Tuesday, February 21, 2017

Charts that bear watching

Here are some charts I've been following for quite some time. Many of them show interesting relationships between seemingly-unrelated asset classes, and all tell an interesting story.


The first chart (above) compares the price of gold to the price of 5-yr TIPS, using the inverse of their real yield as a proxy for their price. The only thing these two assets have in common is their supposed ability to hold their value over time relative to other things: over very long periods, gold tends to track the rise in the general price level, while TIPS pay a real yield that is guaranteed by the U.S. government, thus compensating investors for the effects of inflation. Call them "safe-haven" assets of a sort. As such, it makes sense that their prices would rise and fall together as investors became more or less concerned with "safety." And in fact this is what has happened for the past decade: the price of gold and TIPS have tracked each other remarkably well. If they tell a story it is that investors were willing to pay ever-higher prices for safety for the first half of the past decade, while they have been ever-less willing to pay for safety in the past 5 years. This is another way of saying that markets were very risk averse in 2012 (when the PIIGS crisis was most acute), but have become gradually less risk-averse since then. Both assets, however, are still trading at prices that are relatively elevated compared to their longer-term history, which in turn suggests that markets are still struggling with risk aversion.


It's a well-known fact that the stock market tends to fall when investors' nervousness increases: stock prices tend to move inversely to the Vix index, a good proxy for fear. Dividing the Vix index by the 10-yr Treasury yield gives a number that tends to rise as fear rises and to rise more as yields fall—with yields in turn being a proxy for the market's confidence in the economy's growth prospects. What we've seen since just before the November elections has been a pronounced decline in fear, coupled with a modest rise in 10-yr yields, and that has coincided with a rather impressive rise in stock prices. Investors are a lot less fearful and somewhat more confident in the economy's growth prospects, and that has—not surprisingly—correlated with a rise in equity valuations. It's also the case that corporate earnings have stopped declining and are now starting to rise.


The American Trucking Association publishes an index of the amount of tonnage that is hauled around the U.S. economy by our massive fleet of trucks. As the chart above shows, this index tends to move by the same order of magnitude as the real value of the nation's largest companies (using the inflation-adjusted value of the S&P 500 index as a proxy). The economy is moving more goods today than ever before, and companies are worth more than ever before.


It's a well-accepted fact that interest rates tend to track inflation—except when they don't, as this chart shows. For the past 6 years, 5-yr Treasury yields have not tracked the course of core inflation very well. With inflation running at 2%, yields should be closer to 4% today, yet today they are just under 2%. This suggests to me that the market is still quite risk averse, since the market is willing to accept a very low (even negative) real yield on 5-yr Treasuries, presumably in exchange for their government guarantee. As a general rule, very low Treasury yields are symptomatic of very strong risk aversion. Consider: if people were wildly optimistic about the future, no one would want to hold a bond that paid a zero real rate of interest; real interest rates would have to rise considerably to compete with the generous returns expected of other assets.


The chart above compares the value (in dollars) of U.S. and Eurozone stocks. What stands out is the huge divergence between the two that began some 8 years ago. Since then, U.S. stocks have outperformed their Eurozone counterparts by over 40%. We know the U.S. economy is still mired in its weakest recovery every, so what this says is that the Eurozone economy is really in abysmal shape. No wonder the Brits voted to exit the European Union. I would not hold out a lot of hope for the future of the EU, but that's good news, in the long run, for Europeans. If they succeed in getting rid of an expensive, burdensome, and unproductive layer of government bureaucracy, European economies could be set up for a huge boom.

Over the years I've highlighted the key role that swap spreads play in signaling the health and future growth prospects of financial markets and economies. As the chart above shows, swap spreads (see here for a short primer on what swap spreads are) have tended to rise in advance of recessions, and they have tended to decline in advance of recoveries. At the very least swap spreads are good coincident indicators of economic and financial market health (i.e., higher spreads reflect deteriorating conditions, falling spreads reflect improving conditions), and they have often been good leading indicators. Swap spreads are far more liquid than high-yield credit spreads, so they tend to react quicker to changing fundamentals. That swap spreads have been rising of late while HY spreads have been falling is thus a potential cause for concern. What is going on? Swap spreads are still relatively low, so they are not necessarily forecasting a meaningful deterioration in the economic and financial fundamentals, but over the years I've developed a healthy respect for swap spreads, and so I'm reluctant to dismiss their somewhat troubling message today. Something is going on out there that is worrisome, so some degree of caution is warranted. Maybe that helps explain why 5-yr Treasury yields are as low as they are.


Over the past year or so, the Brazilian stock market has surged more than 145%. Wow. What this says is that a year ago Brazil was considered to be on the cusp of disaster. Instead of collapsing, Brazil is slowly getting back on its feet, having purged at least some of the government corruption that was plaguing the economy. It helps that commodity prices have surged over this same period as well, and despite the fact that the dollar has strengthened (a strong dollar has typically seen falling commodity prices and terrible news for most emerging market economies). Rather than signaling a boom, I think the surge in Brazilian equities is telling us that even though Brazil is still in lousy shape today, it is doing much better than most people expected a year ago. If the U.S. and Eurozone economies start picking up, Brazil's future could look very bright, with lots of upside potential.


The chart above compares the prices of the three major types of goods and services that comprise the U.S. economy. Services (which are mostly driven by wage costs) and non-durable goods prices (e.g., food, gasoline) have been rising more or less steadily since 1995, whereas durable goods prices have been steadily declining. It's not a coincidence that China first emerged as a major source of durable goods beginning in 1995. China has been a source of deflation, and that has helped to moderate the inflation that has persisted outside the durable goods sector. It's all been a tremendous boon to U.S. consumers. Service sector prices (mostly determined by wages) have risen by over 70%, while durable goods prices have fallen by almost one-third. An hour's worth of labor, in other words, today buys 2.2 times as much in the way of durable goods as it did 22 years ago. That's why nearly everyone is able to afford a smartphone these days. We have no reason to fear China. Are you listening Mr. Trump?


Warren Buffett says that the ratio of stock prices to nominal GDP is his preferred measure of stock market valuation. The chart above compares this measure (blue line) to the inverse of 10-yr Treasury yields, because I think that comparison adds value to Buffett's preferred measure. Stock prices, in theory, are the discounted present value of future profits, so it is not unusual to see, as the chart above shows, that equity valuations tend to increase as interest rates (i.e., discount rates) decline, and they tend to fall as interest rates rise. Valuations and yields are roughly the same today as they were in the late 1950s and early 1960s, and neither valuations nor yields appear greatly distorted relative to their historical relationships. Stocks are certainly not cheap at current levels, but neither are they egregiously over-valued. However, it is reasonable to think that unless the U.S. economy picks up and corporate profits resume their long-term rise, the stock market is going to run into trouble at some point. Stocks are also vulnerable to an unexpected rise in inflation, since that would result in much higher interest rates.

Thursday, February 16, 2017

Reflections on the economy and inflation

Despite all the action in the equity market, there's not much going on in the economy that's visible. Concurrent data suggest that the economy continues to plod along at something like a 2% annual growth rate, which has been the norm since mid-2009. Industrial production and business investment continue to be lackluster, while construction expands slowly.


Confidence, however, is definitely up, and the equity market is up some 12% since just before the November elections. This strongly suggests that the market expects business-friendly policies (e.g., tax reform plus regulatory relief) to emerge from the Trump administration this year. Trump's executive orders so far have been impressive, but a lot of good news has been priced in, so further gains likely will require confirmation that policies put in place are indeed of the business friendly variety.

The type and timing of tax reform are crucial issues, however, and they are still in flux. If tax cuts are postponed until next year this could pose a serious risk to the economy this year, since it will give everyone a reason to postpone new investment, realization of gains, and income until next year—in a manner similar to what happened when the initial Reagan tax cuts were (mistakenly) phased in over a number of years and the economy immediately slumped. If Trump is going to cut taxes, he needs to do it ASAP and/or reassure the market and the public that the cuts will be retroactive to the beginning of this year. Alvin Rabushka has some interesting observations along these lines here.

It's disturbing, meanwhile, that Trump seems to be pushing hard for some type of "border adjustable" tax regime. That appeals to him, presumably, since it would allow him to tax imports and incentivize exports, and that in turn would—supposedly—reduce the trade deficit. Unfortunately, that's a dumb thing to want to do; economics teaches us that there is nothing wrong with a trade deficit, since it is always accompanied by a capital surplus (if foreigners want to buy our financial assets instead of our goods and services there is nothing at all wrong with that). Fortunately, it looks like many economists as well as Republican lawmakers are unconvinced that switching to a border-tax regime makes sense, if for no other reason than that it would result in a massive change in the rules of the game for many companies and that could be quite disruptive. Why overhaul the whole tax system when a few simple adjustments to the current one (which admittedly could be improved) could do the trick?

A lot of sensible people I know would much rather see the current system get a few stimulative tweaks, such as reducing marginal tax rates on income, capital gains, and businesses, limiting deductions and subsidies, and slashing regulatory burdens. Those easy-to-implement measures would incentivize work, investment, and capital formation, and that in turn would help everyone, not just exporters. Let's hope simplicity wins out over complexity.

Core inflation has been running around 2% for a long time, but recently we have seen headline inflation move above the 2% level, thus effectively putting a stake through the heart of the deflation demon. With today's January CPI release we now see that underlying inflation pressures are beginning to exceed 2% per year. The headline CPI in January rose by much more than expected (0.6% vs. 0.3%), while both the core and ex-energy CPI rose by 0.3%. Over the past six months, the overall CPI is up at a 3.6% annualized rate, while the core CPI is up 2.5% annualized, and the ex-energy CPI is up 2.1% annualized. This is not enough to warrant a red alert at the Fed (energy still seems to be the major culprit), but it almost certainly means the FOMC will be raising rates sooner rather than later, and by more than the market expects, rather than less. At the very least inflation is set to become a key focus for the market in the months to come. If it looks like the Fed is falling behind the inflation curve (i.e., raising rates by too little, too late), that could be as disruptive to the economy as a failure to implement meaningful tax reform.


I've been featuring the chart above for a long time, and the story hasn't changed: abstracting from volatile energy prices, inflation at the consumer level has been averaging very close to 2% a year for more than a decade.



Over the past year, the CPI is up 2.5%, with energy prices (specifically, a rise in gasoline prices in January that has already been reversed in February) doing most of the work. Taken together, these first two charts aren't very scary. But if recent trends continue, then it will be time to start worrying.



What happened in January wasn't so much that overall prices actually rose, however. What happened was that they didn't stay flat or fall, as is usually the case around October-January. The chart above illustrates that, showing the 3-mo. annualized rise in the non-seasonally-adjusted CPI. The dots highlight the fact that actual inflation is almost always very low around the end of each year. The January report was an outlier; since seasonal adjustments expect price gains to be zero or negative around this time of year, a modest rise in actuality became a big jump after adjustments were applied.


Industrial production has been improving only modestly for the past year. It's encouraging that the Eurozone has been doing somewhat better, but so far it just looks like catch-up to the U.S.


January housing starts were down a bit, but previous months were revised upwards substantially. Given the relatively high level of builder sentiment, the trend of starts over the past year, and the ongoing rise in building permits, it's reasonable to expect residential construction to continue to contribute to growth for the foreseeable future, albeit modestly.



Industrial metals prices are up over 50% since the end of 2015, and that is impressive indeed. As the second chart shows, it is quite unusual for commodity prices to rise while the dollar is also rising (note that the blue line is the inverse of the dollar index). At the very least this suggests that global economic activity has strengthened. It's also possible that rising commodity prices are symptomatic of a rising inflation trend globally. I note that gold prices are up 17% over this same period, and gold is still significantly above its long-term, inflation-adjusted average price, which I calculate to be roughly $500-600 per ounce.

The road ahead looks promising, but there are still significant obstacles to overcome and nasty pitfalls. I think that's obvious to just about anyone, however, so I'm not sure the market is over-extended. For now I'm in the cautiously optimistic camp, mainly because I believe the economy has a tremendous amount of upside potential that is just waiting to be tapped. I think the pessimists are underestimating this, and underestimating the power of supply-side tax and regulatory reforms. I see too many articles arguing that Trump Stimulus is all about goosing spending, financed by bigger deficits—it's not. It's about unshackling the private sector and shrinking the public sector. That hasn't been tried for a long time, and the time to do it is ripe.

Thursday, February 9, 2017

Claims in uncharted waters; is the labor market too tight?


As the chart above shows, the hallmark of the onset of every modern recession has been a precipitous rise in new unemployment claims, each time from a relatively low level. Unemployment claims as a percent of the number of people working have now reached a new all-time low: only 0.17% of the workforce was laid off last week. Is another recession in the cards? Not necessarily. This statistic has been plumbing new lows for decades, and their is no a priori reason this cannot continue or merely stabilize at current or slightly lower levels.

But there is another cause for concern that is not much talked about. If, for example, Trump and the Republican Congress manage to push through a decent, supply-side tax reform package (e.g., one that at the very least lowers marginal rates for businesses and consumers in exchange for limits on and/or the elimination of many deductions, plus fewer subsidies), where will an expanding economy find more workers? There are precious few to be found among the ranks of those receiving unemployment benefits—fewer than ever before. Meanwhile, the population is growing rather slowly—about 0.8% this year, according to the Census Bureau—and the number of people of working age is growing even more slowly—about 0.6% this year (equivalent to 1.5 million new eligible workers), according to projections by the OECD. At its current sluggish growth pace—about 2% per year—the US economy is on track to add about 2.2 million new jobs this year. Based on just these numbers, it doesn't look like we have enough workers to run a bigger, faster-growing economy.

Don't be surprised if Keynesian economists (which includes many at the Fed) look at these numbers and start worrying about how "tight" the US labor market is, and how faster growth could quickly generate upward wage pressures as businesses compete for scarce workers, and how that in turn could spark higher inflation. Their natural inclination will be to call for higher interest rates to keep the economy from over-heating. It could be like deja vu all over again: over-heating was a phrase we heard quite often in the late 1990s, when the Fed was boosting rates even as inflation was falling. Back then the economy was growing at a heady 4-5% rate and stocks were soaring in the expectation that the good times would continue to roll.


However, I don't want to suggest here that we are going to find ourselves in another 2000-style bubble economy, because there are some very important differences between then and now. Back then real interest rates on TIPS were 4%, PE ratios were on the moon, and commodity prices were collapsing. Today, real interest rates on TIPS are less than 0.5%, PE ratios are only moderately above their long-term average, and commodity prices are rising. Back then the Fed was tightening aggressively, having pushed the real Fed funds rate over 4%, and the Treasury yield curve was flat to inverted—both classic signs of very tight money (see chart above). Today the real Fed funds rate is negative and the yield curve is positively sloped—both signs that money is definitely not tight, nor even close. Monetary conditions today are consistent with an economy that is enjoying a prolonged expansion.

So what is going to happen? How can the economy grow much faster if there aren't enough workers?



One way to thread this needle is to tap the huge number of workers—as many as 10 million, as the charts above suggest—who have left the workforce. Lower corporate income tax rates and reduced regulatory burdens would create new incentives for businesses to expand, and cutting marginal income tax rates would create new incentives for people to rejoin the labor force, by offering them more wage bang for their work buck. Let people keep more of what they make and they will likely be more willing to work more, or go back to work.

A dose of supply-side stimulus, in other words, should result in more jobs and more workers willing to fill those jobs. It needn't result in higher inflation.


If inflation becomes a problem in the years to come, it won't be because the economy is growing at a faster pace. It will be because a faster-growing economy goes hand in hand with increasing confidence, and increasing confidence will likely reduce the public's demand to hold the huge cash reserves that have been stockpiled in recent years (see chart above), and it will be because the Fed fails to take the steps necessary to offset declining money demand by shrinking the supply of excess reserves and/or raising interest rates by enough to maintain the banks' willingness to hold those excess reserves. In the end, inflation is a monetary phenomenon, not a by-product of faster growth. The Fed holds the key to inflation. A successful batch of supply-side, Trumpian policies holds the key to faster growth.

Friday, February 3, 2017

January jobs: more of the same

Job gains in January beat expectations by a significant margin (+227K vs. +180K), but from a big-picture perspective, nothing much has changed over the past six months or so. Private sector jobs (the ones that really count) are growing at a modest 1.8% rate, the rate which has prevailed since last summer. We've seen an uptick in animal spirits (e.g., consumer confidence, small business optimism, equity prices), but it hasn't yet translated into anything substantial on the employment front.


As the chart above shows, monthly changes in private sector jobs can be, and typically are, quite volatile. You can't draw strong inferences from one month's numbers.


The chart above looks at the rate of change in private sector jobs over the past six and twelve months. This has been roughly 1.8% since last summer, and that is a relatively slow pace even for this relatively tepid recovery. We'd have to see a few more months of job gains like January's before getting excited. I'm not saying this won't happen, just that it's premature to declare that the pace of economic growth has accelerated.


The growth of the labor force has been unusually weak for most of this recovery, but it has been improving somewhat on the margin for the past year or so. I'd expect this to continue.


Part-time employment has been fairly steady for the past seven years or so, and it has declined to a relatively low level compared to the total employment, as the chart above shows. This is the pattern which has prevailed in almost all modern recoveries. Nothing remarkable. 

Thursday, February 2, 2017

Trump Run

I've been skiing Deer Valley this week with my brother, and yesterday he took me to a run off the beaten path called "Trump," which you can see in the photo below. I note that it is a beginner's run, and goes to the right; I'm happy to report there was no sign of defacement. Today we were honored and pleasantly surprised to share our lift chair with Mitt Romney. Amazing coincidences.


Wednesday, February 1, 2017

Manufacturing outlook improves

The ISM January manufacturing report was somewhat better than expected (56 vs. 55). Whether this reflects actual improvement or improved sentiment and better things to come is tough to say, but at the very least it is encouraging.

As the chart above suggests, the January ISM manufacturing report is consistent with an improvement in overall economic growth in coming months relative to the anemic 1.9% growth in Q4/16 GDP.


The improvement in the employment index suggests that an increasing number of firms are planning to expand their hiring in coming months.


Manufacturing conditions in both the Eurozone and in the U.S. have been improving for the past several months. Meaningful improvement in the Eurozone economy has been a long time coming and thus is probably not fully appreciated by the market. A coordinated recovery in manufacturing conditions in Europe and the U.S. seems like too much to hope for, but that's what these reports are suggesting.