Monday, April 24, 2017

Chemical activity and trade still strong

The American Chemistry Council's Chemistry Activity Barometer continued to rise in its latest April release. This index has been a good coincident at at times leading indicator of both industrial production and overall economic growth, and it continues to point to rising industrial production and continued growth of the US economy. At the same time, there is a growing body of evidence that points to increased global trade, at a time when industrial commodity prices have been rising significantly.


The Chemical Activity Barometer rose 5.2% in the past 12 months, one of its strongest showings in seven years (the strongest being the year ended March, when it rose 5.6%).


This indicator almost always goes flat or declines in advance of recessions. Currently it points strongly to continued expansion.


This indicator has been a good leading indicator of growth in industrial production and economic activity in general. Currently it points to a substantial increase in industrial production in coming months.


As the chart above shows, US goods exports have been rising for the past year, and that is corroborated by a sharp increase in outbound container shipments from the ports of Los Angeles. It's notable that US exports to China rose over 20% in the year ending February, after contracting over most of the 2014-16 period. Japan reports double-digit growth in both imports and exports in the year ending March, after declining over most of the 2015-16 period. According to the Netherlands Bureau for Economic Policy Analysis, the volume of global trade rose at an 8% annualized pace in the six months ended January 2017. Expanding global trade is an excellent indicator of improving economic conditions worldwide. Very encouraging.


Rising prices for industrial commodities over the past year or so—at a time when the dollar has been rising—tell us that global industrial activity has generally exceeded the expectations of commodity producers. Also very encouraging.

Yet despite the good global news, the US economy seems still to mired in mediocrity (i.e., 2% growth). That's not necessarily inconsistent with global strengthening, since trade is much less important to the US economy than it is to most other economies. But improving global fundamentals nevertheless provide strong underlying support for activity here.

It's premature to worry about a US downturn, and it's not unreasonable to remain optimistic that things will improve. It pained me today to learn that Trump wants to impose a 20% tariff on imports of Canadian softwood, since all that does is make life more expensive for US residents (UPDATE: Read Mark Perry's excellent critique of Trump's tariff here). But I'm encouraged that he seems pointed in a positive direction in the area of tax reform, and that there is important progress being made on healthcare reform.

French election relieves systemic risk

This is a brief update on the status of global systemic risk in the wake of yesterday's French elections. By rejecting extremists, the French have reduced the risk of a Eurozone/euro collapse. 2-yr Eurozone swap spreads and default credit spreads on French debt, both key measures of systemic risk, have declined significantly from their recent highs. Europe is not out of the woods completely, but investors nevertheless are breathing a sigh of relief. Equity markets, understandably, have moved higher as a result.


The chart above shows the price of credit default swaps on French debt (a form of insurance against default by the French government). They reached a high of over 70 bps at the end of February, and are now down to just under 35 bps. This puts them only modestly higher than their multi-year low of 27 bps, which was registered last September. For context, CDS spreads on German debt—perceived to be ultra-safe—are a bit less than 20 bps.


The chart above compares US and eurozone 2-yr swap spreads. At 34 bps, US spreads are at the high end of their "normal" range of 20-35 bps, whereas Eurozone spreads are still somewhat elevated. The worst of the panic seems to have subsided, thanks to yesterday's elections, but concerns linger.


Eurozone stocks are now up 25% from their lows of last summer. US stocks have far outpaced their Eurozone counterparts since 2009, but Eurozone stocks are starting to close the gap, having outpaced US stocks by 7% since last summer. 


As the chart above suggests, the French election outcome was a relatively minor "wall of worry" that, now partially resolved, has allowed stocks to float a bit higher.

Thursday, April 13, 2017

Market-based chart updates

There are lots of things going on in the world, with the most significant, in my view, being the threat of nuclear war in/with North Korea, followed by deteriorating US-Russia and Mideast relations. On the domestic front, Trump has yet to make meaningful progress on an alternative to Obamacare or on tax reform, but he has made important progress with most of his nominees. However, if we don't get substantial progress on healthcare and taxes before year end, the economy could weaken as uncertainty mounts and people delay income and investment decisions. In the meantime, the nascent rebound in the manufacturing sector and the likelihood of improving corporate profits should sustain the economy for the next several months; but for now, the economy continues to plod along and markets are less than enthusiastic about the future.

What follows are updates of some of the more important charts—all based on market-driven prices—that I am following. These tell us what the market is thinking, as expressed in the prices of the dollar, gold, real and nominal interest rates, equity prices, volatility, swap and credit spreads, and commodity prices. As I read the charts, the market seems relatively unperturbed by all the turmoil, and hopeful that better times lie ahead. This in turn makes the market vulnerable to any shortfall vis a vis expectations, so now is one of those times to be cautiously optimistic rather than gung-ho.


If the US economy were a company, then the value of the dollar would be a good proxy for its relative attractiveness and its future prospects. The chart above shows two of the best measures of the dollar's value, on an inflation-adjusted, trade-weighted basis. By either measure, the dollar is moderately above its long-term average We can infer from this that the Fed has not printed more dollars than the world wants, though it might be guilty of supplying too few. On the other hand, it would appear that the dollar is one of the currencies in most demand, and that is encouraging since it means the US is attracting investment, and investment is the seed corn of future growth.


The chart above illustrates the tendency of commodity prices to move inversely to the value of the dollar (note that the dollar axis is inverted). In the past few years, however, both the dollar and commodity prices have moved higher. This is worthy of attention. I think it tells us that the rise in commodity prices has little or nothing to do with a monetary reflation (because a plentiful supply of dollars tends to boost the prices of most things (aka inflation), but rather more to do with a general strengthening of the global economy at a time when the US economy is expected to be one of the engines of stronger growth. Again, this is encouraging. 


The chart above shows the very strong correlation between industrial commodity prices and emerging market equities. That makes sense, because emerging market economies tend to specialize in the production of raw materials. I believe the rise in commodity prices reflects a general strengthening of global economies, so what's good for commodities is good for just about everyone, especially emerging markets. And as I pointed out in December 2015, emerging markets and commodities had been severely beaten up and prospects for their recovery were bright.

 

For years I've been amazed at the correlation between gold and TIPS prices, as shown in the chart above (note I use the inverse of the real yield on TIPS as a proxy for their price). The common denominator of both markets is the way they serve to protect people from risk. TIPS are a good hedge for inflation, they are default-free, and they are the only asset that guarantees investors a real rate of return if held to maturity. Gold, on the other hand, is a classic port in a storm for just about anything that makes people nervous about fiat currencies or government excesses. Gold and TIPS have been in a rough holding pattern for the past several years. Declines in gold and TIPS would likely coincide with improvements in the global economic outlook. That they have not yet fallen meaningfully is therefore a good sign that markets are still somewhat risk averse and less than optimistic.


It's almost always the case that stocks tend to weaken as fears tend to rise, as shown in the chart above. But the current level of fear and uncertainty (as reflected in the ratio of the Vix index to the 10-yr Treasury yield) is still quite modest compared to what we've seen in recent years. The Trump era seems to have brought with it a calming effect on global markets. 


Swap spreads are some of the best coincident and leading indicators of financial market and economic health. Spreads have been rising for the past year or so both in the US and in the eurozone, so that could be a sign of deteriorating economic and financial fundamentals. I've tended to dismiss the current rise in US swap spreads, however, because they are still within what we consider to be a "normal" range (20-35 bps); if anything, they were exceedingly low at the end of 2015 and only now have recovered to more normal levels. Eurozone swap spreads have moved substantially higher, however, and that is cause for concern. My guess is that eurozone swap spreads are elevated because of concerns that France could pull a "Frexit," and this could undermine the stability of the euro and the eurozone economy. This risk is not trivial, and is not one to dismiss lightly—unless you believe (as I do) that the demise of the eurozone would not be necessarily a bad thing. For the moment, I note that credit default spreads on French debt are declining (i.e., the market is worrying less about a Frexit since the political left seems to be ascendant for the moment), but this still bears watching.


 Speaking of credit default spreads, the chart above shows that they are relatively low here in the U.S., and that further suggests that systemic risks are low and markets are relatively confident about the future.


One persistent and salient feature of the past 6-7 years has been Treasury yields in the US that are very low relative to inflation, as the chart above shows. Some observers dismiss this with the argument that the Fed is keeping interest rates artificially low, but I'm not a buyer of that line of thinking. I think Treasury yields are very low because markets still have a palpable degree of risk aversion, and are thus willing to pay a lot for the protection of Treasuries. We see this same phenomenon all over the developed world: sovereign yields are unusually low. Most investors have a choice between holding Treasuries and holding riskier assets; that the price of Treasuries is unusually high relative to other assets (e.g., the earnings yield on the S&P 500 is substantially higher than the yield on 10-yr Treasuries) must therefore mean that investors are very distrustful of the outlook for the economy and for corporate profits. In other words, very low Treasury yields are a strong and reliable indicator of a market that is less than optimistic, to say the least. Show me an optimistic/enthusiastic market, and I'll show you nominal Treasury yields that are much higher than they are today.


 The difference between nominal and real yields is a measure of the market's inflation expectations. In the chart above we see that inflation expectations over the next 5 years (the green line) are 2%, and not surprisingly, that is what the CPI has averaged over the past few decades. Markets are not concerned about rising or falling inflation right now; it's steady as she goes. Kudos to the Fed for having managed monetary policy surprisingly well over the years.


The chart above is my attempt to show that the level of real yields on TIPS can and does tell us a lot about the market's expectations for real economic growth. Real growth has averaged about 2% during the current expansion, and 5-yr TIPS yields have averaged about zero. You can invest in the economy and expect to get an average real return of 2%, or you can invest in TIPS and earn a guaranteed zero real rate of return. Guaranteed real rates of return should always be less than expected real rates of return, should they not?. If and when TIPS yields rise significantly, this will be a good indicator that the market is expecting economic growth to accelerate. For now, it may be the case that the market is buoyed by Trump expectations, but to judge from TIPS yields, there is little or no evidence of much optimism.


The chart above shows the 6- and 12-month growth rates of private sector jobs in the US. If anything, jobs growth has slowed over the past few years, from just over 2% to currently about 1.7%. The manufacturing sector looks to be picking up, but the overall economy remains on a sluggish growth trend that of late has been declining modestly on the margin. No sign here of a Trump bump, and it's premature to expect one: we need to see meaningful tax and regulatory reform (or solid reasons to expect such) before getting excited.

Wednesday, April 5, 2017

The two major sources of our healthcare problem

As I noted two weeks ago, the problem with Obamacare is that "it attempted to rejigger a huge fraction of the U.S. economy, and that is something that is virtually impossible to accomplish in a successful fashion by government diktat. Only a freely functioning market economy can make something so huge and so complex work in an efficient manner." So the solution is to restore a freely functioning market to the healthcare industry. That sounds easy, but the complexities involved with undoing Obamacare are nearly intractable, and that is what has bogged down Congress' attempts to repeal and replace.

When faced with very complex problems, the best solution involves simplifying things as much as possible. Fortunately, John Cochrane has taken a giant step in that direction with his recent post. He has come up with what he refers to as the "two original sins" of healthcare regulation. These two sins explain most if not all of the problems that we face with healthcare today. 

The first original sin appeared in the 1940s, when the government agreed to allow companies to deduct the cost of health insurance, but neglected to allow individuals to do the same. (I've discussed this in a number of posts over the years.) This made health insurance provided by employers much cheaper than health insurance purchased by individuals. Not only that, but it created a strong incentive for employers to offer health insurance which covered a whole lot of things; and why not, if the costs were uniquely deductible by companies? Not surprisingly, the vast majority of us today get our health insurance either from our employer or the federal government, and most of the healthcare policies offered (or mandated) today cover all sorts of trivial expenses—it's like buying car insurance that includes oil changes. As a result, only 10.5% of healthcare expenses are paid for out of pocket, while the vast majority of expenses are paid for by third parties—consumers don't know what medical services really cost, and they don't care, so free market forces are absent. This tax distortion is also largely responsible for the problem of portability, since employees can't take their insurance with them when they change or lose their job. We could fix this problem easily by simply changing the tax code to allow everyone to deduct their healthcare insurance costs. 

The second original sin, Cochrane argues, is that "Instead of straightforwardly raising taxes in a non-distortionary way (a VAT, say), and providing charity care or subsidies -- on budget, please, where we can see it -- our political system prefers to fund things by forcing cross subsidies. Medicare and medicaid don't pay what the service costs, because we don't want to admit just how expensive that service is. So, large hospitals make up the difference by overcharging you and me instead." 

Instead of levying a tax designed to cover the cost of healthcare for the unfortunate among us, we have chosen instead to use a system of cross subsidies:

Cross-subsidies are dramatically less efficient than taxes. Cross-subsidies cannot stand competition. Low prices, efficiency, and innovation in the provision of services like health care come centrally from competition, and especially disruptive competition. With no competition -- especially no entry by new doctors, hospitals, clinics, insurance companies -- costs spiral up. As costs spiral up, the cost of the charity care spirals up. As that spirals up, the size of the cross-subsidies spirals up. As that spirals up, the need to restrict competition spirals up.

Read the whole thing.

ADP report not a blockbuster

Lots of hoopla today about the "blowout" ADP employment report. Yes, it greatly exceeded expectations (+263K vs +185K), but lost in the shuffle was the fact that the prior month's number (+298K), which was a true blockbuster, was revised down to +245K. As the chart below shows, what we're left with is nothing out of the ordinary. The economy is still on a moderate growth path, but it is probably getting stronger bit by bit, thanks to a revival in the manufacturing sector.



As the second chart above shows, there has been a burst of employment growth in the manufacturing sector in recent months. This is where the strength in the ADP comes from. It also corroborates other reports that show manufacturing is rebounding after sustaining an oil patch-related setback.


As the chart above shows, the service sector—which employs almost 10 times as many workers as the manufacturing sector—shows only modest improvement over the past year. It's too early to get excited about substantially stronger growth in the broad economy. There's excitement in manufacturing, but it's a very small piece of the GDP pie. 


Service sector industries do not have particularly impressive hiring plans, as the chart above suggests.


Nevertheless, it's still the case that the economic fundamentals have improved somewhat over the past year, particularly in the Eurozone, which had languished for a long time.

In order to get really excited, we're going to have to see Trump pull off a significant reform of the U.S. tax code. I'm still optimistic in that regard, but it's not going to happen soon. 

Tuesday, April 4, 2017

The importance of oil prices

In several recent posts—most recently here—I've noted that the collapse of oil prices which began in mid-2014, and their subsequent rebound which began about a year ago, have had a significant impact on corporate profits, industrial production, and the economy in general. I offer here a chart that puts some meat on that argument:


Note that changes in crude prices tend to lead factory orders (ex- the volatile transportation sector) by about one month. Crude prices bottomed about a year ago, and since then factory orders have risen almost 8%. In the six months ending February, factory orders are up at an annualized rate of almost 11%. That's significant. The positive effects of cheaper oil prices on demand (if you spend less on energy you can spend more on everything else) are now far outweighing the negative effects of lower oil prices on drilling and manufacturing activity. The problems of the oil patch have faded away and the economy is now enjoying a new spurt of growth thanks to cheaper energy.

Monday, April 3, 2017

Strong manufacturing report

The March ISM manufacturing indices released today were uniformly strong, pointing to an improving economic outlook in the months to come. In this context, the Fed's recent moves to raise short-term rates do not yet constitute a tightening of monetary policy, nor are they a threat to growth.


The ISM manufacturing index does a pretty good job of tracking quarterly GDP growth, as the chart above suggests. Recent strength in the ISM index is consistent with Q1/17 growth of at least 3-4%, substantially higher than Q4/16 growth of 2.1%.


The strong reading for export orders, shown in the chart above, is particularly encouraging, since it likely reflects improving conditions overseas.



The prices paid index registered its strongest level in many years (first chart above), and that is corroborated by the strength in the industrial commodity prices (second chart). Prices are rising because global demand has proved stronger than commodity producers had anticipated.


Manufacturing firms are becoming more confident about the future, as seen in the chart above which reflects optimistic hiring plans.


It's nice to see that both Europe and the U.S. are experiencing improving manufacturing conditions. Coordinated recoveries can reinforce themselves.


The chart above suggests we are likely to seeing rising revenues per share in the months to come, since the ISM manufacturing index has a strong tendency to lead year over year gains in S&P 500 company's revenues per share.


The chart above shows the inflation-adjusted level of the Fed's short-term interest rate target, using the Fed's preferred measure of inflation, the Core PCE Deflator. This is the true measure of the impact of Fed policy, as the Greenspan Fed made clear in the late 1990s. Short-term rates have been negative in real terms for almost 10 years, and are still quite negative despite three rate hikes since late 2015. Negative real short-term borrowing costs incentivize borrowing (because borrowers can repay their loans with cheaper dollars), thus increasing the supply of money (because banks create money by increasing their lending activity) and reducing the demand for money (because negative real interest rates make holding cash equivalents unattractive). The net result is accommodative monetary policy. If the Fed persists in keeping short-term interest rates negative while economic activity and confidence rise, it risks allowing inflation pressures to rise.


The chart above compares the real Fed funds rate to the level of real yields on 5-yr TIPS. The latter is a proxy for what the market believes the real Fed funds rate will be in 5 years' time. A positive spread between the two indicates an upward-sloping real yield curve, and that in turn reflects the market's expectation that the Fed will likely continue to raise rates in the years to come. The time to worry is when the spread becomes negative (as it did prior to the last two recessions), since that means the market expects the Fed to lower rates in the future because the market senses a significant weakening of economic activity. In short, the chart above tells us that the market is comfortable with the Fed's actions to date.


The chart above shows the level of real and nominal 5-yr Treasury yields and their difference, which is the market's expectation for inflation over the next 5 years. So far we see nothing unusual afoot; the Fed has been managing policy in a manner consistent with relatively low inflation.

Thursday, March 30, 2017

Corporate profits and equity valuation

Today's revision to Q4/16 GDP statistics brought with it our first look at corporate profits for the quarter. My preferred measure (HT: Art Laffer) is after-tax profits adjusted for capital consumption allowances and inventory valuation, and it notched an impressive $1.61 trillion annual rate for the quarter. This measure has been consistently calculated ever since 1947, and as such it represents the most consistent and contemporary measure of the true economic profits of corporate America. Profits by this measure rose by an impressive 15.7% last year, but most of that rebound was due to the waning effects of the severe drop in oil prices which began in mid-2014. Now that the crisis in the oil patch has passed and oil prices are stabilizing, corporate profits are regaining their prior levels, which from an historical perspective are unusually high relative to GDP. Given that profits are historically quite strong, it is worth noting that equity valuations are only modestly above average.



Q4/16 GDP was revised slightly upwards to an annualized rate of 2.1%, which happens to be exactly the same as the annualized rate of growth of the economy since the current recovery began in mid-2009. It's been the slowest recovery on record. As the chart above shows, if the economy had instead regained its long-term average growth rate of 3.1% per year, the economy today would be roughly $3 trillion dollars bigger. I've called that the Obama Gap.



The charts above compare after-tax corporate profits to nominal GDP. It should be clear that despite this being a very weak recovery, corporate profits have been unusually strong. For years I've explained the shortfall in growth as being the result of very weak investment on the part of corporations; without investment their can be no productivity gains, and without productivity there can be no improvement in living standards. Both corporations and consumers have been generally risk-averse for the past 8 years, due to increased regulatory and tax burdens, and a general, anti-business sentiment emanating from Washington. Consumers have deleveraged significantly, while the government has borrowed heavily, absorbing ever penny of the profits generated by corporations since the recovery began. Corporations might have invested that money more efficiently, but instead the government spent most of it on transfer payments.


As the chart above shows, the increase in corporate profits over time has corresponded rather closely to the increase in equity prices. As I argued a few weeks ago, the stock market is not rising simply because of a "Trump bump," it is rising because global economic fundamentals are and have been improving, as is the outlook for corporate profits.


The chart above compares NIPA profits with reported profits (using Bloomberg's calculation of profits from continuing operations). Note that the two measures tend to track each other over time, with the NIPA measure leading the reported profits measure (because it is based on quarterly annualized profits, whereas the reported profits measure uses a 12-mo. trailing average). The rebound in NIPA profits last year is almost certain to show up in rising EPS in the months to come, and the stock market is priced accordingly. Ed Yardeni expands on this subject in a recent post here. For those interested in why the NIPA measure of profits has been consistently higher than the reported measure since the 1990s, see my post of a few years ago on this subject here.



The standard method of calculating equity multiples (PE ratios), is to divide current prices by a trailing 12-mo. average of earnings per share (see the second chart above). I've refined this a bit by using Bloomberg's calculations of PE ratios, which use only profits from continuing operations. A better way, I would argue (as Art Laffer convinced me many many years ago), is to divide current prices by the most recent quarterly annualized rate of profits as calculated in the National Income and Products Accounts (NIPA).  This compares current prices to the most recent measure of true economic profits. I've taken this analysis a step further (see first chart above), and calculated PE ratios for the S&P 500 using the NIPA measure of profits instead of reported corporate earnings (I then normalized the results so that the long-term average PE ratio using NIPA profits would be similar to the average PE ratio using reported profits). By either measure, PE ratios today are modestly or moderately above average, whereas corporate profits using the NIPA calculation are significantly above average. If I had to choose one, I would go with the NIPA version of PE ratios, which shows the equity valuations today are only modestly above average.


The chart above shows the equity risk premium, which I define as the difference between the earnings yield on stocks (i.e., the inverse of the PE ratio) and the yield on 10-yr Treasuries. This is the extra yield that the market demands in order to feel comfortable accepting the added risk of equities vs. risk-free Treasuries. In the boom times of the 1980s and 1990s this risk premium was consistently negative, a sign that the market was quite confident that equities were attractive. But for the duration of the current business cycle expansion, the premium has been consistently positive, a sign that the market has been quite reluctant to take on the added risk of equities. Risk aversion, as I've argued for years, has been one of the hallmarks of this recovery. It's been declining of late as confidence slowly rebuilds, but it would be difficult to argue from this chart that the equity market is priced to optimistic assumptions. I would further note that current risk premiums are about the same as the were in the late 1970s, during the infamous "Carter malaise."

Finally, I would note that these measures of equity valuation have nothing to do with surveys of investor and/or consumer sentiment. They rely solely on market-based measures, and as such, I think they are more reliable and informative.

Monday, March 27, 2017

Household finances are on solid ground

U.S. households' financial burdens (payments for mortgage and consumer debt, auto leases, rents, homeowner's insurance, and property tax, all as a percent of disposable income, are at historically low levels and have not budged for over five years. Moreover, the overall leverage (total liabilities as a percent of total assets) of the household sector is at 30-year lows. Coupled with the fact that weekly claims for unemployment are at historically low levels, this paints a picture of a household sector that is on financially solid ground, more so than at any time in decades.


Today the Fed released data for the fourth quarter of 2016 covering various measures of household's financial burdens. As the chart above shows, financial burdens have been historically low for over 5 years, and are substantially less now than they were prior to the past 3 recessions. I note that consumer debt includes student loans, which now total over $1 trillion and which continue to grow at a significant pace—the only area of consumer finance that is deteriorating, thanks to our beneficent government which is willing to grant student loans with little or no regard for a student's ability to pay.


Households' leverage has plunged by about one-third since the 2008 recession, as the chart above shows, and leverage is now back to levels last seen some three decades ago.


Initial claims for unemployment, shown in the chart above, haven't been so low for a very long time. Workers at social security offices around the country must have a lot of time on their hands these days!


The chart above compares unemployment claims to total payrolls. Here we see that the chances of a worker getting laid off are as low as they have ever been, and by a substantial margin. In recent weeks, only about 0.15% of the U.S. workforce has been handed a pink slip.

Household finances appear to be about as solid as they have ever been, and job security is also about as good as it has ever been. This is not to say we don't have problems, but these statistics are reassuring nonetheless, and not widely recognized.

Friday, March 24, 2017

Thoughts on the failure of Obamacare reform

I don't buy the conventional wisdom that says that this is a failure of leadership. Leadership alone cannot fix Obamacare. A solution to the problem of Obamacare is going to be extremely difficult, and it can't and shouldn't be done overnight. Obamacare was doomed to fail, as I pointed out many times over the years, because it attempted to rejigger a huge fraction of the U.S. economy, and that is something that is virtually impossible to accomplish in a successful fashion by government diktat. Only a freely functioning market economy can make something so huge and so complex work in an efficient manner. (Friedric Hayek, who died 25 years ago, explained why in this post from Mark Perry)

Thank goodness the Republicans didn't end up succumbing to the hubris that energized the Democrats under Nancy Pelosi's leadership, when they passed a bill so huge and so complex that she was forced to exhort its passage in order that they could find out what was in it. Thank goodness the Republicans didn't ram through a bill that had zero support from the opposition party (as Pelosi did), let alone strong support from their own party; that is not the way to accomplish major legislation.

Obamacare is imploding because it attempted to substitute government decree for market forces. So a fix to Obamacare is only going to work if it unburdens the healthcare market from government  influence. Ryan's proposed solution went a long way towards doing that, but it still relied on too much government interference in the healthcare market. Here's my recommendation: Let's put this intractable problem on the back burner; let's let Obamacare continue to fester; and let's wait until the Democrats beg for a solution and join in supporting new and better legislation.

Meanwhile, let's hope the Republicans can regroup and move on to tackle a big problem that should be a lot easier to solve, and which could end up delivering positive results for everyone in relatively short order: tax reform.

Successful tax reform should involve a few simple ingredients: tax rates should be lower and flatter than they are now, and deductions and subsidies should be far fewer. (Please, Republicans, please don't attempt to impose a Border Tax system on the U.S. economy, since that is very complex and it will have many unforeseen consequences, some good and some very bad. Please don't listen to Trump and his economically illiterate trade advisor Peter Navarro.) Lower and flatter tax rates coupled with fewer subsidies and deductions should boost the economy because they will reduce the amount by which the government interferes in private markets, and they will increase the incentives for the private sector to work, invest, and innovate.

Tax reform can deliver a stronger economy, and a stronger economy ought to make it much easier to reform Obamacare.

Friday, March 17, 2017

Global outlook improves

It's not just a Trump Bump that is driving stocks higher, nor is it unwarranted or unsubstantiated optimism. Rising equity prices are most likely a response to an improvement in global economic fundamentals that is just now becoming clear. Global industrial production has been rising for the past 6-8 months, and the volume of global trade picked up noticeably toward the end of last year. More recently, today's release of industrial production statistics for February shows a significant pickup in U.S. manufacturing activity in the first two months of this year. All of this was foreshadowed by a pickup in chemical activity which I noted early last summer and which continues to suggest a meaningful improvement in overall industrial production in the months to come.

The market is usually pretty good at sniffing out developments in the economy that are not yet obvious in the stats, and this is the latest example.

Here are some charts that tell the story:


U.S. industrial production statistics have been unimpressive for years, due mainly to wrenching problems in the oil patch. Eurozone industrial production in the Eurozone has been abysmal relative to modest improvement in the U.S., but it has nevertheless been improving, and this improvement become noticeably stronger about six months or so ago.


After several years of almost zero growth, U.S. manufacturing production has jumped, rising at almost a 5% annualized rate since the end of November.


The volume of world trade is a key indicator of global economic health, since expanding trade is an unalloyed good thing: increased trade is arguably the best way to improve a nation's productivity, since it allows trade partners to strongly benefit from the things they do best. In the chart above we see that world trade volumes rose at a relatively tepid 2-3% pace for a number of years, which is consistent with the recent recovery being the least impressive in modern history. But in the second half of last year world trade volume rose at a 4-5% pace. This is very good news.


The Chemical Activity Barometer has done a pretty good job of reflecting—and sometimes leading—overall economic activity in the U.S. Starting last summer this indicator started picking up, and in the year ending February it has increased by over 5%.


The chart above shows that the year over year change in the 3-mo moving average of the Chemical Activity Barometer has been a reliable predictor of improvement in U.S. industrial production. Industrial production is now beginning to improve, as predicted, having increased modestly since last March after several years of decline. More improvement should be on the way.


The chart above shows the CRB Raw Industrials commodity index, which has been rising strongly since late 2015. It's now apparent that this has been driven not by a weaker dollar (as has typically been the case), but by an unexpected and significant improvement in global economic activity. The CRB Metals index (which consists of copper scrap, lead scrap, steel scrap, zinc, and tin) has surged almost 60% since early last year. Very impressive, and it's still ongoing.


So it's not surprising that Eurozone stocks have perked up of late, as has nearly every global equity market. The current equity rally is built on a sound economic base, not on flights of fancy.