Wednesday, September 12, 2018

Can optimism make America great again?

It sure can't hurt. Thanks to sharply reduced tax and regulatory burdens, small business owners are more optimistic about the future than ever before. If we can make it through the current tariff wars, the US economy could experience surprisingly strong growth in the years to come.

Chart #1

Chart #1 shows how dramatically small business optimism rose in the wake of Trump's election. The index shown stood at 94.9 as of September '16. It now stands at a record-high level of 108.8. Trump gets pretty much all the credit for this, in my book.

Chart #2

Small businesses account for the great majority of jobs in the US. An index of the hiring plans of small business owners, shown in Chart #2, stood at 10 just before the November '16 elections. That has subsequently soared to a record-high 26 as of last month. New job creation is almost sure to increase as a result.

Chart #3

Not surprisingly, job openings already have increased by over 24% since October '16. I see no reason why this can't continue.

Chart #4

Since job openings now clearly exceed the number of people looking for a job (Chart #4), it is reasonable to think that companies that want and need more workers will inevitably have to entice more workers (that are currently on the sidelines, and which could conceivably total 8-9 million) to enter the workforce via better wages/salaries. What's not to like? All those new companies and expanding companies need more workers because they have, thanks to Trump, become more efficient and more productive. That alone justifies higher wages and salaries.

If Trump can turn his tariff wars (which I and others have argued are essentially negotiating tactics in the pursuit of more and freer trade) into tariff truces, then the future could hold very surprising and promising growth prospects. As I've said before, it makes little sense to bet against what could prove to be a win-win for all parties (i.e., if the threat of higher tariffs results in concessions that lead to lower tariffs, then all parties to international trade can win).


Monday, September 10, 2018

Key indicators are still healthy

This post recaps the market-based indictors that I think are very important to follow. On balance things look quite favorable. As always, all charts contain the most recent data available as of today (with a few exceptions, as noted, where I have estimated the latest datapoint).

Chart #1

I like to begin with 2-yr swap spreads (Chart #1), since they have proven to be excellent leading and coincident indicators of the health of financial markets and of generic or systemic risk (the lower the better, with 15-35 bps being a "normal" range). A more lengthy discussion of swap spreads can be found here. Currently, swap spreads are almost exactly where one would expect them to be if markets were healthy and the economy were growing comfortably. The current level of swap spreads also tells me that liquidity is abundant; i.e., the Fed has not squeezed credit conditions nor tightened enough to disturb the underlying fundamentals.

Note that swap spreads have increased meaningfully in advance of past recessions and have declined in advance of recoveries. At current levels, swaps are consistent with healthy financial markets and an improving economy.

Chart #2

Chart #2 shows the same 2-yr swap spreads over a shorter period, and it adds Eurozone swap spreads for comparison. I note that conditions in the Eurozone have not been as healthy as in the US for some time now, but conditions do appear to be improving on the margin of late. Not surprisingly, Eurozone stocks have underperformed significantly over the past decade. All eyes are thus on the US as the world's growth engine.

 Chart #3

Bloomberg publishes an index of financial conditions which incorporates a wide variety of market based indicators, shown in Chart #3. In contrast to the swap spreads chart, higher values of this index are good. Here again we see that financial conditions are healthy and have rarely been better.

Chart #4

Chart #4 shows 5-yr CDS spreads (credit default spreads). These instruments are widely utilized by institutional investors, and are considered to be a highly liquid proxy for generic credit risk. Today, CDS spreads are rather low, which is good, though they have at times been lower. As with swap spreads, these spreads tend to rise in advance of economic trouble. So far they show not sign of any threats.

Chart #5

Chart #5 shows average credit spreads for investment grade and high yield corporate bonds. They tell the same story as CDS spreads: conditions today are healthy. The bond market is not concerned about credit risk, nor is it concerned about downside risks to the economy.

Chart #6

Chart #6 is a classic, since it shows how Fed tightening has preceded every recession in the past half century. Monetary tightening shows up in different ways: 1) in the level of real short-term interest rates, over which the Fed has direct control, and 2) in the slope of the yield curve. When real short rates rise significantly and the yield curve becomes flat or inverts, a recession eventually follows. Today many worry that the yield curve is almost flat, but it's important to view this in the light of very low real short-term rates. This combination tells me that the Fed has not yet begun to tighten monetary policy. The current slope of the yield curve tells us that the market expects the Fed to raise rates gradually, and not excessively. To date, the various hikes in the Fed's target rate have served mainly to offset a gradual rise in inflation over the past year or so. At its current pace, the Fed is likely years away from becoming "tight."

Chart #7

Chart #7 compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS (inflation-indexed bonds). The difference between the two is the market's expected average rate of consumer price inflation over the next 5 years. Inflation expectations are relatively stable, and at 2%, they are almost exactly what the Fed is targeting. From this we can assume the Fed is doing a reasonably good job of balancing the supply and demand for money. This should be comforting and reassuring to a market that continually frets that something might be on the verge of going wrong.

Chart #8

Chart #8 compares the real yield on 5-yr TIPS to the inflation-adjusted (real) yield on the overnight Fed funds rate. The latter is the same series shown in the blue line of Chart #6 above. The comparison of the two here is important, since the red line is effectively the market's best guess as to what the blue line will average over the next 5 years. This is thus another way of judging the slope of the yield curve. A true yield curve inversion would almost certainly find the blue line exceeding the red line, as it did prior to the past two recessions, since this implies that the market expects the Fed to ease monetary policy in the future, presumably because of deteriorating economic health. According to Chart #8, the front end of the real yield curve is steepening, not flattening, and that is good.

The market is mistakenly focusing too much attention on the nominal yield curve. The real yield curve is more important, and its current message is definitely positive.

Chart #9

Real yields are driven in large part by the Fed's actions, especially in the very front end of the yield curve. However, 5-yr real yields are also driven by the market's perception of the health of the economy. Chart #9 shows how the level of real yields tends to follow the economy's trend growth rate. Currently, real yields are rising slowly, in line with the gradual strengthening of economic growth. There is no sign here of excessive optimism. If anything, both the market and the Fed are behaving in a cautiously optimistic manner.

On balance, all of these indicators are in healthy territory. Consequently, it is reasonable to assume that the economy is going to be growing for the foreseeable future. Systemic risks are low, inflation expectations are low and stable, and liquidity is abundant. The Fed has been doing a good job, and there is no sign they are going to upset any applecart. There's not much more you could ask for at this point.

We don't live in a risk-free world, however. For now, what risks there are, are concentrated in the trade-related sectors, thanks to the tariff wars that Trump seems to relish. Trade risks are undoubtedly acting as a headwind to growth, without which the market might be getting quite enthusiastic about the future.

UPDATE (9/11/18): Chart #10, below, shows just how dramatically US stocks have outperformed their European counterparts. An investment in the S&P 500 has returned 22% more than a similar investment in the Euro Stoxx 600 since just before Trump's election.

Chart #10


Thursday, September 6, 2018

Bullish charts: Manufacturing and corporate profits

The bullish case for the economy (and by extension the stock market) is getting stronger. Here are some charts using recent data releases that tell the story. Manufacturing activity has definitely picked up, and corporate profits are not only strong but rising, leaving equity valuations only moderately above average. All of this is symptomatic of an economy that is slowly but surely ramping up its growth engines, and an equity market that is cautiously pricing all of this in.

Chart #1

Chart #2

Chart #1 compares the ISM manufacturing index with the quarterly annualized growth of GDP. The manufacturing index is about as strong as it has ever been, and in the past, numbers like this have been consistent with GDP growth of at least 4-5%. Expect Q3/18 to be at least 4%, which in turn would make year over year growth in GDP the strongest in 13 years. Meanwhile, Chart #2 shows that the service sector remains quite healthy as well, more so than in the Eurozone.

Chart #3

Chart #3 shows the ISM new orders index, which is also rather strong. The October 2016 reading was 53.3 (just before the November '16 elections), and it has since jumped to 65.1. This is a good sign that business confidence has surged and that businesses are ramping up spending on new plant and equipment. This is the seed corn of future productivity growth and an excellent portent of a stronger economy to come.

Chart #4

Chart #4 compares the ISM manufacturing index to its Eurozone counterpart. Things aren't looking so good overseas of late, which is unfortunate. But this could simply be a reflection of the fact that with the big drop in corporate tax rates in the U.S., businesses are pouring resources into the US at the expense of Europe, where tax rates are still high.

Chart #5

Chart #5 shows the ratio of after-tax corporate profits (as measured by the National Income and Product Accounts, which in turn are based on data submitted by corporations to the IRS) to nominal GDP. By this measure, corporate profits have rarely been so strong. This is of course due in large part to the reduction in corporate tax rates. Skeptics will say that lower tax rates have simply lined the pockets of the fat cats, and that little or none of this will trickle down to the little guy. I think this is a very short-sighted way of looking at things. What is the first thing that corporations do when they find that their profits are growing? From my experience, having known and worked with many senior corporate executives, increased profits are the trigger for increased investment. No one wants to leave profitable activities unexploited.

Chart #6

Chart #6 compares the yield on BAA corporate bonds, which I use as a proxy for the overall yield on all corporate debt, to the earnings yield (the inverse of the PE ratio) of the S&P 500, which I use as a proxy for the earnings yield of all corporations (i.e., the rate of return on a dollar's worth of investment in US corporations). As the chart shows, the past decade or so has a lot in common with the late 1970s; during both of those periods corporate bond yields and equity yields were very similar. During the boom times of the 80s and 90s, however, the earnings yield on stocks was much less than the yield on corporate bonds.

If the economy was humming along and confidence was high, you would expect the earnings yields on stocks to be less than the yield on corporate bonds. Why? Because corporate bonds have the first claim on corporate earnings—it's safer to own bonds than it is to own equity. Equity investors have a subordinate claim on earnings, but they are generally willing to give up current yield  in exchange for greater total returns.

The fact that earnings yields and corporate bond yields are roughly equal these days tells me that investors aren't too confident that corporate profits will remain as strong as they have been for much longer. That's a sign of risk aversion, and risk aversion has been one of the hallmarks of the current business cycle expansion. I've been arguing for a while that risk aversion is slowly on the decline, and I expect that to continue.

Looking ahead, earnings yields will probably stay flat or decline (i.e., PE ratios will probably remain steady or rise), while the yield on corporate debt should rise in line with rising Treasury yields, which in turn will be driven by more confidence and less risk aversion.

Chart #7

Chart #7 shows the current PE ratio of the S&P 500. This is calculated by Bloomberg using 12-mo. trailing earnings from continuing operations. At just under 21 today, PE ratios are somewhat higher than their long-term average.

Chart #8

Chart #8 shows the PE ratio of the S&P 500, but using the NIPA measure of all corporate profits instead of reported GAAP earnings. Here we see that equity valuations are only slightly higher than average, and far less today than they were during the "bubble" of 2000. 

Chart #9

Chart #9 shows the difference between the earnings yield on equities and the yield on 10-yr Treasuries. That's a measure of how much extra yield investors demand to bear the risk of equities instead of the safety of long-term Treasuries. In the boom times of the 80s and 90s, investors were so confident in the value of equities that they were willing to accept an earnings yield that was substantially below the interest rate on Treasuries. For the duration of the current recovery, however, that has not been the case at all. That's another way of appreciating just how risk averse this recovery has been.

Chart #10
 

Chart #10 shows the PE ratio of the S&P 500 using NIPA profits (instead of GAAP profits), and Shiller's CAPE (cyclically adjusted price to earnings ratio) method of calculation. (Current prices divided by a 10-yr trailing average of after-tax quarterly profits.) Here we see that PE ratios are only slightly above their long-term average. That's another way of saying that equities are far from being over-valued.

Saturday, September 1, 2018

Chart of Shame

Courtesy of Newsalert and MarketWatch, here is a chart that memorializes all the bearish calls of well-known analysts over the past six years.

For the record, I have been consistently optimistic/bullish since December 2008. That call was a bit early (the bottom came three months later), but anyone who bought then and held through today is undoubtedly very happy with the results.

click to enlarge

HT: Brian H.

Wednesday, August 22, 2018

Keep on truckin'

Chart #1 is one of the most bullish I have in my extensive chart inventory:

Chart #1

The nations' extensive fleet of trucks has hauled almost 8% more tonnage in year ending July '18. Since just before the November 2016 election, truck tonnage is up 15%. This is powerful evidence that the physical economy is expanding, and at an impressive rate.

Meanwhile, I see and hear more and more evidence of a pickup in business investment. My brother-in-law is in the midst of significantly expanding his fleet of trucks to handle new business, and he is scrambling to get it done before immediate expensing expires. Incentives DO matter to business. Businesses are ramping up investment, and we should see increasing evidence of this in the months to come.

UPDATE (Aug 24): More signs of increasing business investment. Chart #2 shows capital goods orders, which are a direct indicator of business investment. Orders are up 15% since the end of 2016, likely boosted by tax reform, after declining over the previous four years. Orders are up 8% in the year ending July '18. (Note: I'm using a 3-mo. moving average for capex orders in the chart in order to correct for what appears to be faulty seasonal adjustment. The percentage changes referred to above are based on monthly data.) I would add that while nominal orders have been rising at a fairly impressive rate of late, they are still down significantly in real terms compared to where they were in the early 2000s. What this means is that business investment has been rather tepid in the past 18 years, and that is undoubtedly one of the reasons the economy experienced a weak recovery following the 2008-9 recession.

Chart #2

Sunday, August 19, 2018

Minimum wage facts and fantasies

For years I've had fun at cocktail parties by asking this question: what percent of all the people who work in the U.S. are paid minimum wage or less? Of the hundreds of people I've asked, only one has come even close to the right answer. The great majority of the answers I've received (try it yourself!) range from 10% to as much as 50%. My conclusion: A huge number of Americans hold the fantasy belief that a significant percentage of those who work would benefit from raising the minimum wage.

Fact: only 0.5% of those who work take home minimum wage or less.

The facts can be found in a BLS publication from earlier this year: Characteristics of Minimum Wage Workers, 2017.

In 2017, 80.4 million workers age 16 and older in the United States were paid at hourly rates, representing 58.3 percent of all wage and salary workers. Among those paid by the hour, 542,000 workers earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.3 million had wages below the federal minimum. Together, these 1.8 million workers with wages at or below the federal minimum made up 2.3 percent of all hourly paid workers.

According to the BLS establishment survey, there were 147 million people employed in 2017 (those paid by the hour plus those who received a salary), so the percentage of all the people working who were making minimum wage or less was 1.8 /147 = 1.2%. Furthermore, according to the BLS, some 1.3 million of all those who work in the U.S. made less than the minimum wage. In percentage terms, a bit less than 1% (1.3/147) of those who worked in 2017 made less than minimum wage.

But here's where it gets really interesting: "The industry with the highest percentage of workers earning hourly wages at or below the federal minimum wage was leisure and hospitality (11 percent). About three-fifths of all workers paid at or below the federal minimum wage were employed in this industry, almost entirely in restaurants and other food services. For many of these workers, tips may supplement the hourly wages received."

If we assume that the vast majority of those who worked in the restaurant and food service industry (10 million) actually took home at more than the minimum wage (thanks to tips), then in 2017 there effectively were only about 700 thousand people (0.5% of all workers) who actually took home minimum wage or less. Big, under-reported fact: in all likelihood, 99.5% of those who worked in 1017 took home more than the minimum wage for their efforts, and without any help from government fiats. 

So the next time you're at a cocktail party, ask the person next to you to guess the percentage of U.S. workers that earn minimum wage or less. You won't be lying when you tell them it's about ½ of 1%.

Raising the minimum wage would presumably benefit less than 1% of the working population, but it would most likely make it harder for young and inexperienced workers to get a job. It's already hard enough: the unemployment rate for those aged 16-19 is 13.1%, by far the highest unemployment rate for any age cohort. (The unemployment rate across all age groups today is a mere 3.9%.) Politicians should be lobbying to reduce or eliminate the minimum wage, not increase it. The best way for someone to make more than minimum wage is to first get a job, any job, at any wage, then work your way up. 

Tuesday, August 14, 2018

Small business optimism is huge

Economic growth is a function of two major factors: growth in the number of people working, and growth in the output of those working (i.e., the productivity of labor). For most of the current business cycle expansion, which has been the weakest post-war expansion on record, productivity has been unusually weak, averaging about 1% per year. Prior to the Great Recession, productivity averaged over 2% per year. Productivity and jobs growth are in turn a function of investment, and investment—no surprise—has been unusually weak for the past 9 years, despite the fact that corporate profits have been unusually strong. Investment is the seed corn of future growth, since investment builds new businesses, creates new jobs, and gives workers the advanced tools necessary to increase their productivity. 

Something has been holding back the economy, and it might be as simple as a general unwillingness on the part of business to expand and invest in new plant and equipment. Confidence is key, and confidence has, until fairly recently, been low. Risk aversion, by the same token, has been rather high.

(Note my supply-side bias: Supply-side economists believe that investment, hard work, and risk-taking are what drive the economy, not spending. In our global economy, total spending can never exceed total production. Increased production (supply) is the key to increased spending (demand). Beware of all those economists who say the economy is weak because the consumer is not spending enough; they are not seeing the whole picture.)

If the economy is going to grow by 3% or more, productivity is going to have to increase (and maybe jobs growth, but not necessarily), and that means that investment is going to have to increase. Increased investment is likely to follow from lower corporate tax rates, and from increased confidence and an increased willingness to take risk. Thanks to the bulk of Trump's policies, we have the essential ingredients for a stronger economy: lower tax rates on business and business investment, reduced regulatory burdens, and a more business-friendly climate in Washington. There are early indications that the economy is picking up steam (e.g., business investment is up in the past 18 months, and real yields are up), but it's still premature to declare victory. 

Here are two charts which are particularly impressive in this regard, since they document a pronounced and sustained increase in small business optimism and hiring intentions—an increase that dates to December 2016, just days after Trump was elected. Small businesses generate the vast majority of new jobs, and they are a vital source of innovation and productivity. These charts argue convincingly for a stronger economy in the months and years to come, thanks to increased business optimism and investment. (Both charts reflect survey results as of July '18, released today.)

Chart #1

Chart #2

Unfortunately, things are never so straightforward. While we undoubtedly have the essential ingredients in place for a significant pickup in economic growth, we also have—from the same pro-growth Trump who advocated for lower tax and regulatory burdens—an escalation of tariffs, which suppress growth by making imports more expensive for everyone.

I think Trump's ultimate objective is to reduce tariff barriers. I think he sees higher tariffs as a negotiating tool to eventually arrive at a reduced and even zero-tariff world. But for his negotiations to succeed, he has to convince our trading partners (particularly China) that he is willing to sacrifice some portion of US growth to achieve a result that would eventually be a win-win for all concerned. Suffice to say that this is a delicate balancing act. I'm optimistic he will succeed, but my confidence in that belief is not as strong as I would like it to be.

In short, Trump's tariffs are, for the time being, a headwind to growth, while his other policies are a tailwind.

Tuesday, August 7, 2018

Who needs gold when real growth is picking up?


Chart #1

I've been posting updates of Chart #1 for at least the past 5 years. It never ceases to amaze me that the prices of two different assets should be so highly correlated. Of course, gold and TIPS do share a few things in common: both offer promises/guarantees of some sort. Gold promises to maintain your purchasing power over time, and TIPS offer you a government-guaranteed real rate of interest. Both, in other words, offer a form of protection against inflation, and both can be considered "safe" ports in an economic and/or financial market storm.

(Note: in the chart I have used the inverse of the real yield on 5-yr TIPS as a proxy for their price. Like any bond, the price of TIPS goes up as their real yield declines, and vice versa.)

For the past year this chart has been suggesting that gold prices were lagging the decline in TIPS prices. Gold now appears to be "catching up." Awfully tempting to see gold prices move still lower.

Why should these two asset prices tend to correlate so well?

Gold and TIPS prices rose in the late 2000s as the economy crashed. A weaker economy made gold more attractive because many figured that monetary easing in response to significant economic weakness might spark a rise in inflation. And gold is a natural safe place to hide when there is economic and financial market chaos. TIPS rose in price as well, because there was strong demand for the guaranteed real yields that they paid when other asset prices were collapsing.

For the past 5 years, gold and TIPS prices have been irregularly declining, because the market is coming to appreciate that the outlook for economic growth is improving, and that lessens the need for accommodative monetary policy and that in turn lessens the risk of an unexpected rise in inflation. Moreover, the returns on other assets have been very attractive of late, and that weakens demand for gold and TIPS because neither promise much in the way of return (gold pays nothing, and the real yield on TIPS is meager). Plus, there is just less need these days for the security and safety of either asset. And of course there is less demand for inflation hedges now that we have seen two decades of inflation averaging 2% or less, and now that the Fed is beginning to reverse its quantitative easing stance.

Chart #2

Chart #2 shows how real yields on TIPS do indeed track changes in economic growth fundamentals. A very strong economy in the late 1990s saw very high real yields on TIPS, whereas the past decade of sub-par economic growth has seen very low real yields. Both growth and real yields have been moving higher in recent years.

Thursday, August 2, 2018

Putting Apple's $1 trillion in perspective

By now everyone knows that Apple's market cap has reached $1 trillion. I offer the following chart for perspective on Apple's achievement. I've included Microsoft's market cap, since for many years it was assumed that personal computing was owned by Microsoft and that Apple was doomed. I've owned AAPL shares since 2003 (and still do), and have posted several times over the years on the virtues of Apple, beginning with this post in early 2009. It's a wonderful success story.


Tuesday, July 31, 2018

Housing market update: slowing but not collapsing

I'm seeing a significant increase of late in stories which suggest that the housing market has peaked and could be in trouble. Not everything is rosy, to be sure, but from what I can see, the worst that can be said about the housing market is that it is cooling off. The following charts tell the story:

Chart #1

As Chart #1 shows, an index of the prices of homebuilders' stocks is down about 25% since last January. That's a big correction that could easily be the start of a major decline, much as we saw happen in 2006-2009. So: is housing history likely to repeat? It's tempting to say we've seen a major top in this market, but I would note that we have seen corrections such as the current one quite a few times in the past. If anything, it might just be the case that prices got a little too exuberant towards the end of last year and have now come back down to a more reasonable. level.

Chart #2
Chart #2 shows an index of housing affordability, which has dropped considerably in the past 5 years. But if you read the fine print at the bottom of the chart, you find that it is still the case that the average family has an income that is more than sufficient to qualify for mortgage big enough to buy a median-priced home using conventional financing. Prices are up and mortgage rates are up, but so are incomes, and the economy is in pretty good shape. All things considered, homes are still "affordable," only much less so than they were a few years ago.

Chart #3

Chart #3 shows that 30-yr fixed mortgage rates have been roughly flat at very low levels for the past six years. For most of my lifetime, today's 4 ½% mortgage rate would have been unthinkably low. Mortgage rates are not a problem in today's market.

Chart #4

Chart #4 compares the level of housing starts with an index of homebuilders' sentiment. Here we see that starts are still substantially lower than they have been in the past, while sentiment is about as healthy as it has ever been. This further suggests that there is plenty of upside to housing construction. On the other hand, starts have been relatively flat for the past year or so, so new construction appears to have run out of steam, at least for now. A pause that refreshes?

Chart #5

Chart #5 shows that building permits still appear to be in an upward trend. By past standards, we have yet to see a frenzy of home building. If anything, new housing construction has been relatively weak and continues to be so. 

Chart #6

Existing home sales also appear to have flat-lined in recent years, as we see in Chart #6.

Chart #7

Chart #7 shows the long-term history of housing starts. As with Chart #4 above, we see that starts are still quite low from an historical perspective.

Chart #8

Chart #8 shows that the inventory of unsold homes is still quite low. 

Chart #9

Chart #9 compares residential fixed investment (i.e., home building and related activity) to GDP. Here we see that residential construction spending is still very low compared to the rest of the economy. Activity has rarely been this low, in fact. Note the surge in activity that preceded the bursting of the housing bubble in 2005. We are nowhere near that today.

Chart #10

Chart #10 shows an index of the volume of new mortgage applications (i.e., mortgages originated for the purchase of a home, as distinct from mortgages originated to refinance an existing home). Here again we see that activity is still far below the bubble levels of 2005. Today, new mortgages are being originated at less than half the rate they were in 2005. Recall that a big factor behind the housing market collapse that started in 2005 was the wild and crazy way that banks were lending: inverse floaters, zero down payments, stated income, etc. Nothing like that is happening today. 

Chart #11

Chart #11 shows the real and nominal level of housing prices nationwide, according to the folks at Case Shiller. Here we see that prices have been rising in line with historical trends. Over the long haul, this chart suggests that housing prices in inflation adjusted terms tend to rise by a little less than 2% per year. This can be explained by the fact that houses today are bigger and better-appointed than they were in the past. Prices today are still well below their bubble highs when adjusted for trend growth and inflation.

One caveat to Chart #11: the Case Shiller methodology uses a three-month moving average of prices, reported with a 2-month delay. Thus, the prices reported today were the average of prices in the March-April-May period, and they were up some 5-6% from the previous year. It is likely that price increases have slowed considerably in recent months, if we are to believe the anecdotal evidence.

Taking all this into consideration, it looks to me like rising prices are the logical result of a scarcity of supply coupled with relatively strong demand. This can't go on forever, though. Prospective home buyers are being gradually squeezed by rising prices, a scarcity of supply, and a decline in affordability. Higher prices signal a relative scarcity of housing (with local zoning codes to blame in many areas, unfortunately), and higher prices are slowing housing activity in general by making it harder to afford a house. But there is no reason to think that prices are going to collapse, unless of course the whole economy collapses. The housing market is cooling off, but not about to collapse.

Wednesday, July 25, 2018

Winning at trade requires zero

Here is some excellent news that just recently hit the tape:

President Trump on Wednesday declared a “new phase” in the relationship between the U.S. and the European Union, agreeing to hold off on proposed car tariffs and work with the EU to resolve their dispute over metals duties, while also promoting bilateral trade. 
Speaking in the Rose Garden of the White House alongside European Commission President Jean-Claude Juncker, Mr. Trump said the U.S. and the EU had agreed to “work together toward zero tariffs, zero non-tariff barriers and zero subsidies on non auto-industrial goods.” 
“This was a very big day for free and fair trade,” Mr. Trump said. He said the U.S. and EU would “resolve” the steel and aluminum tariffs he imposed earlier this year and the retaliatory tariffs the EU imposed in response.

These are the key words: work together toward zero tariffs, zero non-tariff barriers and zero subsidies. Free and fair trade requires the absence of government-imposed restrictions and subsidies. Trump gets this; he's not a madman intent on starting another global trade war. He knows tariffs are bad and even stupid. But the route he chose to get to the goal of zero was circuitous and risky, and he has been justly criticized on both sides of the political aisle for unilaterally imposing tariffs on our major trading partners. He had to credibly threaten to raise tariffs in order to lower them. This could be the beginning of a new era in global trade and prosperity.

If Trump can convince China to follow the European example, the future will look bright indeed.

As I said in my last post, I continue to believe that tariffs are so universally understood to be bad and even stupid that eventually our leaders will do the right thing and make trade freer and fairer. Why bet against what would be a win-win for all parties?

As it has for many years, it makes sense to remain optimistic about the future.

Wednesday, July 18, 2018

Why are interest rates so low?

Late last year, in my Predictions for 2018, I thought the main theme for the year would be "waiting for GDP." Policy changes in the previous year had set the stage for much stronger growth, higher interest rates, and a stronger dollar, but I thought the market would be skeptical until clear signs of stronger growth emerged. While there is still every reason to believe economic growth is accelerating, the evidence of a new economic boom is still not yet conclusive. The economy is improving on the margin, but budding tariff wars are dampening enthusiasm and keeping risk aversion alive.

Interest rates have moved higher over the course of this year: 5-yr real yields on TIPS have increased from 0.3% to 0.7%, and 10-yr Treasury yields have risen from 2.3% to almost 2.9%, paced by a 0.5% boost to the Fed's short-term interest rate target. That's small potatoes in the great scheme of things. Both the bond market and the Fed have priced in somewhat stronger growth, but these moves are still modest compared to what one would expect from a solid package of supply-side tax cuts and reduced regulatory burdens such as we saw enacted last year. These things take time, to be sure, and we're still in the early innings. Meanwhile, the risk of tariff wars is driving demand for hedges, and Treasuries are the market's favorite port when economic storms threaten. Consequently, interest rates arguably are still depressed relative to where they should be in a robust growth environment.

Back in December I cautioned that higher interest rates would not be well-received, and a month later the equity market shed over 10% of its value in a few days. More recently, nerves have been tested as US-China trade relations deteriorate and reciprocal tariff hikes are announced. In December I thought that further gains in equity prices would not come from higher earnings multiples but rather from rising earnings; so far, the PE ratio of the S&P 500 has fallen from 21.7 to 21.3, and earnings per share (based on trailing 12-month reported earnings) have increased only modestly, from 123.2 to 132.1. Earnings are going to have to continue improving if equities are to march still higher, and that is all part and parcel of a ratcheting up of economic growth that is likely underway but still not yet obvious.

In the meantime, as we await news of unusually strong economic activity, a stronger dollar has accompanied weaker commodity and gold prices, and all have conspired to squeeze emerging market economies, much as I feared. But the dollar is only moderately strong, commodity prices are still quite strong, and the Fed has yet to tighten monetary policy, so the pressure on emerging market economies is nowhere near what it was in the late 1990s and earl 2000s. I think we'll see emerging markets begin to recover, especially as—and if—evidence of a stronger US economy emerges.

Chart #1

The point of Chart #1 is to demonstrate that real yields tend to track the real growth rate of the economy. Currently, real yields on 5-yr TIPS (the best market-based proxy for short-term real yields I know of) are consistent with economic growth of about 2.5% per year. This happens to be only slightly higher than the 2.2% annualized growth the economy has registered since mid-2009, when the current business cycle expansion began. If the market (and the Fed) were convinced that real growth would be 4% or better, we would very likely see real yields on TIPS trading in the range of 3% or so.

Chart #2

Chart #2 demonstrates the link between market-based real yields on 5-yr TIPS, and the ex-post real yield on the Fed's target funds rate. The real funds rate is the Fed's true target, since that is the best measure of borrowing costs. Note that the real funds rate has been zero or less for the past decade, and it hasn't increased much, if any, for almost a year. The red line, the real yield on 5-yr TIPS, is essentially the market's expectation for what the blue line will average over the next 5 years. The market is not expecting the Fed to do much in the way of tightening, but it is definitely pricing in somewhat tighter policy for the foreseeable future.

Chart #2 is also a good way to look at the shape of the real yield curve, which is arguably more important than the shape of the nominal curve, which has been flattening for the past several years (the 2-10 spread is now down to about 25 bps). What we see in Chart #2 is that the real yield curve has been steepening over the past year—expectations of future real rates have risen relative to current real rates. Taken together, the shape of the real and nominal yield curves tells us not that the economy is being squeezed, but rather that neither the market nor the Fed are very enthusiastic about the idea of a stronger economy. 

Chart #3

Chart #3 shows that nominal Treasury yields have been unusually low relative to the prevailing rate of inflation for the past seven years. Only in the past year have nominal yields begun to catch back up to inflation—and they're still relatively low. The fact that the bond market has been willing to accept only paltry real yields for so long is a function, I believe, of a relatively strong degree of risk aversion and a lack of enthusiasm for real growth prospects. Markets have been willing to accept minimal returns in exchange for the safety of Treasuries. In a stronger growth environment, this would not be the case. If inflation holds around 2% and the economy picks up convincingly, I would expect 5-yr Treasury yields to rise to 4% or more.

Chart #4

Chart #4 compares the ISM manufacturing survey to quarterly real GDP growth. If there is any one chart that makes the case for a significant pickup in growth, this is it. Based on past experience, the current ISM reading suggests second quarter growth could be well in excess of the 4% that is currently expected. But that tells us nothing about the long-term outlook for growth. The second quarter GDP release is almost certain to be strong, but doubts still linger about later quarters.

Chart #5

Chart #5 shows the growth rate of private sector jobs. Much has been made of recent "strong" jobs reports, but the truth is that the growth of jobs remains rather mild compared to recent years. The best that can be said is that the growth of jobs over the past 6- to 12-months has increased from 1.6% several months ago to now about 2%. With these kinds of numbers, strong-growth skepticism is warranted. In order to get 4% or better GDP growth, we're going to need a big increase in productivity, and that in turn is going to require lots of new investment. I think we'll see it, but we can't find the evidence yet. 

Chart #6

Today's release of June housing starts was disappointing (+1273K vs +1320K), but as Chart #6 shows, starts can be very volatile from month to month. Strong sentiment readings from builders suggests we haven't yet seen the peak in housing construction, but for the time being housing is not going gangbusters.

Chart #7

Architecture billings have been in positive (increasing) territory for quite some time now, and that points to increased construction spending for the next 9-12 months, according to the AIA. But compared to past cycles, it's hard to see anything like a boom underway.

Chart #8



Chart #8 compares industrial production in the U.S. to that of the Eurozone. Production is rising, but not by much compared to prior peaks. 

Chart #9

If conditions in the U.S. were booming, not only would you expect to see much higher interest rates, you would also expect to see a very strong dollar. However, as Chart #9 shows, the dollar today is only modestly higher than its long-term average vis a vis other currencies.

Chart #10

In past cycles, a strong dollar has tended to correspond to weak commodity prices (note that the dollar is plotted on an inverted scale in Chart #10) and vice versa. But: although the dollar today is a lot stronger than it was 5 years ago, commodity prices are roughly unchanged compared to 2013. That's good news for emerging market economies, since they are particularly sensitive to commodity prices. They are also sensitive to competing returns in the U.S. and other developed economies. Despite the relative strong dollar, it remains the case that real returns in developed economies are still unusually low, and commodity prices are still historically high. So recent concerns about emerging market economies are likely overblown. Look for some recovery from recently-depressed levels.

Chart #11

In the final analysis, the biggest concern these days is the potential fallout from escalating tariff wars. To give Trump the benefit of the doubt—which not many are willing to do these days—his ultimate objective is to lower all tariff and non-tariff barriers, and he believes this can be accomplished only by a demonstrated willingness to do the opposite: Trump is playing a game of "tariff chicken." Chart #11 shows facts that he arguably believes bolster his strategy. In the past 12 months, the US has imported about $525 billion of Chinese goods, while at the same time exporting to China only $135 billion. China is selling almost four times more "stuff" to us than we are selling to them. So, the thinking goes, if both countries jack up tariff rates to prohibitive levels, the Chinese have much more to lose than we do, particularly since our economy is still half again as big as China's. At some point the Chinese will wave the white flag, we'll all agree to reduce or eliminate tariffs and intellectual property right theft, and sweetness and light will return to international trade relations.

We can't rule out a successful end to today's tariff wars, but neither can we be confident that they will inexorably lead to a repeat of the Smoot-Hawley tariff wars which in turn led to the Great Depression. I continue to believe that tariffs are so universally understood to be bad and even stupid that eventually our leaders will do the right thing and make trade freer and fairer. Why bet against what would be a win-win for all parties? (Zero tariffs are an economist's dream, since by facilitating free trade they would be a boon to all countries.) So I remain optimistic, but there is ample reason for many to remain cautious and concerned.

And that is another reason why interest rates remain so low and the U.S. economy appears to be reluctant to take off for points north of 4%.