Sunday, December 31, 2017

Predictions for 2018

One year ago I expected to see an improving economy and further gains in equity prices, and I sure got that right. Stocks are up big-time and GDP growth has accelerated somewhat. But I worried, as I have every year for the past 8 years, that the Fed might be slow to react to rising confidence and declining money demand, and that this could set off a bout of rising inflation. Fortunately, I got that wrong yet again, since inflation has remained in a comfortable 1.5 - 2% range. For the past two years I've liked emerging markets, and they have done quite well. Last year I didn't much care for gold or commodities, but they have done well thanks to a weaker dollar—which I didn't see coming. So it's a mixed bag for calls, but last year's 19.4% rise in equity prices goes a long way to making up for a few smaller losses. In any event, take the following with suitable grains of salt. I've been bullish and right (on stocks) for so long now that it makes even me nervous.

All throughout 2017 the world worried that Trump and the Republicans were going to prove incompetent. Was Trump crazy? Could he actually govern? Could the Republicans abolish Obamacare as promised? Could they pass tax reform? Turns out they did a pretty good, if far from perfect, job. Obamacare is being dismantled, beginning with the elimination of the mandate. Tax reform could have been better, but it achieved its main objective: to stimulate investment. Meanwhile, hidden behind the distractions of tweet storms and faux pas, Trump has accomplished a major reduction in federal regulatory burdens. This can really make a difference over the long haul, and it may already be contributing to faster growth.

Thinking back, Obama in his first year got a $1 trillion dollar stimulus package designed to boot-strap the economy by redistributing income (see my analysis here). The result was the slowest recovery on record; Obama ended up borrowing some $8 trillion to no avail, since nothing he did was aimed at increasing the market's desire to invest, work harder, or take risk. Trump in his first year got a $1.5 trillion (CBO-scored "cost") stimulus package designed to boost the economy by increasing the after-tax returns to business investment. I'm betting the results of Trump's tax reform will be much better than expected, but the market is not yet willing to make that same bet, and that is the point of departure for all predictions of what is to come.

If 2017 was about just one thing, it was the ability of the Republicans to pass meaningful tax reform. The market spent most of the year handicapping the odds of tax reform, and it would appear that it is now mostly, if not fully, priced in. The tax reform package boils down to a one-time 20% boost to after-tax corporate profits (by cutting the corporate income tax rate from 35% to 21%), and that's pretty much what we have seen happen to equity prices this past year.

If 2018 is going to be about just one thing, it will be whether boosting the after-tax rewards to business investment results in a stronger economy. Beginning in 2009, Obama and the Democrats gambled that a massive redistribution of income would boost demand and thus boost the economy, but they lost. They ended up flushing $8 trillion down the Keynesian toilet. Trump and the Republicans are now gambling that a significant increase in the after-tax rewards to business investment will boost the economy. Only time will tell, but there are already hints of a stronger economy in the data: e.g., capex is up, industrial production is up, business confidence and the ISM indices are up, and industrial metals prices are up. It's likely that the current quarter could mark the first time we've enjoyed three consecutive quarters of 3% or more growth in over 12 years.

I think the meme for 2018 will be this: waiting for GDP. If the economy shows convincing and durable signs of stronger growth, more investment, more jobs, and rising productivity, then the Republicans' gamble will have paid off. If not, the Democrats will have carte blanche to take control of Congress and oust a sitting president.

From my supply-sider's perspective, we now have the essential ingredients for a stronger economy in place. Tax incentives are correctly aligned to encourage more business investment; regulatory burdens are being slashed, business confidence is high, and the Fed is not a threat for the foreseeable future. Swap and credit spreads are low, as is implied volatility, and that tells us that liquidity is plentiful and systemic risk is low. The fact that the rest of the world is also doing better as well is just icing on the cake.

But, argue the skeptics, won't businesses just use their extra profits to buy back shares and increase their dividends, making the wealthy even wealthier without creating any new jobs? This oft-repeated allegation is an empty argument, because it ignores one key thing: what do those who receive the money from buybacks and dividends do with it? John Cochrane explains it in this brief excerpt (do read the whole thing):

Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.
The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.

In other words, what some companies do with their extra cash is immaterial. What matters is that tax reform has increased the marginal incentive to invest—for the entire economy—by reducing tax rates and by allowing the immediate expensing of capex. On the margin, investment now has become more attractive and more profitable in the US, and this will almost certainly result in more investment (some of which is likely to come from overseas firms deciding to relocate here), which in turn means more jobs, more productivity, and higher real incomes. As I explained a few years ago, productivity has been the missing ingredient in the current lackluster recovery, and very weak business investment is one reason that productivity has gone missing. A pickup in investment is bound to raise productivity, which is the ultimate driver of growth and prosperity.

So it's clear to me that tax reform is a big deal, because it's very likely to boost the long-term growth trajectory of the US economy by a meaningful amount. Surprisingly, however, the market does not appear to share that view. Why else would real yields still be miserably low (e.g., 0.3% for 5-yr TIPS)? Why else would the market expect only a modest increase (0.75% or so) in the Fed's target funds rate for the foreseeable future? The current Fed target is 1.5%, while 2-yr Treasury yields, which are the market's expectation for what that rate will average over the next two years, are only 1.9%. As for real yields, the current Fed target translates into a real yield—using the PCE Core deflator—of roughly zero, while the yield on 5-yr TIPS says the market expects that rate to average only 0.3% over the next 5 years. If the economy really gets up a head of steam (e.g., real growth of 3% or more per year), I can't imagine the Fed wouldn't raise rates by more than the market currently expects, and I can't imagine nominal and real yields in general won't be significantly higher than they are today. The last time the economy was growing at 4% a year (early 2000s), 5-yr TIPS real yields were 3-4%.

Yet the Fed is the one thing I worry about, which is nothing new. The Fed has been responsible for every recession in recent memory, because each time they have tightened monetary policy in order to reduce inflation or to ward off an expected increase in inflation, they have ended up choking off growth. They are well aware of this, however, so they are going to be very careful about raising rates as the economy picks up steam. But as I've explained many times before, the Fed's worst nightmare is a return of confidence. More confidence in a time of surprisingly strong growth would almost certainly reduce the demand for money; if the Fed doesn't take offsetting moves to increase the demand for all those excess reserves in the banking system (e.g., by raising the funds rate target and draining bank reserves) the result would be an unwelcome rise in inflation. Inflation is a monetary phenomenon: when the supply of money exceeds the demand for it, inflation is the inevitable result. And higher inflation would set us up for the next recession.

On balance, I think it's quite likely the economy is going to improve, and surprisingly so. Ordinarily that would be great news for the equity market, since a stronger than expected economy should result in stronger than expected profits. But the market is still cautious, so good news is going to be met with increased skepticism: if the Fed raises rates as the economy improves, the market will worry that higher rates will increase the risk of recession. And even if the Fed is slow to raise rates, the market will see that as a sign that inflation is likely to move higher, and that would in turn increase the odds of more aggressive Fed tightening and eventually another recession. In short, we're probably going to see the market climb periodic walls of worry, just as it has for the past several years.

Risk assets should do well in this environment, given time, but there will be headwinds. Rising Treasury yields will act to keep PE ratios from rising further, so equity market gains are likely to be driven mainly by stronger-than-expected earnings. At the same  time, higher bond yields will make it easier to people to exit stocks (very low yields today make being short stocks very painful).

Emerging market economies are so far behind their developed counterparts that they have tremendous upside potential in a world that is increasingly prosperous, but a stronger than expected US economy is likely to boost the dollar, which in turn would put pressure on commodity markets and the emerging economies that depend on them.

I continue to believe that gold is trading at a significant premium to its long-term, inflation-adjusted price (which I estimate to be around $600/oz.) because the world is still risk-averse. So a stronger US economy and a stronger dollar would spell bad news for gold. Who needs gold if real yields and real growth are rising?

In order to judge whether things are playing out in a healthy fashion, it will be critical to periodically assess the status of the world's demand for money—particularly bank reserves, of which there are over $2 trillion in excess of what is needed for banks to collateralize their deposits. If banks' demand to hold excess reserves declines faster than the Fed's willingness to drain reserves and/or raise the interest rate it pays on reserves, then higher inflation is almost sure to rear its ugly head. Signs of that happening would likely be seen in rising inflation expectations, a falling dollar, a steeper yield curve, and/or rising gold and commodity prices.

The world is on the cusp of a new chapter of stronger growth, led by US tax reform. The US economy has plenty of upside potential, given the past 8 years of sub-par growth and a significant decline in the labor force participation rate and lingering risk aversion. Tax reform can and should unleash that underutilized potential and boost confidence. The future looks bright, but there are, of course, lots of things that could go wrong (e.g., North Korea, the Middle East, Trump's ego, the Fed) so if and as the world becomes less risk averse, an investor would be wise to remain cautious, since very few things these days are obviously cheap. On the other hand, Treasuries, and bond yields in general, look very low and should thus be approached with great caution.

Thursday, December 21, 2017

Truck tonnage is impressive

I've been tracking truck tonnage for a long time, and it's been a reliable—and generally bullish—indicator of underlying economic activity. It measures the actual tonnage of freight hauled by the nation's carriers, and this physical measure of the economy's size has also tracked the inflation-adjusted gains of the US equity market. Truck tonnage surged almost 8% in the year ending November, and this is one of the most impressive proofs that economic activity has improved measurably this year.

Chart #1

As Chart #1 shows, truck tonnage over time has increased very much in line with the inflation-adjusted increase in equity prices. The latest surge in truck tonnage correlates well with the strength of the stock market this year. If anything, this chart suggests that the equity market is behaving in line with the economic fundamentals and is not, as many fear, in a bubble.

Chart #2

Chart #2 shows a closeup of the past 5 years of the truck tonnage index. The economy appears to have gotten a significant boost starting in the second quarter of this year. As we know now, real GDP growth jumped from 1.2% in the first quarter to 3.1% in the second quarter, and it continued stronger with 3.2% in the third quarter. By all indications, we should see at least 3% growth in the current quarter. It's been 12 years since we have seen three consecutive quarters with 3-handles or better. The economy has really improved this year, and Trump's efforts to reduce regulatory burdens arguably get a significant share of the credit.

And the economy should continue to improve next year, as the significant reduction in the corporate income tax rate just passed by Congress spurs more investment, more jobs, and rising real incomes.

Tuesday, December 19, 2017

The bond market begins to figure things out

For the past year the stock market has had a blast pricing in tax reform. The S&P 500 is now up some 25% or so since the day before the November '16 election, and that gain is only slightly more than the degree to which a cut in the corporate tax rate, from 35% to 21%, causes a one-time rise in after-tax corporate profits. (Here's the equation: (1-.21)/(1-.35) = 21.5%.) The bond market, however, hasn't taken much notice: 10-yr Treasury yields today are 2.45%, only modestly higher than the 2.33% they have averaged over the past year. On the other hand, 5-yr real yields on TIPS (a key, must-watch indicator as I've argued), today have climbed to 0.37%, which is meaningfully higher than the 0.05% they have averaged over the past year. The rise in bond yields is still modest, but the rise in real yields is better still, since it's the best indicator that the bond market is beginning to price in a stronger economy. And we're still in the early innings. Bond investors, hold on to your hats.

I first raised this issue—how the stock market was excited about tax reform, but the bond market was ignoring the likely consequences—in a post two weeks ago (Tax reform is priced in, but not a stronger economy). It now looks like the bond market is in the early stages of figuring out that a big cut in corporate tax rates is indeed likely to result in an investment boom and a stronger economy in the years to come. The ranks of the Trump despisers have been thinning ever since the summer of 2016, as more and more become convinced he is going to adopt more business- and growth-friendly policies, and the bond market is now beginning to join the party. Yields have just begun what could eventually prove to be a significant move higher, and early signs of that can be found in the slope of the yield curve, which has steepened in recent days.

 Chart #1

Chart #1 shows the slow and gradual uptrend of 5-yr real yields on TIPS. In the past 18 months they have risen by 85 bps, and 70+ bps of that rise has occurred since just before the November '16 election.

Chart #2

To be sure, one of the driving forces behind higher real yields is the Fed. Chart #2 shows how the Fed has raised real short-term rates by about 140 bps (from -1.4% just before the '16 elections to about zero now), by increasing its nominal overnight target rate by 1% during a period in which core inflation has fallen from 1.9% to 1.5%. The same chart also shows how the real yield curve has flattened during that same period, as 5-yr real yields (red line) rose by less than overnight real yields. That's again symptomatic of the bond market's reluctance to believe in a stronger economy. (The Fed has shared this belief, and still holds to it, but that is likely to change going forward.)

Chart #3

Chart #3 shows how real yields on 5-yr TIPS have a strong tendency to track the economy's underlying growth rate. As real growth picks up, real yields are very likely to follow suit. If the economy upshifts from 2% real growth to 3% real growth, as already seems not only possible but likely, real yields are likely to move to 1% or more. Nominal yields will likely rise by about the same amount, assuming inflation expectations remain relatively stable. If we end up with an investment-led boom that delivers 4% real growth, real yields could easily rise to 2-3%, pushing nominal yields on 10-yr Treasuries to 3.5-4.5% or so. Will that kill the economy? No, because higher yields and a stronger economy go hand in hand. We only need to worry about higher yields when the real and nominal yield curves go flat or invert, because that will be a sign that the Fed is too tight. That's not the case today, and the Fed is taking pains to emphasize that it won't move rates up aggressively.

Chart #4

Chart #4 shows the evolution of the yield curve from 2 to 10 years (the top panel shows 2- and 10-yr Treasury yields, the bottom panel shows the spread between the two). The curve has flattened substantially since early last July (a sign of the bond market's reluctance to embrace stronger growth), but it has steepened by 8 bps so far this week.

Keep an eye on real yields and the slope of the Treasury yield curve. They are excellent barometers of how optimistic the capital markets are about the prospects for stronger economic growth.

And don't worry about the impact of higher yields on the economy—at least not until you start to see the yield curve inverting.

Thursday, December 14, 2017

The Fed is not yet a problem

Yesterday the FOMC raised its short-term interest rate target to 1.5%, as expected, and indicated that it expects to gradually raise this target to 2.25% over the next year or so. Markets received the news with barely a ripple. Inflation expectations and the value of the dollar haven't budged for months, swap and credit spreads remain quite low, and while the yield curve has flattened in the past few months, it remains reasonably positively-sloped. The market seems to agree with the Fed that it won't need to raise rates by much more than 75 bps for the foreseeable future. We can thus conclude that the Fed and the market are in general agreement about the outlook, and that the outlook calls for only a modest pickup in growth with continued, relatively low and stable inflation.

Despite recent and prospective rate hikes, it's important to note that the Fed is not yet "tight," and monetary policy today is probably best described as "neutral." The economy has been picking up a bit of late, optimism is up, and the demand for money consequently is softening. The Fed is correctly offsetting these developments with a minor boost to short-term rates designed to bolster the demand for money.

Chart #1

The Fed's record on inflation speaks for itself: for the past 10 years, consumer price inflation has averaged 1.8% with impressively low variance. As Chart #1 shows, the average level, range and variability of CPI inflation in the current decade is lower than in any other decade in the past century. (To read the chart, the red bars show the range of year over year readings in the CPI, The yellow line represents the annualized rate of CPI change over each decade, and the blue bars represent the average plus or minus one standard deviation.) Abstracting from energy prices, which have been extraordinarily volatile in recent decades, the ex-energy CPI has averaged 1.7% in the past year, 1.8% for the past 5 years, 1.8% for the past 10 years, and 2.1% for the past 20 years. On the inflation front, things haven't been this good for generations, and the Fed deserves credit for doing a great job.

Chart #2

An important part of the Fed's mandate is to maintain the dollar's purchasing power. As Chart #2 shows the dollar today is pretty close to its long-term average against other currencies, after adjusting for inflation. A relatively stable dollar vis a vis other currencies is one important way to ensure the dollar maintains its overall purchasing power.

Chart #3

As Chart #3 shows, the market's expectation for inflation over the next 5 years is currently 1.8%. That is just about exactly the prevailing rate of inflation in recent years, and very much in line with historical experience. Although some worry that this is below the Fed's "target" of 2%, I think most economists and consumers would prefer 1.8% to 2%. 

Chart #4

As Chart #4 shows, the real yield on 5-yr TIPS has a strong tendency to track the economy's underlying trend rate of growth, for which I use the 2-yr annualized change in real GDP. Real yields have been rising slowly and very gradually in recent years, suggesting the market is pricing in a modest increase in real growth. Real growth has averaged about 2.2% per year for most of the current recovery, but the market now seems to be pricing in something in the range of 2.5-2.8% growth over the next year. That also happens to be in line with the FOMC's forecasts. I note also that the Atlanta Fed is now projecting 3.3% annualized growth for the current quarter, which would result in a 2.7% annual rate of growth for the current year.

This is encouraging, of course, but as I argued last week, the market is not yet pricing in a significant boost to growth from the pending tax reform package.

Chart #5

As Chart #5 shows, 2-yr swap spreads are quite low. This strongly suggests that market liquidity conditions are excellent, systemic risk is low, and the economic fundamentals are generally rather healthy. That's not surprising, actually, since the Fed has yet to withdraw a significant amount of bank reserves from the system, as it did in prior tightening cycles. 

Chart #6

As Chart #6 shows, Credit Default Swap Spreads are also quite low. These instruments are very liquid, and are excellent proxies for short- to medium-term credit risk in the corporate bond market. Conditions look pretty good right now. 

Chart #7

Chart #7 tells the same story by showing indices of credit spreads in the broad market for corporate bonds of investment grade and high-yield ratings. The market has a good deal of confidence in the outlook for the economy.

Chart #8

As Chart #8 shows, all postwar recessions have been preceded by a significant tightening of monetary policy (as evidenced by a sharp rise in the real Fed funds rate) and a flattening of the yield curve (as evidence by a negatively-sloped Treasury curve). Currently, inflation-adjusted short-term rates are close to zero, which is hardly punitive. And while the yield curve has flattened substantially, it is still reasonably positive. Taken together, these two conditions suggest that the Fed is at least a year or two away from delivering monetary policy tight enough to begin to hobble the economy.

Chart #9

Chart #9 focuses on the outlook for the real yield curve (which also has inverted prior to past recessions), by comparing the current real funds rate (blue) to what the market expects that real rate to average over the next 5 years (red). Although the real yield curve is rather flat, it is not inverted, and real yields are not projected to be very high. Indeed, both the Fed and the market expect that the Fed funds rate will be increased only modestly, in line with a modest pickup in real growth.

Chart #10

Chart #10 shows a big-picture view of the nominal Treasury yield curve, as represented by 2- and 10-yr Treasury yields and the spread between the two. I note that the current spread (54 bps) is about the same as we saw in the mid-1990s, when the economy was quite healthy.

Chart #11

Chart #12

As Charts #11 and #12 show, over the past year there has been a significant slowdown in the growth of bank savings deposits. I take this as a sign that the demand for money has dropped meaningfully. Savings deposits have paid almost nothing in the way of interest, but demand for them was incredibly strong in the years following the Great Recession. The appeal of savings deposit was not their yield, but their safety. Now, even though they are yielding more than zero, demand for them has dropped. People are no longer so interested in safety. It's not surprising that equities have done very well for the past year; as the public has attempted to pare its holdings of cash in favor of riskier assets, the price of cash has risen and the yield on equities has declined (i.e., short-term rates have increased as equity yields have decreased). The Fed would be irresponsible to not raise rates given this important shift in the demand for money. 

Chart #13

Chart #14

As Charts #13 and #14 show, there has been a significant increase in confidence in the past year, both among consumers and small business owners. This increase in confidence is fully consistent with the slowdown in the growth of savings deposits. On the margin, people are deciding to put money to work rather than stashing it away in banks.

Chart #15

The counterpart to a slowdown in the demand for money is an increase in the velocity of money. Chart #15 illustrates how we may have seen the peak in money demand. Going forward, even if the supply of money in the economy grows at a slower pace, rising velocity should ensure that nominal, and perhaps also real GDP growth, should pick up. We are seeing that already in Q3 and Q4 GDP, and it should continue, especially if tax reform passes.

Conclusion: If tax reform passes in anything like its current form, the economy is quite likely to pick up by more than the market and the Fed are expecting. That's because tax reform will directly increase the incentives to invest, and that in turn means more jobs, more productivity, and higher wages. This also implies that 10-yr Treasury yields are going to have to rise by more than the market currently expects, if only because real yields should rise as the economy's real growth potential increases. Tax reform thus spells very bad news for the long end of the Treasury market. However, it's also true that rising market yields could (and should) put downward pressure on equity multiples. Thus, even though the economy strengthens and corporate profits increase, the rise in equity prices going forward could be modest rather than meteoric. 

Friday, December 8, 2017

No jobs boom yet, but...

The November jobs data were slightly better than expected (+221K vs. +195K), but from a big-picture perspective, jobs growth remains at best moderate. Private sector jobs, the ones that count, are increasing at a 1.6-1.7% annual rate, as they have been for most of the past year. Ho-hum. However, small business optimism looks strong, particularly in regard to future hiring plans. Small businesses are almost sure to be the main engine of jobs growth going forward, so this is very good news.

Chart #1

 Chart #2

As Charts #1 and #2 show, there hasn't been any change in the underlying rate of growth of private sector jobs for most of the past year. Indeed, the pace of hiring this year has been slower than it was in prior years.

 Chart #3

However, there has been a significant improvement among small business owners, as Chart #3 shows. An index of future hiring plans in November posted its strongest reading in the 44-year history of the survey. This suggests that Trump's efforts to reduce regulatory burdens, coupled with a strong expectation of reduced future tax burdens, have already produced positive results.

As I mentioned earlier this week, though, the market has still not priced in a stronger economy. Optimism is building, but the market is still in a "show-me" frame of mind.

UPDATE: Today (Dec. 12, '17) the overall Small Business Optimism Index was released, and it was also impressive, surging to a level that is just shy of that which occurred at the dawn of the boom years which followed the Reagan tax cuts:

Thursday, December 7, 2017

Wealthier and wealthier

Today the Fed released its quarterly estimate of household net worth. Things just keep getting better and better. Household net worth as of Sept. 30 was almost $97 trillion, having risen $7.2 trillion over the past year (+8%). As in recent years, gains have come mostly from financial assets (up $18 trillion since late 2007), plus real estate (up $2.4 trillion since the peak of 2006), offset by only a minor increase in debt (total liabilities rose from $14.5 trillion in 2008 to $15.4 trillion). Further details in the charts below:

Chart #1

Chart #1 summarizes the evolution of household net worth. 

Chart #2

Chart #2 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 65 years. Is this a great country, or what? I note also that recent levels of net worth do not appear to have diverged at all from long-term trends. That wasn't the case in 2007 however, when stocks were in what we now know was a valuation "bubble."

Chart #3

Chart #3 shows real net worth per capita. The average person in the U.S. today is worth almost $300,000, and that figure has been increasing on average by about 2.3% per year for the past 67 years. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce almost $20 trillion of income per year.

Chart #4

Chart #4 shows that households have been extremely prudent in managing their financial affairs since the Great Recession. Household leverage (total debt as a % of total assets) has declined by fully one-third since its Q1/09 high. Leverage is now back to the levels which prevailed during the boom times of the mid-80s and 90s. Of course, while households were busy strengthening their finances, the federal government was doing just the opposite: the burden of federal debt more than doubled from June '08 to September '17 (i.e., federal debt owed to the public rose from 35% of GDP to 75% of GDP).

Tuesday, December 5, 2017

Tax reform is priced in, but not a stronger economy

The S&P 500 keeps setting new record highs, we're on the cusp of a major tax reform, and the economy is showing signs of perking up. Pessimists fret that we're in another bubble that could pop at any moment, while optimists believe the economy has lots of upside potential. I'm still in the latter camp, though I do acknowledge that it's tough to find much that is cheap these days. In any event, what the market seems to be ignoring is that the kind of tax cuts we're about to experience—which are unprecedented in their focus on businesses—are very likely to lead to a business investment boom, and that in turn is likely to result in more jobs, more productivity, and higher wages and salaries in the years to come.

The S&P 500 is up about 24% since the week before Trump won last year's election. Half of that gain is due to increased earnings on continuing operations, while the other half is due to a rise in the multiple the market is willing to pay for a dollar's worth of those earnings (i.e., PE ratios). Over that same period,  5-yr Treasury yields have jumped by about 80 bps (from 1.3% to 2.4%), and real yields on 5-yr TIPS have jumped 65 bps (from -0.33% to +0.33%), implying a meaningful increase in real growth expectations but only a modest rise in inflation expectations.

Both the bond and the stock market have thus undergone some significant price adjustments that are consistent with an improved economic outlook. Investors expect more growth (as seen in rising real yields) and rising after-tax profits (as evidenced by higher PE ratios). So: is the market now pricing in an economic boom because of the likely passage of Trump's tax reform? Or is the market just pricing in the boost to future after-tax earnings that would result from a sizeable reduction in corporate income taxes (from 35% to 20%)? The way I read the market tea leaves, the market has little doubt that tax reform will pass, and that it will in turn boost after-tax corporate profits. But as yet I see no convincing evidence that the market is pricing in a substantial increase in economic growth rates—almost certainly not of the magnitude which the Republicans are touting (i.e., 3% or more). So we're faced with a mixed bag of market expectations: good news for profits and equity investors, but not much reason to cheer for the man on the street. That's missing the forest for the trees.

Outside of the Republican booster community and supply-side economists, I see very few who expect real GDP growth to rise significantly in coming years. Left-leaning commentators argue that the tax reform being pushed is very unlikely to do anything outside of lining the pockets of big business and the wealthy. A recent Bloomberg article, "Supply-Siders Still Push What Doesn't Work" argues that what has really been holding growth back is not high taxes and heavy regulatory burdens, it's an aging population that is still nursing the wounds to confidence it suffered in the Great Recession of 2008-09. It's not hard to deploy statistics in a way that bolsters your argument, as the Bloomberg article does, but there are some facts in the historical record which should be incontestable: the tax cuts that occurred during the Reagan and Clinton eras boosted economic growth considerably, while the massive fiscal spending "stimulus" of the Obama years failed miserably. (see charts below)

As I argued a year ago, the only good thing about the American Recovery and Reinvestment Act of 2009 was that it served as a laboratory experiment to test the value of the government spending multiplier. ARRA boosters argued that it would kick-start the recovery and deliver strong growth for years to come. Unfortunately, the results were the exact opposite of what was expected by the Keynesians. Why? Because the ARRA was all about income redistribution. It did nothing to change the incentives to work and invest:

Fully 63% of the "stimulus" spending was income redistribution in disguise (i.e., tax benefits and entitlements). And if you reclassify things such as education, housing assistance, and health as transfer payments, then over 75% of the $840 billion allocated to "stimulus" was essentially income redistribution. Only 8%—$65.5 billion—went for transportation and infrastructure (i.e., the "shovel-ready" projects that would put American back to work). Not a dime went to increase anyone's incentive to work harder or invest more.
The ARRA was a laboratory experiment in the power of the government spending multiplier to grow the economy by "stimulating demand." It ended up proving that the multiplier is way less than one. American taxpayers borrowed $840 billion only to learn that the payoff was only a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.

Income redistribution does nothing to change the long-term growth path of the economy. It takes investment, risk-taking, and working harder and more effectively to boost growth. Incurring debt to finance spending is a waste of the economy's resources, but incurring debt to finance productive investment can lead to a real payoff. Indeed, that was the lesson we learned from the ARRA: excessive spending financed by debt can weaken the economy.

The principle virtue of the Tax Cuts and Jobs Act about to be passed by Congress is that it significantly increases the after-tax rewards to business investment by slashing corporate income tax rates and by allowing immediate expensing of capital investments. This automatically lowers the hurdle rate for all investment projects, and thus it should lead to a significant increase in investment, jobs, and incomes over time. The TCJA  has its faults, unfortunately, and these center on measures which produce only one-time gains in after-tax income (e.g., increases in the standard deduction and the child credit which do nothing to reward new investment, harder work, or risk-taking). But on balance it is very pro-growth.

The TCJA differs importantly from the Reagan tax cuts in the early 1980s, since the latter focused almost exclusively on lowering individual income tax rates. Reagan gambled that cutting tax rates on individuals would eventually lead to a stronger economy since everyone would have an incentive to work harder and invest more. But by focusing directly on the investment side of the economy, the TCJA could prove even more effective than the Reagan tax cuts.

The charts that follow illustrate the various ways in which the economy is already perking up, and they also illustrate why I think the market has yet to price in a stronger economy as a result of the passage of the TCJA.

Chart #1

 Chart #2

Charts #1 and #2 illustrate the substantial recent upturn in US industrial & manufacturing production, and how that has been accompanied by a significant pickup in Eurozone industrial production. We're seeing a coordinated acceleration in global manufacturing and output, which is a nice tailwind to enjoy.

Chart #3

Chart #3 suggests that housing starts have lots of upside potential, especially considering the strong levels of builder sentiment. By eliminating or limiting the mortgage interest deduction (which subsidizes housing and thus makes housing more expensive than otherwise), the TCJA could make housing more affordable for the middle class and thus stimulate more housing supply. A dramatic increase in the standard deduction would render the loss of the mortgage deduction moot for a whole swath of the population.

Chart #4

As Chart #4 suggests, the ISM manufacturing report is consistent with GDP growth exceeding 3% in the third quarter. The Atlanta Fed's GDPNow index currently predicts fourth quarter real growth of 3.2%. That would put real growth for the year at over 2.7%, which is comfortably above the 2.2% annualized growth rate of the current business cycle expansion. This is very encouraging.

Chart #5
Chart #6

Chart #5 shows a substantial recent slowdown in the growth of Commercial & Industrial Loans (a proxy for bank lending to small and medium-sized businesses). Ordinarily, this would be disturbing since it could be the result of a severe tightening in lending standards. But as Chart #6 shows, banks have little reason to tighten lending standards since delinquency rates on all loans and leases are at record lows. This suggests that the slowdown in lending reflects caution on the part of business borrowers, and that is not necessarily a bad thing. Relative to GDP, C&I Loans are about as high as they have ever been.

Chart #7

Chart #8

Chart #7 illustrates the incredible and lasting strength of corporate profits over the past decade. Chart #8 uses this measure of profits (derived from income tax data supplied by businesses to the IRS and compiled into the National Income and Product Accounts) to show that current PE ratios are not excessive by historical standards. Yes, PE ratios are above average, but profits have been way above average for a long time, so the market is not necessarily in bubble territory. I wrote more extensively on this issue here.

Chart #9

Chart #10

Chart #9 looks at the 2-yr annualized growth rate of GDP since 1970. I use this measure in order to smooth out the typically volatile nature of this series on a quarterly and annual basis. It should be easy to see how strong growth was during the mid- to late-1980s, following the Reagan tax cuts. It also illustrates the impressive strength of the economy in the late 1990s, during which time the capital gains tax rate was cut. Chart #10 illustrates how sensitive capital gains tax collections are to changes in the capital gains tax rate. Capgains realizations surged in advance of the big hike in the capgains rate in late 1986, and surged again as the rate was cut during the late 1990s. Lower tax rates can indeed boost tax revenues, while the threat of higher rates can crush tax revenues.

Chart #11

It is noteworthy that the current equity risk premium, illustrated in Chart #11, has remained relatively high in recent years. This suggests investors have been very reluctant to price in a stronger economy. Risk premiums were much lower in the boom years of the 80s and 90s.

Chart #12

Chart #12 shows how weak business investment has been in the past decade, despite the extraordinary level of corporate profits shown in Chart #7. A dearth of business investment has been at the root of the economys sluggish performance over the past decade. That is why the TCJA, which boosts incentives for business investment, could be so important—it directly addresses the problem that has plagued the economy for years. And by lowering business income tax rates here relative to other countries, it could act as a magnet for international capital flows.

Chart #13

Chart #13 shows the 5-yr annualized growth in productivity, highlighted by presidential terms. The Bloomberg article cited above showed the annual growth in output per hour on a year over year basis. This measure of productivity is naturally volatile, so measuring it over longer periods makes it easier to see the big trends. Output per hour isn't the same total labor productivity, however, which is shown in Chart #13, and in any event changes in productivity are one thing while growth in the overall economy (which includes productivity and the number and hours of people working) is another. Regardless, the very weak growth of GDP and productivity in the Obama years is pretty good proof that the policies pursued during the Obama years were not conducive to growth or prosperity. The second half of the Clinton years, in contrast, rank right up there with the Reagan years, all of which featured tax rate reductions.

Chart #14

Chart #14 shows nominal and real rates on 5-yr Treasuries, plus the difference between the two, which is the market's expectation for consumer price inflation over the subsequent five years. Inflation expectations haven't changed much in the past few decades, and currently average about 1.8% per year for the foreseeable future, which is very much in line with what inflation has averaged in recent decades.

Chart #15

Chart #15 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (the Fed's target for overnight rates minus the rate of inflation as measured by the PCE Core deflator). Think of the red line as the market's expectation for what the blue line will average over the next 5 years. Note that the real yield curve inverted (i.e., the blue line exceeded the red line) prior to each of the past two recessions. That happens when the Fed becomes so tight that the economy begins to weaken and the market begins to assume that the Fed will be cutting rates in the future. Currently, the real yield curve is still positively sloped. If anything stands out here, it is the market's belief that the Fed is going raise rates only a few more times in the years to come. If the economy picks up steam, however, the Fed is going to be raising rates by a lot more than that.

Chart #16

As Chart #16 shows, the level of real yields on TIPS (blue line) tends to track the economy's real rate of growth over time. That's only logical, since very high real yields can hardly be generated by a weakly-growing economy, whereas a strongly-growing economy, such as we had in the late 1990s, can produce very positive real yields on a variety of asset classes. The current level of real yields in the bond market is consistent with real economic growth rates that are roughly 2%, which is what we've seen over the recent business cycle expansion. If real growth rates were to ratchet up to 3% or more per year, I would bet lots of money that real yields on TIPS would rise to at least 1-2%. With stable inflation expectations, that would imply 5-yr Treasury yields of almost 3-4%, substantially higher than the current 2.2% rate on 5-yr Treasuries. Bond investors need to brace for sharply higher yields if I'm right about the impact of the TCJA.

Chart #17

Chart #17 suggests that nominal yields on 5-yr Treasuries are unusually low given the current level of core inflation. This reinforces the fact that stronger real economic growth would necessarily lead to substantially higher nominal Treasury yields.

As should be obvious from the last two charts, Treasury yields are quite low compared to where they would probably trade if the economy were to prove much stronger than currently expected as a result of tax reform. 

To sum up: the rally in equity prices is evidence that the market is pricing in the passage of tax reform. But the continued low level of real and nominal Treasury yields is evidence that the market has yet to price in the stronger economic growth that is likely to result from tax reform.

UPDATE: I'm adding my chart of GDP growth vs its long-term trend in order to give some broader context to this discussion, and to add to some discussion of the subject of "potential" GDP in the comments section.

Thursday, November 16, 2017

AAPL still looks good

I've been a fan of Apple's ever since I bought the stock about 15 years ago. I've had a number of posts on Apple over the years, all of which have been bullish. I'm still optimistic about Apple's prospects, even as it approaches the $1 trillion capitalization mark.

I got my new iPhone X a few days ago, and it is by far the most beautiful and exciting of all the iPhones I've ever had (and I've owned every model they've made). Face ID is surprisingly fast and seamless (and accurate!), the display is much larger and a pleasure to look at, the build quality is superb, the battery life is much longer, the camera is much better, and the gestures that replace the home button are powerful and easy to use, not to mention it's wicked fast. It costs more than its predecessor (iPhone 8), but it delivers much more at the same time. Since my digital life revolves around this little jewel, I'm happy to pay extra, and I'm sure tens of millions of others will feel the same way. Apple can no longer be accused of not innovating. Its flagship product has leapfrogged the competition, and it's become the "apple" of everyone's eye.

The iPhone X is going to set sales records. Face ID is almost surely coming to Apple's entire product line over the next year, and that will very likely trigger a wave of upgrades. But the market, believe it or not, is still not convinced that Apple's best days lie ahead. Apple's cash-adjusted PE ratio today is less than 17, giving it an earnings yield of 6%. That implies, in my judgment, that the market still suspects Apple will have a hard time increasing earnings. If expectations were solidly behind continued earnings gains, Apple's PE ratio would be a lot higher. Following are some nifty charts which tell the story.

Chart #1

Wow. One of the Great American Success Stories, told in one chart. (Note the y-axis is done with a semi-log scale.)

Chart #2

If the market were wildly optimistic about Apple, it would be tough to recommend the stock. But as the chart above shows, Apple's PE ratio has been below 20 for the past seven years, even as its stock price as more than quadrupled. As I've suggested in my prior posts, the market has consistently under-appreciated Apple's ability to grow. And that still looks to be the case, with the S&P 500 trading at a PE of just under 22 (using earnings from continuing operations), and Apple's PE trading at more than a 10% discount to that. If you adjust for the mountain of cash that Apple has sitting offshore, Apple's PE ratio is trading at almost a 25% discount to the broad market.

Chart #3

As the chart above shows, Apple's earnings haven't grown nearly as fast in recent years as its stock price. In the past 5 years, earnings per share have grown over 45%, while the stock price has more than doubled. The way I see it, the market has become a lot less pessimistic about Apple's prospects in the past 5 years, which is why Apple's PE ratio has increased from a meager 10 in early 2013. But the market is still cautious.

Chart #4

Is a $1 trillion capitalization reasonable? Apple is not outrageously priced compared to other companies, as Chart #4 shows. Microsoft today is only $250 billion behind Apple's current market cap, and most of what MSFT sells is software and services. This chart is a great David vs. Goliath story, with once-tiny Apple leapfrogging its gigantic former rival. 20 years ago the market thought MSFT would control the entire PC market within a few years. Today Apple has made tremendous gains, but they still don't have a majority of smartphone sales, nor a majority of PC sales. There's plenty of room for Apple to grow.

Chart #5

One final note: I could be wrong, but it strikes me that Apple has set an important precedent with the pricing of iPhone X. Prior to this, Apple (and most of its competitors) routinely brought out better, faster, and more capable products for the same price as what was being replaced; customers were thus getting more and more power and features for the same price. Now, for the first time, a hi-tech computer product has come out that is not only better but more expensive. Apple has demonstrated pricing power in an industry that has suffered from 20 years of deflation. You can see that in Chart #5 above.

The BLS uses what is called "hedonic pricing" to calculate that personal computer and peripherals have effectively fallen continuously over the past 20 years—if you get more of something for the same price as before, its price has effectively fallen. The index in the chart has fallen by more than 96% over the past 20 years. But it should also be apparent that the rate of decline has been slowing ever since the early 00s. In the initial heydays of PCs, prices fell 35% a year; then 20% per year; then 10% per year. In the past 12 months, prices have fallen by a mere 3.3%. The pricing and the success of the iPhone X may be among the first signs that in coming years you can expect to pay more in order to get more when it comes to computers.

Full disclosure: I am long AAPL at the time of this writing, and have no plans to sell in the near future.