burdensome tax code. As Pfizer's Ian Read noted in today's WSJ:

This week’s Treasury action interprets the tax laws in ways never done before. This ad hoc and arbitrary attempt to single out and damage the growth opportunities of companies operating within the current law is unprecedented, unproductive and harmful to the U.S. economy. 

The action was accompanied by much unfortunate rhetoric about tax avoidance. No one was shirking their U.S. tax bills. In a merger with Allergan PLC, an Irish company, we would have continued to pay all federal, state and local taxes on our U.S. income. All that these new rules will do is create a permanent competitive advantage for foreign acquirers. Simply put, there will be more foreign acquisitions of U.S. companies resulting in fewer jobs for American workers.

If the rules can be changed arbitrarily and applied retroactively, how can any U.S. company engage in the long-term investment planning necessary to compete? The new “rules” show that there are no set rules. Political dogma is the only rule. 

Why punish our most successful companies, when it would be so much more reasonable to simply revise our tax code so that U.S. businesses are not double-taxed on their foreign income, and are not taxed at the highest rate in the developed world? If the objective is to have more money to redistribute to the "poor" it's doubly stupid, because income redistribution only creates perverse incentives. Unfortunately, we've been seeing a lot of stupid policies out of Washington, for about as long as I can remember.

Why tear down the rule of law upon which our country was built? As an aside: if Hillary escapes prosecution for what are almost certainly serial and willful violations of U.S. intelligence and secrecy laws, while the Clinton Foundation has every appearance of being massively corrupt, think of the example this sets. When rules are only for the little people, trust in government goes down the toilet almost as fast as government "stimulus" spending. Even Hillary acknowledged this when she said "There’s no daylight on the basic premise that there should be no bank too big to fail, and no individual too powerful to jail."

And then you have the problem that there is way too much ignorance of the fundamental laws of economics these days, especially among the political class. How else to explain Trump's vow to impose huge tariffs on Chinese imports? Or California's decision to raise the minimum wage to $15/hour? Or the $370 billion of M&A deals aborted on Obama's watch? These policies are virtually guaranteed to lead to perverse outcomes. It takes magical thinking to believe that a $15 minimum wage will do anything but shrink job opportunities for youth. At its worst, this exercise in hubris will lower living standards for all Californians, by sending jobs elsewhere and increasing poverty among the young. Raising the prices of Chinese imports will certainly be a negative for all consumers, but won't provide any guarantee of creating new domestic jobs.

And then you have the failure of our educational system, which has allowed a generation to grow up thinking that socialism is the wave of the future. How else to explain the huge popularity of Bernie Sanders?

I won't dwell on the Dept. of Labor's new rules which will place more onerous requirements on private sector financial advisors and push more people into government-run savings plans. (Who in their right mind would trust the government to invest your money?) Or the ongoing failure of Obamacare, which has only pushed up healthcare costs for everyone while restricting choice, all but ensuring that we will have a growing shortage of doctors in the future. Is it any wonder that the only two institutions that affect most everyone in the country and which provoke the most concern and frustrations—education and healthcare—are almost entirely under the control of government? If a private sector business delivered the miserable results that we find in education and healthcare it would have gone out of business a long time ago.

Then of course you have the problems of the slowdown in the Chinese economy and the collapse of oil prices, but these are problems which can presumably be solved if market forces are allowed to operate, as I've argued in numerous posts of late.

Now, of course none of this is a secret. The market is fully aware of all these problems, and anyone paying attention to quality news outlets and scouring the internet should not be surprised to hear it. There's lots of bad news out there, and that's why I think the market is still dominated by pessimism. The chart above makes my point: 5-yr real yields on TIPS are trading at levels which suggest that the market expects real GDP growth in the U.S. to be somewhere in the neighborhood of 1-2% per year for the foreseeable future. The market has been underestimating growth for years, and it continues to see weak growth ahead.

But it's not enough to be worried about the future, or to be optimistic. You have to match your knowledge and expectations against the expectations that are built into market prices. If you think the market is too pessimistic, as I do, then you should be optimistic, even though you don't expect real GDP growth to be more than 3% a year for the foreseeable future, and you fully expect the economy to be stuck in a slow-growth rut until policies change for the better.

I'm still optimistic, mainly because there are so many problems out there and because expectations are so dismal. But here's the kicker: if we could just fix a few things that are so easily fixable (e.g., the tax code, burdensome regulations), the potential for an upside growth surprise could be gigantic. How hard can it be to do the right thing?

Auto loans in perspective; not a huge problem

I've been seeing more buzz lately on the subject of auto loans: they are surging, more and more loans are of subprime quality, it could the next bubble to burst, etc. Here are a few charts which help put the issue in perspective:

Outstanding motor vehicle loans (loans that have been securitized plus loans that are held by lending institutions) now exceed $1 trillion, and they rose by 8.6% last year. But the latest spurt of growth is relatively mild compared to what we saw in the 1980s, when loans were expanding at strong, double-digit annual rates. Loans today are only 25% above their high of 10 years ago.

As a percent of disposable income, motor vehicle loans today are about as much as they were in the late 1980s, and substantially less than they were about 10 years ago. However, interest rates on new car loans today are in the neighborhood of 4%, whereas they were much higher in the past.

The chart above looks at the burden (i.e., monthly payments as a % of disposable income) of all consumer debt and financial obligations. This confirms that the burden of motor vehicle loans today is much less than it has been in the past. Consumers in general are in pretty good financial shape these days.

As this article points out, new subprime auto loans last year were only about $20 billion, and represented less than one fourth of all new car loans. Only 3.4% of auto loans are seriously delinquent, and lenders have developed surprisingly innovative ways of repossessing cars these days.

However you look at it, motor vehicle loans today are not an obvious problem, and are very unlikely a tail big enough to wag the U.S. economy dog, at least for the foreseeable future.

A few encouraging developments

We're still in the midst of the weakest recovery ever, and there's a lot of unease among the population, as evidenced by the surprising strength of the unconventional Trump and Sanders campaigns. The economy only grew by a  miserable 1.4% annualized in the fourth quarter, and some forecasts are saying the first quarter just ended was miserably slow as well. The market complained so loudly about the Fed's plan to raise rates two or three more times this that Janet Yellen had to do a mea culpa and back off, at least for the time being. Decent fiscal policy is what has been lacking, but at this point there's no telling how the elections are going to change the future of policy. Trump seems to be losing momentum and the FBI is hot on Hillary's trail. Sanders is so addled he wants to boost the economy by saddling its more productive members with a mountain of new taxes. Cruz is holding his own for now, but not feeling much love (though he's got my vote, that's for sure).

So it seems a bit odd that the stock market has staged a big comeback in the past few months. Could there be something positive brewing beneath the economy's surface? Only time will tell, but I can point to several encouraging developments of late.

The March ISM report was stronger than expected, although still in weak territory. As the chart above suggests, the improvement in the manufacturing sector portends a pickup in first quarter GDP growth, which could come in at  2 - 2 ½%, or about the same as we've seen over the past 6-7 years.

The economy has been pretty resilient of late, and jobs continue to grow at just over a 2% annualized rate. Add to that the miserably weak productivity that the economy has suffered from for the past 5 years, and you get real growth of 2 - 2 ½%, which confirms the message of the ISM index. In other words, the economy's central growth tendency hasn't changed over the past several years. 

The past few months have seen an uptick in both the growth of the labor force and the labor force participation rate (see charts above). The labor force participation rate has now been flat for the past two years, a welcome respite from the almost unprecedented declines we saw over the previous five years. People are re-entering the workforce. Perhaps because they are getting hungry for some extra income, or because they are somewhat more confident they can find a job. Either way, more people working and looking for work means the economy retains its inherent dynamism, and that is what has helped it weather the Eurozone, China, and oil patch slowdowns.

Industrial commodity prices have jumped since last December, ending a multi-year slump. Perhaps it's because the dollar has stopped rising, and/or because the global economy is picking up a bit on the margin. Either way, it's a welcome positive and should help put deflation fears to rest.

Stronger commodity prices have brought a sigh of relief to emerging market economies. Brazil in particular has seen a rather dramatic surge in its stock market and in its currency in recent months, as the chart above shows. There are some encouraging political developments as well that are percolating in Latin American economies today: Brazil may get new, non-corrupt leadership, and Argentina's new president is straight out of central casting. (A friend spotted Macri on a commercial flight out of Buenos Aires just the other day, and tells me he has decommissioned the government's aircraft fleet to help reinforce his message of cutting costs and setting a conservative fiscal course.)