Friday, October 20, 2017

Not cutting tax rates is boosting the deficit

It's pandering season again, with politicians and journalists wringing their hands about how cutting taxes will be a windfall to the rich and result in higher deficits. The truth, however, is that by NOT cutting taxes the federal government is losing money and the economy is suffering from sluggish growth. Cutting taxes would almost surely result in a significant boost in revenues and stronger growth. How do I know this? Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.

It's amazing: rising incomes, rising profits, and soaring asset prices have resulted in no increase in revenues to the federal government, even though tax rates weren't cut. How could that possibly happen? Simple: people are rational, and they respond to incentives. Given the incentive that tax rates may be reduced in the future, individuals and corporations have apparently taken steps to reduce their current tax liabilities by delaying income, accelerating deductions, postponing investments, and postponing the realization of profits.

Consider these simple facts: S&P 500 trading volume has plunged over 40% since early last year. One reason stocks are up is that people are increasingly reluctant to sell; on the margin they would rather postpone the realization of their gains in order to minimize their current income tax liability. I can assure you that has been a powerful motivator for me, and I'll wager that there are millions of investors who would agree. It's no wonder that NYSE member firms report a 25% increase in margin balances since Feb. '16 (from $436 billion to $551 billion) after no increase over the previous two years. Need income but don't want to pay capital gains taxes? Just don't sell anything and instead add to your margin balance.

Here are some charts which fill out the story:


The chart above shows the rolling 12-month totals of federal spending and federal revenues. Spending has been increasing steadily for the past several years, roughly in line with the growth of the economy. Revenues, however, stopped growing early last year. As a result, the 12-month deficit has increased from $405 billion in February 2016 to $665 billion in September 2017. That's a whopping increase of over 60%!



The chart above shows the major sources of federal revenues (it excludes things such as excise and customs taxes, and miscellaneous revenues, all of which are down somewhat). The only revenue category that has been increasing steadily for the past few years is Payroll Taxes (i.e., income tax withholding), by about 5% per year. That's very much in line with the growth of wages and salaries, which have been increasing at a 3.8% annual rate since Feb. '16. The thing that is unique with payroll taxes is that individuals don't have much discretion over their reported income. If their salary goes up, their withholding is going to go up as well. But individual income taxes are different. They are impacted by deductions, which can be shifted in time, as well as capital gains taxes, which can be legally postponed indefinitely, simply by not selling an appreciated asset. The rich can employ a variety of strategies to postpone or defer their income.

As it turns out, revenues from individual income taxes have experienced zero growth since Feb. '16, despite ongoing growth in personal income and sharply rising stock prices. Corporate income tax revenues have actually declined by about 10% since Feb. '16, despite an 8% rise in trailing, after-tax EPS over the same period. If you were the head of a large corporation and you thought there was a good chance of a meaningful cut in corporate income taxes, wouldn't you take all available steps to postpone income and accelerate deductions? Is it any wonder that US corporations have refused to repatriate trillions of overseas profits? 


So, despite ongoing growth in the economy and in incomes, plus surging stock prices, federal revenues have declined by about 1% of GDP since early last year, as the chart above shows. A static model would have projected a significant increase in revenues. No one (especially the OMB, which is still enamored of static forecasting models) expected federal revenues to be flat over the past 18-19 months.  But that's what happened.


As the chart above shows, the rolling 12-month federal budget deficit has increased from $405 billion in  Feb. '16 to $666 billion in Sep. '17. Relative to GDP, the federal deficit has increased from 2.4% to 3.4%. And it's ALL due to zero growth in tax receipts, which occurred despite no reduction in tax rates and sizable increases in incomes and capital gains. 

It's only reasonable to conclude that the reason federal revenues have failed to materialize as would have been expected is that people and corporations have taken meaningful steps to postpone income, accelerate deductions, and postpone the realization of capital gains. And they have done all that because they have been thinking there was a decent chance of significant tax reform. 

It's a safe bet that if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue. Tax reform would unleash a wave of profit-taking, a surge of capital gains realizations, a massive redeployment of capital to more productive uses, more investment (reducing taxes increases the after-tax returns to investment, thus prompting more investment), more risk-taking, more work, more growth, and ultimately reduced budget deficits. I'm not talking ideology, I'm just talking basic common sense.

But won't the rich get the bulk of the benefit from lower tax rates? Sure, because the top 10% of income earners pay about 70% of all income taxes, and half the working population pays zero income tax. Anyway, wouldn't you rather let a rich person keep more of his money, instead of giving it to the politicians in Washington? Who do you think would spend a million dollars more productively: a rich person who is already consuming as much as he or she wants, or a politician, who would love to buy votes? When the rich keep more of their hard-earned money, they almost certainly will invest most or all of it, and that's what creates jobs and prosperity. When politicians get a windfall of revenues, they will spend it, and don't forget that over 70% of every dollar that Congress spends goes out in the form of transfer payments (i.e., money given to people who haven't worked for it). 

Congress needs to cut taxes in order to boost revenues and stimulate the economy. Quickly! We can't afford to wait.

UPDATE: Art Laffer has made this same point repeatedly over the years when explaining the mistake that Reagan made in phasing in his tax cuts. If you promise that tax rates will fall in the future, you only weaken the economy today. When lower tax rates make sense, as they do today (especially corporate tax rates) rates need to be cut ASAP, otherwise capital will go dormant, awaiting the lower rates.

Thursday, October 19, 2017

A Goldilocks dollar?

I've had a number of posts over the years that have looked at the value of the dollar vis a vis other currencies. One common thread in these posts has been a reference to each currency's Purchasing Power Parity (PPP), which in theory is the exchange rate which would make prices roughly comparable between two countries. Since the mid-1980s I've used the same methodology for estimating this value, and I've been continually impressed with how it's held up over time. Since I started this blog in late 2008, the dollar has been all over the map: plunging to its weakest level ever in 2011, then soaring over the subsequent five years to its late-2016 high. My PPP analysis says that today the dollar is pretty close to what could be called "fair value" against most of the major currencies, with the notable exception being the Australian dollar, which I estimate to be trading about 25% above my estimate of its PPP value vis a vis the dollar.

To calculate a currency's PPP value against the dollar, I first look for a period—a base year—when prices in that country were roughly comparable to prices in the US. I then adjust the value of the currency in the base year for the difference in inflation between that country and inflation in the US over time. If a country has lower inflation than the US, its PPP value will rise over time, and if a country has more inflation than the US, its PPP value will decline. I should add that I've had occasion to visit each country over the years, and have been able to validate my PPP estimate by subjectively comparing how prices for food, clothing, hotels, etc. compare to US prices (there's an element of judgment at work here, but I think most observers would agree that my estimate of PPP is not too far off—comments pro and con are welcome). As you can see in the charts below, a currency rarely trades at or near its PPP. Instead, most currencies tend to cycle up and down relative to their PPP value, becoming alternately strong and then weak. One important caveat: although divergences between a country's PPP rate and its actual exchange rate tend to close and even reverse over time, PPP should not be used to bet on a currency's future strength or weakness, since it can take years for conditions to change. This is not a trading tool, it's a way to judge how strong or weak a currency is at any one time.


I begin with the Fed's calculation of the dollar's inflation-adjusted value vis a vis a trade-weighted basket of currencies. This is arguably the single best measure of the dollar's overall strength or weakness. The blue line measures the dollar against a basket of more than 100 currencies, while the purple line compares it to a basket of about a dozen currencies. Against a broad basket of currencies the dollar is today is roughly equal to its average since 1973. Relative to the largest currencies, the dollar is about 5-10% above its long-term average. Call it a Goldilocks dollar: neither too strong nor too weak.


The chart above shows how the Euro has tracked its PPP over time. The Euro began in 1997, but I extended its value back in time using the DM as a proxy. Note that the Euro's PPP has trended upwards against the dollar over many decades, a reflection of the fact that Europe has had less inflation than the US. Today the Euro is trading at almost exactly my estimate for its PPP. US visitors to Europe should find that prices there are pretty similar to prices here. Similarly, European visitors to the US should not be surprised to find things cost about the same here as in Europe.



As the first chart above shows, Japan has had a lot less inflation than the US since the late 1970s, and the yen has been very strong throughout most of that period. Some would say the Bank of Japan has been too tight, keeping inflation too low and the yen to strong, and that in turn has curtailed economic growth by making Japanese exports expensive, among other things. In any event, the yen is no longer too strong. As the second chart shows, the yen may now be at a level that is allowing the economy to pick up. Note that the stock market has surged in the past year or so, even as the yen has strengthened a bit.


As the chart above shows, the UK has experienced a lot more inflation than the US in the past several decades; as a result the Pound has been in a long-term, declining trend vis a vis the dollar. Currently the Pound is trading very close to my estimate of PPP. Traveling to the UK in the mid-2000s, as I did frequently, was a painful experience since prices were very expensive. Today it's a much nicer experience.



As the first chart above shows, Canada's inflation has been very similar to US inflation for the past 30 years. However, the Canadian dollar has been all over the map—very weak in the early 2000s, and extremely strong in the late 2000s. The strength or weakness of the Canadian dollar has tended to be the mirror opposite of the dollar's strength or weakness, and both have been highly correlated—until recently—with commodity prices, as the second chart above shows. (Canada positively correlated, the US dollar negatively correlated)


Finally, we come to the Australian dollar, which by my calculations is trading about 25% above its PPP value vis a vis the dollar. Australia continues to benefit from strong commodity prices and from strong demand from China. But the loonie is no longer egregiously strong, as it was some 5 years ago.

At current levels, exchange rates paint a picture of a global economy that is rough equilibrium. No country, with the possible exception of Australia and a few others—is judged by the market to be inherently more attractive than others, on a risk-adjusted basis, and thus worthy of a relatively strong currency. Currency risk has ebbed, as a result, and this may contribute to a continuation of global growth (less risk tends to favor investment, which in turn is the engine of growth). Altogether, not a bad state of affairs.

Wednesday, October 11, 2017

Recent & notable charts

Here is a collection of charts, in no particular order, that I have updated in the past week and which I think are worth noting. If they have a common theme, it's that economies both here and abroad continue to improve.


The message of this chart is that the real value of the S&P 500 index has increased in line with the physical expansion of the US economy for the past 45 years. As a proxy for the economy's physical size, I've used the American Trucking Association's index of total truck tonnage hauled by the nation's truckers. I note that there have been a few times when equity markets have diverged significantly from the the trucking index, particularly the late 1980s, the late 1990s, and during the depths of the 2008-2009 recession. I would characterize those as periods of excessive optimism and pessimism—sentiment not warranted by the progress of the overall economy. Currently, the advance in equity valuations seems to be very much in line with the growth of the economy.


Today the Japanese stock market reached a two-decade high, after not making much progress on balance for a very long time. It's interesting that this occurred despite the fact that the yen has been strengthening of late against the dollar. As the chart above shows, since 2005 Japanese equities had shown a strong inverse correlation to the value of the yen (e.g., equities would rise as the value of the yen fell, and vice versa). People have made various attempts to explain this inverse correlation, with perhaps the most convincing being that the Bank of Japan has been pursuing misguided monetary policy at times, such that a stronger yen (one result of very tight monetary policy) put a lot of downward price pressure on Japan's industries (because it made their products more expensive to foreign buyers), while a weaker yen mitigated this pressure and eventually became "stimulative." I'm not quite sure what to make of the action offer the past year or so, but I think it may be that the yen has settled into a reasonable valuation zone. Perhaps not coincidentally, my calculation of the Purchasing Power Parity exchange rate between the yen and the dollar is about 114, which is very close to the current exchange rate of 112. This further suggests that central banks have been doing a pretty good job of managing things, and currencies are trading at reasonable levels in general. (The Fed's Real Broad Trade Weighted Dollar index is currently very close to its 45-year average, by the way.) This suggests that the uncertainties that arise from significant currency fluctuations have been mitigated, and that further suggests that economic fundamentals have become more conducive to investment and growth. Reduced uncertainty is almost always good for investors, and for investments, and for economies.


As the chart above shows, property prices for commercial real estate continue to rise, and have clearly surpassed their prior peak. You hear a lot these days about how shopping malls are dying all over the country (thanks to predators such as Amazon), but this suggests that things are not necessarily bad at all in general.




The charts above are based on Bloomberg's calculation of equity market capitalization. I note that non-US equity markets have been strongly outperforming their US counterparts for most of the past year. However, all markets have registered equivalent gains for the past decade or so, on balance. We're in a global recovery that shows every sign of continuing.


The September ISM survey of service sector businesses in the US was extremely strong, as the chart above shows. This could well be one of those random blips, but at the very least it suggests that the US economy continues to improve. It's also worth noting that a similar index of Eurozone service sector businesses has been trending higher for the past several years. It looks like we're in a synchronized global growth cycle.


I've commented often and for years about the curious and continuing dance between gold and TIPS prices, as illustrated in the above chart (see a recent post here). I've also commented on how the real yield on 5-yr TIPS (shown inversely in the chart in order to serve as a proxy for their price) tends to move in line with the real growth trend of the US economy. With 5-yr TIPS real yields only slightly above zero, the market is apparently unconvinced that any good will come from the Trump administration, at least insofar as something that might push the US economy out of its 2% real growth rut. If there is anything that makes a convincing rebuttal to the widespread claims that the market is insanely optimistic and egregiously overpriced, this chart is it. If the market were convinced that the economy was on the cusp of growing 3% per year or more, I think real yields would be significantly higher and gold prices would be significantly lower.


The most recent survey of small business optimism showed a downtick, but the index is still at rather lofty levels. Small business owners are already seeing a reduction in regulatory burdens, as are banks. It may well be the case that entrepreneurs are already gearing up for better things ahead, but that we won't see the results (e.g., more hiring, more investment) for some months to come. These things take time to unfold.


As the chart above shows, car sales had been in a disturbing slump since last year. Fortunately, the September numbers revealed a substantial bounce. This may be just one of those quirks of seasonal adjustments, so we'll have to wait for a few more months to declare victory, but it is nevertheless encouraging. 

Saturday, October 7, 2017

Healthy households

A few weeks ago, I had some charts (the last two in this post) that showed how our net worth as a country on a real and per capita basis has reached new all-time highs. Our collective prosperity rests on the value of our savings, our investments, and our capital stock. Regardless of who owns all that money (as of June 2017 the net worth of the private sector was over $96 trillion, with total assets worth over $111 trillion), we all enjoy the fruits of those assets in the form of jobs, services, products, and infrastructure. Does a worker really care who owns the building he works in? Who pays his salary? Who owns the toll road he drives to work on? Who owns the tools he uses? He shouldn't. What's important is that the assets that have generated our record-setting wealth are available to all of us, everyday.

The Fed recently updated its calculation of households' debt service burdens, as of Q2/17. Total household liabilities climbed to a record $15.2 trillion, but that represents less than 14% of total household assets. As the charts below show, households' financial burdens (the cost of servicing debt as a percent of disposable income) are about as low as they have been for decades. And households' overall leverage (total debt as a percent of total assets) has fallen by one-third since its record high in early 2009.

On balance, U.S. households are in very healthy financial shape, and that in turn means that the fundamentals of the U.S. economy are also in good shape.



Friday, September 29, 2017

Tax and deficit scaremongering

The media is full of stories claiming that lower tax rates will cause a huge and damaging increase in the federal deficit and will fail to stimulate the economy. Here are some charts which show that those claims are not backed by historical experience. On the contrary: worrying about tax cuts is not necessarily sensible at all.


The chart above compares top tax rates to tax revenues as a % of GDP. (Comparing taxes collected to the size of the economy is the only meaningful measure of revenues.) Note that despite the huge reduction in tax rates in the early years of the Reagan administration (early 80s), revenues hardly fell at all, and in fact increased at a fairly impressive rate through the late 80s and 90s.


There is not a shred of evidence to suggest that rising federal budget deficits have any impact significant impact on interest rates. In the chart above we see that huge increases in the budget deficit have occurred alongside very low interest rates. Predicting higher interest rates as a result of rising deficits is not supported by the experience of the past.


As the chart above shows, recessions almost always result in very weak tax collections. No surprise: recessions cause incomes and employment to fall; the tax base shrinks and revenues decline. Periods of economic growth almost always cause revenues to rise.


Federal spending almost always rises as a result of recessions. Politicians can't resist spending extra money to "stimulate" the economy, and automatic stabilizers like food stamps and unemployment insurance kick in. The most important influence on revenues and spending is the health of the economy.


The Reagan tax cuts did little if anything to worsen the deficit, which began rising in the wake of the recessions of '81 and '82. The current deficit, relative to GDP, is well within the range of post-war experience.


The chart above makes it clear that people respond to incentives, especially when it comes to taxes. Prior to the increase in capital gains taxes in late 1986, capital gains realizations surged. They then fell dramatically, coming in at about half what the CBO had projected prior to the hike in the capital gains tax rate. Note also that declining capital gains tax rates in the late 90s saw a big increase in capgain revenues—exactly the opposite of what an accountant would have projected. The capital gains tax is the only tax you can legally avoid, by the way. All it takes is not selling something you hold at a gain. If we reduced capital gains taxes tomorrow I would bet a lot of money that federal revenues would rise. I for one would sell a lot of things that I have avoided selling. I would also diversify my portfolio in the process, and I would be much more willing (and able) to invest in new things. As it is, a lot of my money is tied up in gains that pain me to realize. It's the same story for corporations who refuse to repatriate their profits. It's therefore hard to overestimate the potential impact of true tax reform.


The chart above shows that federal spending and revenues today are very much in line with historical experience. The weakness in revenues of late could very well be driven by the anticipation of lower tax rates. Taxpayers have lots of ways to postpone or defer income, just as they can postpone or defer capital gains—if they think there is a chance that tax rates will fall in the future. Corporations can postpone or defer new investment as well. Thus, it's not wise to promise tax cuts in the future and then delay their implementation. That was the mistake that Reagan made with his first round of tax cuts; revenues promptly declined because people were waiting for the second round of cuts.

Meanwhile, there is still little if any evidence to suggest that the market has priced in any meaningful increase in the economy's health. People may be postponing income in anticipation of lower tax rates, but nobody's betting that the economy is going to pull out of its 2% annual GDP growth rut anytime soon.


The chart above compares the real yield on 5-yr TIPS to the real Fed funds rate. It's best to think of the red line as being the market's forecast for the average level of the blue line over the next 5 years. Right now the market is not expecting the Fed to do much more in terms of raising the real rate of short-term interest rates in coming years. That expectation, in turn, is very likely driven by the belief that the economy is going to be stuck in its 2% growth rut for as far as the eye can see.


The chart above confirms that from another angle. Here we see that real yields tend to match the economy's growth rate trend. The current level of real yields is consistent with economic growth of about 2%. If the market were more enthusiastic about the economy, TIP yields would be much higher.


The gold market agrees. The prices of gold and TIPS have been strongly correlated over the years. My interpretation of this is that people are more inclined to buy gold when the economy is weak, and less inclined when it is strong. If the market really believed the economy were about to break out of its 2% growth rut, real yields would be a lot higher and gold prices a lot lower. Why hold gold if the economy is improving? Better opportunities can be found when the economy is healthy and chugging along. Gold and TIPS have been meandering around the same levels of several years, all the while the economy has been stuck in a 2% growth rut.

Thursday, September 21, 2017

FOMC's cautious and correct plan to unwind QE

The bond market was little rattled yesterday after the FOMC announced that, despite the trauma of two major hurricanes, despite the absence of news suggesting the economy has strengthened, and despite the fact that inflation remains somewhat below their 2% target, they would proceed, starting next month, with the long-awaited unwinding of their Quantitative Easing efforts. This moderate surprise was somewhat offset by the FOMC's decision to hold off on hiking short-term interest rates, presumably until December. Now that the dust has settled, short-term interest rates are a handful of basis points higher, gold is down a bit, and the dollar is up a bit—all of which suggest a slight improvement in the market's outlook for the economy. People feel better knowing the Fed is finally on track to "normalize" its balance sheet, even though it will likely take several years to accomplish. (Their plan to start selling $6 billion per month of Treasuries and $4 billion per month of MBS, to be ramped up slowly, is very cautious and conservative and will take a long time.)

A review of some key market-based indicators shows that the market's outlook for economic growth is has only improved marginally from sub-par levels. More importantly, however, there are few if any signs in the market that the Fed's plans to raise short-term rates modestly, while slowly paring down the size of its monster bond portfolio, pose any threat to growth. This tells me that the Fed is moving in the right direction, and its caution is warranted. The Fed is proposing to move slowly and cautiously to take steps to bolster the demand for money (by raising the interest rate it pays on excess reserves), now that there are increasing signs that money demand is beginning to ebb. I reviewed this in detail in a post last month, "Something to worry about." As long as the Fed keeps the supply of money in line with the demand for money, we won't have to worry about inflation. So far, it looks like they have been doing their job, since inflation has been relatively low and stable for quite a few years, and forward-looking inflation expectations have not increased.


This first chart is one of the most important. Although neither the press nor the Fed normally talk about the inflation-adjusted Fed funds rate, that is the monetary variable which is the most important for the economy, since it sets the floor for the true cost of borrowing and the true benefit to saving. Today, the real rate of interest on overnight money is slightly negative (the funds rate is 1.25% and the inflation rate is about 1.5%). It's a lot less negative now than it has been for most of the current recovery, but it's still the case that although real borrowing costs are negative and real savings rates are very low or negative. This has been the case for years, and we have yet to see any unpleasant consequences. It can't go on forever, however. If the Fed holds the real funds rate to an unreasonably low level, that would inevitably result in an imbalance between the supply and demand for money, and that in turn would result in rising inflation, a weaker dollar, and rising gold and commodity prices.

The real yield on 5-yr TIPS is best thought of as the market's expectation for what the real Fed funds rate will average over the next 5 years. 5-yr TIPS today carry a real yield of only 0.1%, while the current real yield on the Fed funds rate is about -0.15% to -0.25%. That means the market expects only very modest "tightening" from the Fed over the next 5 years. This squares with implied forward rates which show the Fed raising rates only 2 or maybe 3 times over the next several years. Both the market and the Fed believe that interest rates need rise only modestly, and that in turn implies a belief that the economy will not pick up significantly from its 2% trend rate of growth that has prevailed since 2009.

As I've said many times before, one thing to watch for and worry about would be the nominal funds rate exceeding the 5-yr real TIPS yield. That would be the market's way of saying that the Fed is entering "tight" territory and thus threatening real economic growth.


The chart above is also very important. It shows that every recession in the past 60 years has been preceded by a substantial tightening of monetary policy. Monetary policy is tight when the real Fed funds rate (blue line) is at least 3-4%, and when the Treasury yield curve (red line) is flat or inverted. We are likely years away from seeing those conditions. 


As the chart above suggests, today's very low level of real interest rates is consistent with real GDP growth of about 2%. If the market today were convinced that major tax reform is going to happen in the foreseeable future, I have to believe that real interest rates would be significantly higher, because true tax reform could unleash a lot of the economy's untapped potential. So despite rumblings of progress on tax reform, the market has not priced it in yet. The market remains cautious, just as the Fed remains cautious.


The chart above shows how the bond market reveals its inflation expectations. The difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS gives us the market's expectations for what the CPI is going to average over the next 5 years. That's currently about 1.75%, which is very much in line with the current level of inflation (the CPI is up 1.9% in the past 12 months, and the Core CPI is up 1.7%). That tells me the market is reasonably confident that the Fed is going to be doing a good job for the foreseeable future. If the market were worried that the Fed was being too aggressive, inflation expectations would be declining.



The two charts above compare the price of gold to the price of 5-yr TIPS over different time frames. I find it fascinating that these two completely different assets should behave so similarly. If anything, it means that strong economic growth (which typically coincides with high real yields such as we had in the late 1990s) depresses demand for gold, and weak growth increases the demand for gold. That in turn suggests that buying gold today is a hedge against a weaker economy.



The two charts above show that credit spreads in the US are at relatively low levels ("normal" swap spreads are 15-30 bps or so). That implies that systemic risk is low, liquidity is plentiful, and the economy is unlikely to throw a wrench into the sales and profits of the US economy's businesses. Conditions are expected to be good, and profits are expected to rise. The Fed is years away from creating a liquidity squeeze, which could only be precipitated at this point by a massive reduction in bank reserves.


In the absence of obvious or budding threats to the economy, investors find it difficult to resist the stock market, which continues to drift higher. At the current PE ratio of the S&P 500 (21.5), stocks have an earnings yield of almost 4.7% (i.e., if companies paid out all their after tax profits in the form of dividends, the market's average dividend yield would be almost 4.7%). That yield beats the 4.3% yield on the average BAA corporate bond, and it towers over the 1 - 2.8% yields to be found in savings deposits and the Treasury market. Since stocks uniquely can be expected over time to produce capital gains in addition to their yield, the only reason the market would price stocks to yield more than bonds is that the market does not expect earnings to rise, and to more likely fall. Again, this is a sign of market caution.

But what is slowly happening is that the yield on stocks is declining as their prices rise, and the yield on cash is slowly rising as the price of money declines. This process could continue for some time to come, as the Fed sets the pace for the yield on cash and the market balances the expected risk-adjusted yield on equities with the risk-free returns on cash. It's a big balancing act that could be disrupted by unforeseen events, but for the time being it looks like everything is working out OK.

If something about this picture changes, I'd bet that it's the outlook for growth, which could improve if and when Congress manages to pass meaningful tax reform and privatize—at least to some extent—the healthcare industry. That would trigger reduced demand for money (since it would boost confidence and make risky investments more attractive), and that in turn would compel the Fed to accelerate rate hikes and the unwinding of QE. But even if all those good things came to pass, I would not expect to see the future returns on equities exceeding the returns we have seen in recent years. Stocks are no longer cheap and are instead arguably overvalued; dramatic grains from these levels are thus unlikely.

Monday, September 18, 2017

Big Picture charts

UPDATED: The last two charts now reflect recently-released data as of Q2/17, which showed continued strong gains in every measure of households' balance sheets. Net worth rose by $8.2 trillion (a gain of 9.3%) over the most recent 12-month period, driven by a $6.6 trillion gain in financial assets and a $1.9 trillion rise in the value of real estate holdings, which are now worth $2 trillion more than at the peak of the housing bubble in 2006. Total household debt rose by less than $500 billion in the past year, and now stands only $600 billion higher than the prior peak in 2008; household leverage (total debt as a percent of total assets) has thus fallen by fully one-third since the all-time high in 2009.

The global economy and global financial markets are huge, but just how huge? Answer: a lot bigger than most people realize. Here are some charts which help put things in perspective. They also show that what's going on today is not unprecedented nor extraordinary. As always, all the charts contain the most recent data available at the time of this post.


Global GDP is roughly $80 trillion, about four times the size of the US economy. As the chart above shows, the global economy supports actively traded bonds and stocks worth $132 trillion, of which about 40% are US-based. There's nothing unusual about any of this, considering that a typical US household has a net worth (stocks, bonds, savings accounts and real estate) equal to about three times its annual income. 




As the charts above show, the market cap of Non-US equities has grown at a much faster rate than US equities since 2004 (US equities have grown at a 5.4% annualized rate, non-US equities at a 8.9% annualized rate). US equities are now worth about 50% of the value of non-US equities, down from more than 80%. Non-US equities have suffered somewhat, however, due to the dollar's 5% rise (on a trade-weighted basis) over the period of these charts, but that's relatively insignificant in the great scheme of things.


The defining characteristic of the current US economic expansion is its meager 2.1% annualized rate of growth, which stands in sharp contrast, as the chart above shows, to its 3.1% annualized rate of growth trend from 1965 through 2007. If this shortfall in growth is due, as I've argued over the years, to misguided fiscal and monetary policies, then the US economy has significant untapped growth potential and could possibly be $3 trillion larger today if policies were to become more growth-friendly.


As the chart above shows, the value of US equities relative to GDP tends to fluctuate inversely to the level of interest rates. This is not surprising, since the market cap of a stock is theoretically equal to the discounted present value of its future earnings. Thus, higher interest rates should normally result in a reduced market cap relative to GDP, and vice versa. Since 10-yr Treasury yields—a widely respected benchmark for discounting future earnings streams—are currently at near-record lows, it is not surprising that stocks are near record highs relative to GDP. If the economy were $3 trillion larger, however, stocks at today's prices would be in the same range, relative to GDP, as they were in the late 50s and 60s. Valuations are relatively high, to be sure, but not off the charts nor wildly unrealistic.


As the chart above suggest, over long periods the value of US stocks tends to rise by about 6.5% per year (the long-term total return on stocks is a bit more due to annual dividends of 1-2%). The chart also suggests that the current level of stock prices is generally in line with historical trends. 


Adjusting for inflation, we see that stock prices tend to rise about 3% a year, and the current level is not unreasonably high, as it was in the late 1990s.


US equities have significantly outpaced Eurozone equities over the past nine years. That has a lot to do with the fact that the US economy has grown faster as well.


US households (i.e., the private sector) have a net worth that is approaching $100 trillion. That figure has been growing at about a 3.5% annualized rate for a very long time. The current level of wealth is very much in line with historical experience.


Adjusting for inflation and population growth, the average person in the US is worth almost $300,000. That is, there are assets in the US economy which support our jobs and living standards (e.g., real estate, equipment, savings accounts, equities, bonds) worth about $300,000 per person. We are richer than ever before, but the gains are very much in line with historical experience.