The outlook is still healthy

The world hasn't changed much in the past month, and neither has my outlook, which remains bullish on the economy and moderately bullish on stocks. Trump's tax reform is a big deal, because it is designed to stimulate investment directly, by increasing the after-tax value of corporate profits. More investment means more jobs, more productivity, and higher living standards for all. This type of tax reform needn't explode the deficit, because it will greatly expand the tax base by 1) encouraging more investment, 2) making tax evasion less profitable, 3) attracting overseas investment, 4) increasing the number of jobs, and 5) increasing real wages. In the end, a significant boost to growth would likely dominate concerns over any near-term increase in the federal deficit. (I will refrain from projecting deficits at this point, however, since there are simply too many variables involved, especially real GDP growth and the growth of entitlement spending, with the former being more important than the latter.)

Since stronger economic growth dictates higher real interest rates, any concerns about higher interest rates negatively impacting the economy are premature. Higher interest rates are the natural result of stronger growth, as FOMC members have taken pains to explain. In any event, real yields are not even close to levels which might threaten growth. Moreover, there are still plenty of excess bank reserves in the system, and key indicators of market liquidity (e.g., swap and credit spreads) confirm that financial conditions are healthy. By all indications, the Fed is moving short-term rates higher in a healthy and non-threatening fashion.
 
Since early last year, there have been some profound changes in the US economy which augur well for the future. Perhaps the most important is increased confidence, which has largely replaced the risk-aversion that characterized most of the current recovery.

As I've argued many times over the years, the Fed's Quantitative Easing was a necessary response to the  risk aversion that led to the world's almost insatiable demand for money and safety in the wake of the Great Recession. QE is no longer necessary now, so it is appropriate for the Fed to wind down QE by raising short-term interest rates and draining excess bank reserves. If the Fed weren't taking these steps, that would a source of concern, since they would be allowing a buildup of excess money which would inevitably find its way into much higher and unwanted inflation. To date, market-based measures of inflation expectations remain within reasonable levels, and that in turn confirms that the Fed is acting appropriately.

Here's a review of the vital signs of the economy and financial markets (all charts include latest data available as of time of posting):

Chart #1

Chart #1 shows the level of the M2 money supply, which is widely considered to be the best measure of the amount of cash and readily-spendable cash equivalents in the economy (M2 consists of savings deposits, retail checking accounts, currency in circulation, small time deposits, and retail money market funds). M2 has been growing on average by 6-7% per year since 1960, and the most recent decade is no different, despite the Fed's alleged "money printing." As I've argued previously, QE was not about printing money, it was about transmogrifying notes and bonds into T-bill equivalents (aka bank reserves). Note, however, the recent slowdown in M2 growth; what looks like a moderate shortfall relative to trend is actually one of the most significant monetary developments in many years, as I explain below.

Chart #2

Chart #3

Chart #2 shows the level of bank savings deposits, whose growth was rather spectacular in the years following the Great Recession. Bank savings deposits represented about 50% of M2 in late 2008, and they now represent 66%, which is the highest level in recorded history. A terrified world deposited trillions of dollars in bank savings accounts, despite the fact that they paid almost no interest. Banks effectively used this huge inflow of funds to purchase notes and bonds and subsequently sell them to the Fed as part of the Fed's Quantitative Easing program. As Chart #3 shows, banks were happy to hold onto trillions of the bank reserves that the Fed used to pay for the notes and bonds it purchased. This was a direct reflection of the economy's increased demand for money and money equivalents.

Chart #4

Chart #5 

But as Charts #4 and #5 show, beginning in 2017 the growth of savings deposits collapsed as consumer confidence surged. People no longer want to accumulate piles of cash. Instead, they have become more willing to bear risk. Not surprisingly, the stock market has experienced heady growth over the same period (see Chart #16 below). The public's demand for money has begun to decline, and the Fed is thus obliged to shrink the supply of money by reversing its balance sheet expansion. The Fed is also correct to raise short-term rates in order to boost the attractiveness of all the excess bank reserves still held by banks, lest they be tempted to lend excessively and thus further expand the money supply at a time of dwindling money demand.

Chart #6

Chart #7

Charts #6 and #7 show that to date the Fed has only pushed rates modestly higher. Chart #6 compares the current, inflation-adjusted overnight Fed funds rate (blue), which today is about zero, to the 5-yr real yield on TIPS, which is the market's estimate of what the blue line will average over the next 5 years, and which today is about 0.5%. Chart #7 shows the same real Fed funds rate as shown in Chart #6 in an historical context; note that real rates typically have been at least 3-4% before the onset of a recession. Chart #7 also shows the slope of the Treasury yield curve, which is typically flat or inverted prior to recessions (a flat or inverted curve is the bond market's way of saying it thinks the Fed has tightened enough or perhaps too much, and that lower rates thus lie ahead). Recessions typically happen when real borrowing costs are high and the yield curve is flat or inverted. Currently, we have neither such condition.

It's important here to note that prior to 2009, the only way the Fed could push short-term rates higher was by restricting the supply of bank reserves. Thus, monetary "tightening" involved not only higher interest rates but also a scarcity of liquidity in the banking system; at some point the combination of the two can be lethal. That's not the case at all today, as Chart #3 illustrates. Today, liquidity is plentiful, real borrowing costs are very low, and the yield curve is within "normal" ranges. The risk of recession is thus very low.

Chart #8

Chart #9

As Charts #8 and #9 show, inflation expectations over the next 5 and 10 years remain well within historical ranges (currently both are about 2.15%). The bond market is not concerned about either inflation or deflation or the Fed's ability to hit its 2% inflation target.

Chart #10

Chart #11

As Charts #10 and #11 show, swap and credit spreads are relatively low and very much in line with "normal" conditions. The market's expectations for growth and profitability are healthy.

Chart #12

Chart #13

Chart #12 shows that bank lending to small and medium-sized businesses has been stagnant of late, after reaching a relatively high level compared to the size of the economy. But as Chart #13 shows, the slowdown in lending has little or nothing to do with the health of borrowers; delinquency rates for all bank loans and leases are at historically low levels. Credit expansion is slow, but not because banks are actively restricting lending; rather, borrowers are less willing to borrow these days. That's a healthy situation, not a cause for concern.

Chart #14

Chart #15

Meanwhile, as Chart #14 shows, mortgage rates haven't changed much in the past several years, despite the rise in Treasury yields. That helps explain why the outlook for residential construction remains upbeat, as shown in Chart #15.

Chart #16

Despite all the good news about financial market conditions and the economy, the market is still having trouble digesting the new reality of higher interest rates. But as Chart #16 suggests, the market has surmounted at least half of the recent "wall of worry." I would reiterate my earlier views that higher rates are not necessarily a bad thing—especially since they result from a stronger economy—but nevertheless higher rates pose competition for the earnings yield on stocks. Consequently, further gains in equity valuations are more likely to come from higher earnings than from expanding multiples. Total equity returns are likely to be decent going forward, but substantially less than we have seen in recent years, which is why I'm "moderately bullish." 

One more wall of worry

I've featured this chart numerous times in recent years. What it shows is that every significant decline in stock prices in recent years has coincided with a spike in market nervousness (which I define by dividing the Vix index by the yield on 10-yr Treasuries—this measure increases as nervousness rises and yields decline, and vice versa). To date, all those "panic attacks" have proved unfounded—the economy kept on growing at a modest pace. I'm guessing that the current bout of nerves is being driven primarily by rising bond yields, which in turn are the natural result of improving economic fundamentals that are laying the groundwork for a stronger economy. There are other worries at work, to be sure, and the list would include 1) concerns that the Fed is going to be spooked by rising inflation expectations and stronger growth and thus tighten too much, 2) volatility hedgers caught in a squeeze, 3) concerns that valuations are too high, and/or 4) the combination of tax cuts and increased spending which could lead to more trillion-dollar budget deficits.

So, as has been the case during most of the bouts of nervousness in recent years, there is no shortage of things to worry about. But, I would argue, the main thing to worry about is the health of the economy. If the economy continues to strengthen, that will "trump" just about all the above worries. For example, if the deficit increases temporarily but we end up with a stronger economy, the burden of debt will likely decline. So let's review some key economic and financial market fundamentals, all of which are quite positive. (All charts reflect the most recent data available as of February 9th.)

Chart #1

Chart #1 shows that 2-yr swap spreads (a highly liquid and reliable measure of generic, high-quality credit risk) have increased only slightly during the recent equity selloff, and remain well with a "normal" range. This further indicates that financial markets are liquid and that financial market fundamentals are healthy. Historically, swap spreads have been good predictors of recessions and recoveries, rising in advance of recessions and declining in advance of recoveries.

Chart #2

Chart #2 compares swap spreads here with those in the Eurozone. Notably, Eurozone financial fundamentals have been improving of late. No hint of trouble either here or abroad.

Chart #3

Chart #3 shows that swap spreads have also been good predictors of credit spreads in general. Currently there is little reason to be concerned.

Chart #4

Chart #4 shows that both high- and low-quality corporate credit spreads are relatively low, having risen only marginally in the past week. This indicates that the bond market is not very concerned at all about the quality of earnings or the health of the economy.

Chart #5

Chart #5 shows the nominal and real yields on 5-yr Treasuries, and the difference between the two, which is the market's expected annual rate of inflation over the next 5 years. Inflation expectations are well-anchored at just slight above 2%. It's tough to conclude from this that the market is concerned about either too much or too little inflation. Current inflation expectations are very much in line with what we have seen in recent decades.

Chart #6

Chart #6 shows the same comparison as Chart #5 for 10-yr Treasuries and expected inflation over the next 10 years. Again, current expectations are very much in line with past experience.

Chart #7 

Chart #7 shows two measures of the dollar's value vis a vis other currencies, on a trade-weighted and inflation-adjusted basis. These are arguably the best available measures of the dollar's relative value against other currencies. What we see is that the dollar today is roughly equal to or slightly above its long-term historical average.

Chart #8

Chart #8 shows a simpler measure of the dollar vis a vis major currencies since the beginning of last year. The dollar has been declining meaningfully over this period. Taken alone, this would suggest that the market has either become bearish on the outlook for the US economy and/or concerned that the Fed has been too complacent about raising interest rates. I'm inclined toward the latter explanation, since it's hard to believe the world has ignored the many signs of improvement in the US economy over the past year.

As I've explained before, over the past year we have seen accumulating evidence that the demand for money in the US has been weakening. That's the natural result of a return of confidence and a growing desire on the part of the public to become less risk-averse. Yet the Fed has been slow to take offsetting measures (e.g., by raising short-term interest rates and/or draining excess reserves, which remain quite abundant). In short, this suggests that the Fed has fallen a bit "behind the curve." They haven't kept the supply of dollars and the demand for dollars in balance; the result has been a surplus of dollars and thus a weaker dollar. This has shown up as well in higher gold and commodity prices in the past year. If the dollar were to weaken more I would become concerned, but for now, with inflation expectations still reasonable, it is premature to conclude that the Fed has made a big mistake. I am somewhat reassured by the recent decline in gold, commodity prices, and oil prices that has occurred opposite the strengthening of the dollar.

Chart #9

Chart #9 compares the real yield on 5-yr TIPS with the 2-yr annualized growth of the US economy. It strongly suggests that real yields over time tend to follow the real rate of growth in the economy. The recent rise in real yields—which is still modest—tracks very well with the growing perception that the rate of growth in the US economy is picking up. In fact, over the last three quarters the economy has grown at a 2.9% annualized rate, which is comfortably above the 2.2% rate it has averaged since the recovery began in mid-2009. Growth expectations from the NY and Atlanta Fed offices put first quarter GDP growth at somewhere between 3.3% and 4%.

The rise in rates is thus fully explained by the improvement in the outlook for growth, and is nothing to be concerned about. There is no a priori reason equities can't continue to rise in value even if stronger growth results in higher interest rates. But it is nevertheless likely that higher interest rates will tend to depress PE ratios and thus keep future equity returns more modest than we have seen in the past.

Chart #10

Chart #10 compares the real yield on 5-yr TIPS with the inflation-adjusted Fed funds rate. The blue line is the overnight real short-term interest rate, while the red line is the market's expectation for what the blue line will average over the next 5 years. This tells us that the market expects only a modest amount of "tightening" from the Fed in coming years. The slope of the real yield curve today is positive; if it were negative, that would be a sign that the market thinks the Fed has tightened too much and will need to lower rates in the future.

Chart #11

Chart #11 looks at the nominal yield curve, from 2 years to 10 years. Rates have risen and the curve has flattened in recent years, which is very much in line with what one would expect when the economy is growing. But importantly, the yield curve is not flat nor is it negative. During most of the fast-growing 1990s, the curve was actually a bit flatter than it is now. So it's hard to get concerned about recent developments in the yield curve.

Chart #12

Chart #12 is the classic way to see whether the economy is at risk of recession. Recessions have always been preceded by a substantial increase in real short-term interest rates (blue line) and a flat or negatively-sloped yield curve (red line). Today we are not even close to the conditions that would suggest a near-term risk of recession. That's another way of saying that the Fed is not even remotely too tight, nor is it expected to be any time in the foreseeable future.

It's also important to note that excess bank reserves are still abundant (about $2 trillion). Past recessions were triggered by very tight Fed policy, when the Fed drained bank reserves and squeezed liquidity in order to boost short-term interest rates. Today, thanks to an important change in the Fed's operating policy in late 2008, the Fed can tighten by either draining reserves (but it might take a long time to create a scarcity), and/or directly raising short-term interest rates. To date they have done neither in a way that might be considered a threat to financial stability. They have merely nudged rates higher in response to a healthier economy.

Chart #13

Meanwhile, the signs of improving economic fundamentals are abundant and impressive. Chart #13 suggests that the current health of the manufacturing sector is consistent with a substantial pickup in overall growth.

Chart #14

Chart #14 shows that manufacturers are experiencing healthy demand from overseas. The US is improving and so is the rest of the world. That's a heady combination.

Chart #15

Chart #15 shows that the all-important service sector is expecting to increase hiring significantly in coming months. This is consistent with surveys of consumer and small business confidence, all of which are showing a big improvement over the past year.

Chart #16

Chart #17

Charts #16 and #17 compare—vary favorably—the health of the manufacturing and service sectors in the US and Eurozone. All are looking about as good as it gets.

Chart #18

As for equity valuations, Chart #18 reflects the recent decline in the PE ratio (using trailing 12-month earnings) of the S&P 500 to 21.1. The one-year forward PE ratio is now only 15.2, only slightly above its long-term average. Trailing 12-month earnings are up almost 13% as of January '18, and sharply lower corporate tax rates going forward can only boost them further. Stocks are no longer cheap, that's for sure, but neither are they are egregiously overvalued.

The current selloff may well continue for awhile, but sooner or later the reality of a stronger economy and a non-threatening Fed likely will allow the market to overcome this latest wall of worry.