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 #12 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 Recession. 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%.

Friday, June 29, 2018

Corporate profits are huge

I've had many posts over the years highlighting the strength of corporate profits. This post adds to the list, but it is notable for being the first to highlight the impact of Trump's tax reform on after-tax corporate profits. As I mentioned last December, Trump's reduction in corporate income taxes translated (via math) into a 20% one-time boost to the after-tax profits of a given level of nominal profits. According to yesterday's release of revised GDP stats for the first quarter, after-tax corporate profits (adjusted for inventory valuation and capital consumption allowances, a measure Art Laffer convinced me was the best, being based not on GAAP profits but on true economic profits using IRS filings) reached a record $1.92 trillion (annualized), up almost 17% from a year ago. That's equal to 9.6% of GDP, a level that has been exceeded in only 4 quarters in our nation's recorded history. After-tax profits are likely to move higher still, once the full impact of lower corporate income tax rates filters through to the data as the year advances.

Corporate profits paint an attractive picture for today's investors, since equity valuations seem only moderately higher than their long-term averages, even as profits reach very high levels relative to GDP, as I discuss below.

 Chart #1

Chart #1 compares after-tax corporate profits to nominal GDP. Over the past three decades, profits have increased at a much faster pace than nominal GDP. (Note that the two y-axes have a similar ratio from bottom to top, and both are semi-log.)

 Chart #2

Chart #2 shows the same measure of profits, but as a percent of nominal GDP. Note that for many decades prior to the current business cycle expansion, the ratio of profits to GDP averaged just over 6%. Five years ago I thought that the market was skeptical that profits would remain at such "elevated" levels and would inevitably revert to their 6% of GDP mean. Yet profits just get stronger. If there has been any long-term theme in my posts since late 2008, it's that the future ends up being better than the market expected, even though the economy's growth rate has been sub-par. The market has held relatively dismal expectations for many years, and has been pleasantly surprised. That's why equity prices have been moving higher.

 Chart #3

Chart #3 shows the traditional measure of stock market valuation: the ratio of trailing 12-month after-tax profits per share to share price (using reported earnings from continuing operations). Currently, the PE ratio of the S&P 500 is 20.9 by this measure. That's higher than the 16.8 average since 1960, but it is also lower than past extremes.

Chart #4

Stocks are attractive today because they have an earnings yield of 4.8%, which is substantially higher than the 2.8% yield on 10-yr Treasuries (see Chart #4). Consider: the PE ratio of a 10-yr Treasury bond is 35! With stocks, you get a much better yield than risk-free Treasuries, plus you get plenty of upside should the economy continue to exceed what are still modest growth expectations. These conditions hold only because the market continues to worry that future profits will inevitably revert to their historical mean.

 Chart #5

Chart #5 substitutes after-tax corporate profits using the National Income and Product Accounts for the traditional measure of GAAP profits (i.e., reported earnings). I've normalized the ratio so that the long-term average is similar to that of the traditional PE ratio. Note the extreme overvaluation of stock prices in the late 1990s. Today's valuations by this measure are very close to their long-term average. (I discuss the difference between NIPA and GAAP profits in this post.)

A disinterested observer might look at the charts above and wonder why stocks aren't more expensive, especially relative to risk-free bonds. One reasonable answer would be that the market must be worried about another collapse or correction or even a recession. To be sure, there are legitimate things to worry about, chief among them being that Trump's tariff wars could get out of hand and precipitate a global recession. Quite simply, today's valuations imply that risk aversion is still alive and well, a theme I've revisited many times in recent years.

Tuesday, June 19, 2018

The US keeps on truckin'

Truck tonnage continues to post significant gains, according to the American Trucking Association's latest release. Tonnage is up 7.8% year over year, and it is up at an annualized rate of 7.8% year to date.

Chart #1

Chart #1 is an updated version of the one in my post last month, "Truck tonnage evidence of a Trump Bump." As it suggests, there is a strong correlation between truck tonnage—a good proxy for the physical size of the economy—and equity prices.

From the ATA's latest release, including some relevant facts:
“This continues to be one of the best, if not the best, truck freight markets we have ever seen,” said ATA Chief Economist Bob Costello. “May’s increases, both sequentially and year-over-year, not only exhibit a robust freight market, but what is likely to be a very strong GDP reading for the second quarter.

Trucking serves as a barometer of the U.S. economy, representing 70.6% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

For all the reported angst over Trump's escalating trade war with China, the Vix/10yr ratio has barely budged (see Chart #2), which suggests the market does not expect much if any damage to occur as a result. My own assessment is that rising tariffs are acting as a headwind to growth, but that this will not prove terribly disruptive. Without this headwind, the economy would likely be on its way to sustained growth of 4% or more; with the headwind, we're more likely to see 3-4% growth. For Trump's purposes, I believe, higher tariffs are a temporary disruptive factor that is necessary to achieve a long-term reduction in overall tariff barriers and freer overall trade. It's a risky gambit, to be sure, which could backfire if China continues to counter Trump's tariffs with more of their own. But in the end, tariffs are so universally understood to be counter-productive that I find it hard to believe the escalation won't reverse sooner or later.

Chart #2

Meanwhile, the ongoing flattening of the yield curve (see Chart #3) is not a danger signal. It's more accurate to say that it reflects the market's judgement that, if anything, tariff wars will keep the Fed from hiking rates more than just a few times over the course of the next year, because the economy is not likely to "overheat." To date, no one is suggesting the economy will prove so weak that the Fed will need to lower rates: that's what would be necessary for the curve to invert. We'd also need to see much higher swap and credit spreads, which so far remain quite low, as I noted yesterday.

Chart #3

Monday, June 18, 2018

Key credit indicators still green

A typical boom-bust cycle starts with the Fed tightening monetary policy, usually in response to rising inflation and/or an economy that seems to be "overheating," or growing too rapidly. Prior to late 2008, when the Fed began its Quantitative Easing, tighter monetary policy worked by draining liquidity (i.e., by making bank reserves scarce and thus restricting banks' ability to create new loans), which in turn led to higher real borrowing costs and a general credit squeeze. Tight credit conditions and rising borrowing costs dealt a one-two punch to leveraged borrowers, and the bond market expressed this by pushing credit spreads higher as default risk rose.

We are now 2 ½ years into a Fed rate-hiking cycle: the Fed started raising short-term rates in late 2015 from a low of 0.25% to now 2.0%. Real yields have risen from -1.5% to now about zero—still very low from an historical perspective. Not surprisingly (since there has effectively been no tightening), there are still no signs of rising systemic risk or deteriorating credit conditions. Credit spreads remain low and liquidity remains abundant. Although the Fed has been draining bank reserves, they are still magnificently abundant, totaling about $1.9 trillion. 

Bottom line: the Fed "tightening" cycle looks very different today than in the past, mainly because bank reserves are still quite plentiful and real borrowing costs are still very low. 

Chart #1

Chart #2

Swap spreads, shown in Chart #1, have traditionally been excellent coincident and leading indicators of economic and financial market health. (See my primer on swap spreads for more background.) Currently, swap spreads are generally low and fully consistent with healthy financial and economic conditions. Low swap spreads are also indicative of plentiful liquidity conditions and healthy risk appetites. Eurozone swap spreads (see Chart #2) are a bit elevated, however, suggesting that conditions in Europe are not as healthy as in the U.S. Not surprisingly, we observe that the Eurozone stock market has been underperforming the U.S. by a widening margin for the past decade. But despite their being elevated, Eurozone swap spreads are not indicating a serious credit squeeze..

Chart #3

Chart #4

Chart #3 shows the spreads on investment grade and high yield (aka "junk") corporate bonds, and Chart #4 shows the difference between these two spreads. All three measures of corporate credit risk are low by historical standards, and they appear to have been improving in recent years.

Chart #5

Chart #5 shows Credit Default Swap spreads for 5-yr investment grade and high-yield corporate bonds. Credit Default Swaps are highly liquid contracts used by institutional investors to hedge generic credit risk. Here too we see that spreads are quite low.

Chart #6

Chart #7

Chart #6 compares the yield on 5-yr A1-rated industrial bonds to the yield on 5-yr Treasury yields. Both have been rising since the Fed started raising rates. Chart #7 compares the spread on 5-yr A1 Industrials to 5-yr swap spreads. Both are relatively low despite the substantial increase in yields. Note how spreads rose in advance of prior recessions, at a time that the Fed was pushing yields higher. This is further confirmation that the Fed has not been tightening. If anything, these two charts suggest we are still in the middle of what could prove to be a very long business cycle expansion.

Chart #8

Chart #8 shows the delinquency rate on all bank loans and leases, as of March, 2018. Here we see still more confirmation that rising yields have not negatively impacted businesses. Delinquency rates have been falling for almost a decade, and continue to do so.

Chart #9

Chart #9 shows the ratio of C&I Loans (Commercial and Industrial Loans, a good proxy for bank loans to small and medium-sized businesses) to nominal GDP. Here we see little if any sign of excess, and little if any indication that businesses are being unusually starved for credit.

Taken together, these key market-based indicators of credit conditions are still flashing "green." There is no sign of rising systemic or credit risk, liquidity conditions are still plentiful, and thus the outlook for the economy is healthy.

Friday, June 15, 2018

A simple fix for Argentina's peso

Since April 25th, the day the country imposed a foolish 5% tax on non-residents' holdings of Central Bank debt, Argentina's peso has lost almost 30% of its value, falling from 20 to 28. In the past year, the peso has lost almost half its value. The tax was merely the catalyst for the peso's abrupt decline, however. The real source of its persistent weakness since 2010—when the peso was trading at a relatively stable 3.8 to the dollar—is a 30% annual increase in the supply of pesos. Until Argentina's central bank stops massively printing money, the peso will continue to decline.

Why so much money printing? Because it's an easy, sneaky way of financing the government's deficit. The Central Bank effectively allows the government to spend Monopoly money in exchange for a meaningless IOU. Whoever holds pesos suffers a loss of purchasing power on an almost daily basis. That loss of purchasing power is otherwise known as an "inflation tax." The government funds its deficit by effectively robbing holders of its currency. That hits the little guy hard, and destroys confidence in the country in the process. It's hard to make significant investments in a country with a constantly depreciating currency.

Rather than own up to its shenanigans, the central bank first tried to "defend" the peso by selling one-fifth of its foreign reserves. Then the government sought $50 billion of "help" from the IMF, which it is in turn selling to further try to defend the peso. None of this has worked, of course, because it hasn't addressed the underlying problem, which is that there are way too many pesos being created. Selling a large part of your monetary base without a corresponding decline in the money supply (there has been no decline at all in Argentina's money supply for months) only facilitates capital flight. Technically speaking, Argentina's central bank has been engaging in sterilized intervention in the currency market.

In the face of a big decline in the world's demand for pesos, the only way to support the peso's value is to make a big reduction in the supply of pesos. Until that happens the peso will continue to decline over time. Sure, at some point if the peso declines enough, it will prove an attractive bet and some foreign capital will return and the peso will stabilize for a time. But it will just be a temporary respite.

Chart #1

Chart #1 is my attempt to illustrate the fundamental problem of the Argentine peso. To begin with, the supply of pesos has been increasing by about 30% per year since 2010, while the supply of US dollars has been increasing by about 6% per year. So the supply of pesos relative to the supply of dollars has been increasing by about 24% per year. That implies that the value of the peso relative to the dollar should be declining by about 19% per year, and that is shown in the green line. (Equity investors can understand this if they consider that a two-for-one stock split—a 100% increase in the number of shares—implies a 50% reduction in the price of a stock.)

Today the government announced that Luis Caputo, a man with extensive Wall Street experience, will be the new head of the BCRA. Let's hope he understands the peso's fundamental problem and promises to sharply curtail future money printing. If he does, confidence would be immediately restored and the peso could stabilize and even firm a bit. If he doesn't, then Argentina will eventually squander the IMF's $50 billion and the country will continue to suffer.

Tuesday, June 12, 2018

The Fed hasn't yet begun to tighten

Tomorrow we'll likely learn that the Fed is raising its target funds rate (and the rate it pays on excess reserves) by another 25 bps, to 2.0%. It won't be surprising, and it shouldn't pose any threat to financial markets. That's because this latest hike is necessary just to keep monetary policy "neutral." In fact, the Fed has been in neutral for the past year. How is that? Because the economy has been gradually picking up steam over the past year, and inflation is up as well. A modest pickup in growth and a modest rise in inflation fully justify a modest rise in rates. Indeed, it would be worrisome if the Fed doesn't raise rates tomorrow.

Chart #1

Chart #1 is an update of a chart I've been following for years. It shows that over time there is a correlation between the pace of real economic growth and real interest rates. Very strong growth (4-5%) in the late 1990s was matched by very high real yields (4%). Since then the economy has been downshifting, with growth in the current business cycle averaging a little over 2% and real 5-yr yields meandering around zero. Growth has picked up of late, however, and so have real yields. Current estimates for Q2 growth are roughly 4%, and if that proves to be the case, then real growth over the past year will have been about 3%. (The chart shows the 2-yr annualized growth rate, to better track the recent "trend" which I project will reach 2.6%.)

If growth continues to accelerate, as I expect it will (but the market is not yet convinced of this), then real yields could rise to the 2-3% range in a few years. That would of course imply a lot more Fed rate hikes than the market is currently expecting.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS to the real, inflation-adjusted Fed funds target rate—which is the only rate that really matters to the markets and the economy. I've projected the real funds rate to rise to about 0.1% by the end of this month. Note that the real funds rate has been relatively stable for the past year; 3 rate hikes have been necessary simply to offset the rise in inflation.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS with the "Natural Real Rate" as calculated by the Laubach-Williams method. This is "the rate interest rate consistent with output equaling potential and stable inflation." In short, it's one way of estimating what the real Fed funds rate should be if the economy is operating at or near its potential and inflation is stable. Note that 5-yr real yields (which can be thought of as the market's forecast for what the real fed funds rate will average over the next 5 years) are effectively projecting that the Fed will "tighten" monetary policy only moderately over the next several years, in a manner consistent with inflation remaining stable and the economy picking up a little speed. The Natural Rate should rise as the economy picks up speed.

Chart #4

Chart #4 compares the real funds rate with the Natural Real Rate. It's likely that the Fed keeps an eye on the natural rate, and manages the real funds rate accordingly. If they need to "tighten" policy they push the real funds rate above the natural rate, and if they need to "ease" (as they did for most of the current business cycle), then they push the real rate below the natural rate. The two lines converged in June of last year, which can be interpreted to mean the Fed decided in early 2017 that the economy no longer needed policy "stimulus," and therefore monetary policy should shift to neutral. (I'm not endorsing this way of thinking, merely commenting on how it might work.)

Chart #5

It's worth repeating Chart #5, to make the point that it takes very tight money policy to precipitate a recession. Tight monetary policy shows up in the form of very high real short-term rates and a flat or inverted yield curve. We're a long way from seeing those two conditions repeat. The current shape of the yield curve is still upward-sloping, which means only that the market expects the Fed to continue to raise short-term rates for the foreseeable future. That's not remarkable or in the least scary. Besides, real interest rates are still unusually low.

Chart #6

Chart #6 compares the nominal and real yields on 5-yr Treasuries, with the bottom line being the difference between the two, which is the market's implied forecast for what the CPI will average over the next 5 years. Happily, inflation expectations are only slightly above 2%, which is fully consistent with the Fed's objectives and fully consistent with stable inflation. If the Fed is going to hike rates significantly, we'd first have to see stronger growth and/or rising inflation expectations.

Chart #7

The CPI ex-energy, shown in Chart #7 has actually been very stable around 2% for the past 15 years. I justify taking out energy prices because they are by far the most volatile of all commodity prices, and it makes no sense for the Fed to try to control energy prices. And in the long run, there is not much difference between the full CPI and the ex-energy CPI.

Chart #8

Chart #8 shows the history of the CPI and the ex-energy CPI, using a 6-mo. annualized calculation to focus on recent trends. Note the huge amount of volatility imparted to the full CPI just by adding energy prices, even though energy represents less than 4% of personal consumption expenditures. Over the past 20 years, the full CPI has averaged 2.2% per year, while the ex-energy CPI has averaged 2.0%. 

Chart #9

One of the least-remarked developments on the inflation front is arguably the disappearance of deflation from computer prices. Chart #9 shows how prices for computers and peripherals were falling 30% per year about 20 years ago. So far this year, prices have been stable, for the first time ever.

Chart #10

One reason to expect stronger economic growth is shown in Chart #10. Small business optimism has never been higher than it is today. Entrepreneurs are excited about lower tax rates and a substantial reduction in regulatory burdens. This should translate into more investment, more jobs, and higher productivity (which has been sorely lacking during the current business cycle).

Chart #11

Chart #11, another perennial favorite, shows how every major increase in the market's level of concern and uncertainty has coincided with a sharp selloff in equity prices. Once fears subside, prices float back up. The same cycle has repeated a number of times in recent years, and we're at the tail end of the most recent.

Chart #12

Chart #12 compares the Core measure of consumer price inflation (ex-food & energy) with 5-yr Treasury yields. Normally the two should move together. That relationship broke down in 2011, however, when the market started worrying about the collapse of the Eurozone, the fiscal cliff, China, oil prices, Brexit, and the US election, successively. Risk aversion throughout most of the current business cycle drove strong demand for Treasury yields, keeping them unusually low relative to prevailing inflation. Now we're getting back to normal. Higher interest rates are not scary, they're to be expected.

I don't think the Fed is going to be a source of concern for the market for the near future. But if the economy heats up, the Fed governors are going to be wringing their hands and losing sleep at night. And if inflation expectations rise, well, then we'll all start to worry. But for now the main thing to watch is the economy, which should continue to show signs of faster growth. (See my last month's post "Waiting for GDP") If I'm right and GDP growth accelerates convincingly above 3-3.5%, then the Fed is going to have to raise short-term rates, and bond yields are going to have to rise as well, and both by much more than the market is currently expecting. Will higher interest rates kill the economy? No, because they will be the natural result of a stronger economy. Interest rates will only become a concern when the Fed thinks it needs to step on the brakes and raise real rates significantly.

Thursday, June 7, 2018

Household leverage hits a 30-yr low, net worth exceeds $100 trillion

Today the Fed released its Q1/18 estimates for Household Net Worth and related measures of prosperity. Of note, households' leverage (liabilities as a % of total assets) fell to a 30-yr low, and households' net worth hit hit a new all-time high in nominal, real, and per capita terms. Total household net worth now exceeds $100 trillion, up almost 50% from pre-2008 highs, whereas liabilities are up only 6% from their Great Recession highs. Housing values have increased by about 13% since their 2006 bubble high, but are still about 7% lower in real terms. Households have been busy deleveraging, saving, and investing, and the housing market is back on its feet and healthy. Major trends are all virtuous and consistent with past experience.

Chart #1

As Chart #1 shows, private sector (households and non-profit organizations) leverage (liabilities as a percent of total assets) has now fallen fully 35% from its early 2009 high, and has returned to levels last seen in late 1987, when the economy was in full bloom. Our federal government, in contrast and unfortunately, has borrowed with abandon, raising the burden of federal debt (federal debt owed to the public, as a percent of GDP) from 44% to 77% over the same 31-year period.

Chart #2

Chart #2 summarizes the evolution of aggregate household balance sheets. Note the very modest increase in liabilities over the past decade, the gradual recovery of the real estate market, and the strong gains in financial assets, driven by increased savings and rising equity prices.

Chart #3

Chart #3 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 66 years. Note that recent levels of real net worth do not appear to have diverged appreciably from this long-term trend. That wasn't the case in 2000 or 2007 however, when stocks were in what we now know was a valuation "bubble."

Chart #4

Chart #4 shows real net worth per capita. The average person in the U.S. today is worth about $308K, and that figure has been increasing by about 2.2% per year, adjusted for inflation, for the past 67 years. (Note: the difference in the trends of Chart #3 and #4, 1.3%, is the average rate of population growth.)

To be sure, there are lots of mega-billionaires these days who are skewing the statistics upward, but that doesn't imply that the average person's living standards may have declined. A person making an average income in the U.S. enjoys all the advantages that our nation's net worth has created. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, the software, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce $20 trillion of income per year. Ask yourself: Would the average wage-earner in the U.S. enjoy the same quality of life if he or she earned the same amount while living in a poor country? I seriously doubt it.

(Apologies for the two-week absence of posts; we were enjoying some time in Tuscany and Amalfi. It's hard to get concerned about world events in such tranquil settings. Fortunately, the overall picture seems to have improved since we left, notwithstanding a brief scare over the possibility of Italy leaving the euro—a risk that seems quite unlikely in my view.)

Wednesday, May 23, 2018

Truck tonnage evidence of a Trump Bump

For years I've had a number of posts linking Truck Tonnage to equity prices, and they've all been impressive—in the sense that the physical volume of trucking activity has had a strong tendency to track equity prices. I can't say which leads which, but when they move together they appear to be self-validating.

Chart #1

As Chart #1 shows, truck tonnage has surged 9.5% in the year ending April '18, and the S&P 500 Index is up almost 14% over the same period. Both have experienced substantial growth since Trump's election, in what might be called a "Trump Bump." This further suggests that the economy's growth rate is picking up.

Tuesday, May 22, 2018

Waiting for GDP

In my last post of 2017 (Predictions for 2018), I argued that the investment theme which drove markets in 2017 was the potential for tax reform, and that this year's meme would likely be waiting for GDP. Tax reform brought with it a one-time upward revaluation of after-tax future profits, and arguably, most if not all of that had been priced in by last January. For the past several months, markets have fretted over the impact of rising bond yields and a potential trade war with China, not to mention concerns over a nuclear NoKo. Fortunately, these concerns appear to have ebbed, and a certain calm now prevails. Looking forward, all eyes will be on the lookout for signs that last year's tax reform will result in a significant pickup in economic growth, which I believe we'll see. There are early indications that this is playing out, as I show in the following charts:

Chart #1

As Chart #1 shows, the market's degree of anxiety (proxied by the ratio of the Vix index to the 10-yr Treasury yield) recently has settled back down to relatively low levels. Prices have drifted higher, though they have yet to return to their January '18 highs. The market has digested the impact of higher yields, and Trumps' tariff wars have failed to materialize. In fact, there appears to have been a measure of progress with regards to relations with China and North Korea. In the absence of unexpected distress, and in the presence of rising profits, equity prices are floating slowly higher.

Chart #2

As Chart #2 shows, Credit Default Swap spreads are trading at relatively low levels. These spreads are an excellent, market-based proxy for the outlook for corporate earnings. Investors are saying that it doesn't get much better than this.

Chart #3

Chart #3 tells the same story: credit spreads in general are low, which implies that the market is confident in the future of corporate earnings.

Chart #4

Chart #4 focuses on 2-yr swap spreads in the US and Eurozone. US 2-yr swap spreads at current levels are also about as good as they get, which in turn suggests that credit markets have plenty of liquidity and systemic risk is very low. This further suggests that financial market fundamentals are strong, and that is consistent with improving economic growth conditions.

Chart #5

Chart #5 shows Bloomberg's index of a variety of market-based indicators of financial conditions. It too is a sign of low systemic risk and improving growth conditions.

Chart #6

Chart #6 compares the real yield on 5-yr TIPS with the 2-yr annualized rate of growth of the US economy. This shows that there is a connection between prevailing real economic growth rates and real interest rates; both tend to rise and fall over time. The modest rise in real yields which began last year has coincided with a modest increase in the economy's growth rate. The bond market senses that growth fundamentals are improving, but by no means has the market become overly optimistic.

Chart #7

Chart #8

Chart #7 and #8 compare international interest rate spreads to the value of the dollar. It's important to note that nominal and real interest rates spreads between the US and the Eurozone today are at record highs. With spreads sharply in favor of the US at present, it is very tempting to think that the dollar has significant room to appreciate.

Chart #9

Chart #9 shows that excess bank reserves have declined about 30% from their all-time high. This is the result of 1) increasing levels of bank deposits, which require banks to hold a certain level of bank reserves as collateral, and (mostly) 2) the gradual shrinking of the Fed's balance sheet, which has largely been accomplished by not reinvesting the proceeds of maturing securities. This should not be mistaken for Fed "tightening," however. QE was not about printing money, and the gradual unwinding of QE is not about tightening. This is best viewed as the Fed reversing part of its massive injection of dollar liquidity that began almost 10 years ago, a move that was designed to supply risk-free T-bill substitutes to a market that was desperate for safe and liquid assets. Today the demand for safe money is declining, so it is entirely appropriate for the Fed to be shrinking its balance sheet.

Chart #10

Chart #10 shows the significant decline in the rate of growth of bank savings deposits, a process that began in early 2017. Savings deposits account for about two-thirds of the M2 money supply, and they mushroomed from $4 trillion at the end of 2008 to now over $9 trillion. I consider bank savings deposits to be excellent proxies for the demand for money, especially over the past decade, since they have paid almost nothing in the way of interest. People poured trillions of dollars into bank deposits not for their return, but for their safety. But now the era of strong demand for money has ended. Confidence is up, and people are attempting to shift their portfolios away from risk-free assets to more risky assets. The Fed absolutely needs to reverse QE to accommodate this, lest the financial system finds itself with excess money—a condition that would likely foster an unwanted acceleration of inflation. 

Chart #11

Chart #11 gives you the big picture behind the Treasury yield curve. The curve has flattened substantially in recent years, and this is typical of economic expansions. It is also typical of periods during which the Fed is raising short-term interest rates. Much has been made of the flattening of the yield curve, because flat and inverted yield curves typically have preceded recessions. But the curve is not flat, it is still positively sloped, and it has been this way several times in the past when recessions were still on the far horizon.

Chart #12

Chart #12 adds more information to the shape of the yield curve, since the yield curve is only one way that the Fed acts on the market and the economy. The other key variable is the real Fed funds rate (blue line). Recessions are reliably preceded not only by a flat or inverted yield curve but also by a significant increase in real borrowing costs. Today, short-term real borrowing costs are effectively nil. The Fed is not tight.
Chart #13

Chart #13 compares the current real, inflation-adjusted Fed funds rate (red line) with what the market expects the real funds rate to average over the next 5 years (red line). Here we see that the market fully expects the Fed to continue raising short-term interest rates gradually over the next several years. If there were any hint that the economy is weakening, the market would be expecting the Fed to stop raising rates and/or to begin to lower rates in coming years. That is not the case today.

Chart #14

Chart #14 shows the history of nominal and real 5-yr Treasury yields and their spread (green line), which is the market's implied forecast for what the CPI will average over the next 5 years. Here we see that despite all of the supposed "money printing" of the past decade, inflation expectations are well anchored. The bond market fully expects that inflation in the years ahead will be just about what the Fed is targeting, i.e., 2% or so per year. This further suggests that the Fed has yet to make a serious mistake. It's also worth noting that essentially all of the increase in 10-yr yields from their all-time low of July '12 is accounted for by rising real yields. Yields are higher because the market is more confident about the outlook for real economic growth. This is an optimal development.

Adding it all up, financial market and economic conditions are quite healthy. Add to the mix the fact that corporate income tax rates have been sharply reduced, and you have a recipe for stronger economic growth, which will likely be a by-product of increased corporate investment. We can't say for sure this will happen, but the evidence is mounting and the market is still only in the early stages of pricing this in.