Friday, July 26, 2019

Random thoughts and chart updates

For weeks I've been struggling to come up with a post that puts recent events and trends into a coherent perspective. It's been difficult, however, since for every positive there seems to be a negative. Optimism here, pessimism there. Good fundamentals (e.g., great liquidity, very low credit and swap spreads, very low weekly claims, strong confidence numbers, lots of job openings) alongside obvious signs of economic weakness (e.g., trade wars negatively impacting global trade, very low real interest rates, slowing jobs growth, an inverted yield curve, a big slowdown in earnings growth, weak manufacturing surveys, and most recently, slowing GDP and corporate profits growth). The stock market seems optimistic about the future (it just keeps going up), but the bond market is priced to slow growth for as far as the eye can see. Neither market is priced to unreasonable assumptions.

At best, I can say that the outlook for economic growth is Ok—not great, but not terrible either. Maybe more of the same: 2-3% real growth. Lower tax rates have not yet created boom-time conditions. Business investment has been disappointing. Overlooked, however, is the significant reduction in regulatory burdens that the Trump administration has been able to achieve. It's hard to quantify this, but we haven't seen anything so positive in this area since just about forever. If Trump's tariff wars can be resolved (by drastically reducing are eliminating tariffs), the economy has lots of upside potential.

What follows is a random collection of 14 charts and comments:

Chart #1

Q2/19 growth (see Chart #1) came in above expectations, and the level of real GDP in Q1/19 was revised upwards a bit as part of the yearly revision to prior years. But the distribution of growth over the past 4-5 years changed, with the result that the economy was a bit stronger a few years ago than we thought, and in recent quarters it has been a bit weaker. The media was quick to note that downward revisions to 2018 growth rates robbed Trump of his claim to have delivered 3% real growth (it is now estimated to have been 2.5% instead of the previously reported 3%). Still, the economy has definitely picked up from its 2016 slump, when year over year growth fell to 1.3% in Q2/16. The current expansion is now just over 10 years old, and it has registered an annualized growth rate of 2.3%. 

Chart #2 

Chart #2 is my now-famous "GDP gap" chart, updated for the latest GDP statistics. The current economic expansion remains by far the weakest in history, with annual growth averaging only 2.3% instead of the 3.1% that prevailed from the mid-60s to the mid-00s. For the first time ever, the economy failed to reattain its long-term growth trend following the last recession. The "shortfall" in growth now amounts to $3.4 trillion by my calculations. Maybe we'll never reattain that long-term trend—who knows? But if nothing else, the chart demonstrates just how much lost income can accrue from a modest reduction in long-term trend growth rates. If this had been a typical recovery, the economy today would have been at least $3-4 trillion bigger. That translates roughly to just over $10,000 per person of "lost" annual income.

Chart #3

As Chart #3 shows, real yields on 5-yr TIPS are trading just under 30 bps. As the chart suggests, that implies that the market's estimate of the economy's current trend rate of growth is about 2.4% per year, which is somewhat less than what we have seen in recent years. The bond market, in other words, is priced to a continuation of the kind of growth we have seen over the past 10 years. Expectations of a Trump boom have all but evaporated. That may be too pessimistic, in my view, but it's not all that terrible either: just more of the same so-so growth. On the bright side, there's virtually no sign of what might be considered "overheating." No growth boom might well mean less chance of a growth bust.

Chart #4

Chart #4 compares the year over year growth rate of the economy to the year over year growth rate of private sector jobs. Not surprisingly, the two tend to track each other. More jobs translate into a bigger economy. But note the gap between the two lines, which is roughly equivalent to labor productivity. When the economy grows faster than the growth of jobs, it can only mean that workers are becoming more productive. We've seen a mini-boom in productivity under Trump's leadership, but it has faded in the past 6-9 months, and it is nowhere near as strong as we have seen at times in the past. It's disturbing
that this is occurring just as the growth of private sector jobs has slowed meaningfully (see my last post for the numbers). Undoubtedly it is these sorts of numbers which have put the bond market in a pessimistic mood.

Chart #5

Today's GDP figures included revisions to past data going back 4-5 years. One of the most significant changes was to corporate profits, which were reduced in the past 1-2 years by almost one percentage point of GDP (with most of that being added to incomes). Yet despite that significant reduction, corporate profits remain historically strong, well above their long-term average relative to GDP.

Chart #6

Chart #6 compares the two major measures of corporate profits: one, according to the National Income and Product Accounts (blue line), and the other according to reported earnings per share. The former includes all businesses, while the later includes only those that are publically held. The recent downward revisions to NIPA profits have substantially reduced the gap between the two measures. (Note that the y-axis for both measures uses the same ratio between high and low values—thus the growth rates of both measures have been substantially similar since 1960.) Note also that the growth of both measures has subsided quite a bit over the past year or so. Reported EPS are up by a mere 1.3% annualized rate over the past six months, and NIPA profits have registered no net growth over the previous year.

Chart #7

Does the big slowdown in profits growth mean the stock market is overvalued? Not necessarily, as suggested by Chart #7. The current PE ratio of the S&P 500 is just under 20, which is only 18% above its long-term average. We've seen big PE "bubbles" in the past, but the current uptick in PE ratios is more in the nature of a blip than a bubble. And it's quite consistent with the prevailing level of Treasury yields, as we will see in Chart #9.

Chart #8

Since NIPA profits and the EPS measure of profits are tracking each other pretty closely these days, it's fair to use NIPA profits as a proxy for EPS, which is what Chart #8 does. NIPA profits have the advantage of being seasonally-adjusted, quarterly annualized figures, whereas EPS typically are reported using the last 12 months of earnings. NIPA profits are thus more timely, and they may be more accurate since they reflect true economic profits, thanks to adjustments for inventory valuation and capital consumption allowances. This exercise produces results which are not greatly different (although less volatile) from those of Chart #7. Both measures of PE ratios currently tell the same story: equity multiples are above their long-term average, but they are not excessive.

Chart #9

The line in Chart #9 is the result of taking the earnings yield on the S&P 500 (which is equivalent to the dividend yield on stocks if all companies paid out all their earnings each quarter) and subtracting the yield on 10-yr Treasury bonds. Investors currently are willing to give up about 300 bps of earnings yield in order to hold 10-yr Treasuries (conversely, it means that investors demand an extra 300 bps of yield in order to hold equities instead of 10-yr Treasuries). From a price-multiple perspective, the PE ratio on 10-yr Treasuries is 48, which is almost 2 ½ times higher than the PE ratio on the S&P 500. That tells me the market is pretty pessimistic. Numbers like these only make sense if you assume the market expects corporate profits to decline meaningfully in the future, and for there to be little if any improvement in the economy's health in coming years.

Chart #10

Long-time readers of this blog know that I interpret monetary policy from a strictly monetarist perspective. When the supply of money exceeds the demand for money, money loses value and inflation goes up. Conversely, deflation occurs when the supply of money is less than the demand for money. Big swings in inflation invariably prove harmful for growth. The best monetary policy, in my book, is the one that maintains a low and stable rate of inflation. That alone is all the "stimulus" an economy needs. The Fed can't create growth out of thin air, but it can provide a growth-enhancing environment for an economy.

I focus on the Fed's willingness to supply money and money equivalents and how that compares to the market's demand for same. I don't consider the Fed's decisions to raise or lower interest rates to be necessarily restrictive or stimulative. A reduction in short-term rates (which implies an increase in the supply of money) might actually be harmful if the demand for money is rising at a faster rate. Last May I argued that the Fed needed to reduce rates in response to an increase in the demand for money. Not because the economy was on the cusp of a recession, and not because it needed a shot of stimulus, but because to not do so would imply a tightening of monetary conditions at a time when pessimism was the order of the day, and that might eventually lead to uncomfortably low inflation (or deflation) and/or a recession.

So Chart #10 is important to keep in mind. What it shows is that the demand for money (using the ratio of M2 to nominal GDP as proxy) soared in the wake of the Great Recession. Subsequently, money demand fell from mid-2017 to mid-2018 as confidence soared and the economy strengthened, and it has creeped back up in the past few quarters, as tariff wars and slowing global growth have brought risk aversion back into fashion. Quantitative Easing was necessary to satisfy the economy's demand for money; it was not full-bore stimulus as many seem to think. The dollar's relative stability and the persistence of relatively low and stable inflation are proof that the Fed wasn't "printing money." That's still the case today. I continue to believe the Fed is justified in reducing short-term interest rates, which they will likely do at next week's FOMC meeting. This won't necessarily be "stimulative" but it will reassure markets and keep liquidity conditions healthy.

Chart #11

Chart #11 looks at one very important financial variable, namely 2-yr swap spreads (which are briefly explained here). Currently, swap spreads in both the US and the Eurozone are low. This is a very good sign, since it implies that liquidity is abundant and financial conditions are generally quite healthy. Liquid financial markets are essential to a well-functioning economy, just like shock absorbers are essential for a smooth ride. Swap spreads have also tended to be good predictors of future economic health. Swap spreads today tell us that systemic risk in most major economies is quite low, and that the economic outlook is therefore positive.

Chart #12

Chart #13

Charts #12 and #13 are some of the most troubling charts in my collection. Manufacturing conditions have deteriorated significantly in the past 6-9 months, both here and in Europe. Not surprisingly, we now know that real growth also slowed over that period. Fortunately, while conditions remain relatively weak, they are not bad enough (so far) to imply an impending recession. Especially considering the ongoing health of the service sectors.

Chart #14

Chart #14 looks at the service sectors of the US and Eurozone. Here we see that conditions have not deteriorated to the same extent as they have in the manufacturing sector (the US service sector is orders of magnitude larger than the manufacturing sector). The relative health of the service sector undoubtedly reflects the fact that Trump's ongoing tariff wars are directed almost exclusively to the manufacturing and goods-producing sectors of global economies. 

Tariffs are disruptive, there's no question about it. We need to get rid of them as soon as possible. When and if that happens, confidence is likely to return and economies are once again likely to flourish. 

19 comments:

Cabodog said...

Scott, as always, a huge thank you for publishing your thoughts.

I heard the other day that truck tonnage was down? What are your thoughts on this (and is that true)?

steve said...

Great stuff Scott. A sincere thank you. One point of departure; I now believe that the reason the bond market is so pessimistic is that it believes Trump will NOT end tariffs-in fact he does not WANT to. He and his chief minion Navarro have some inane belief that to "Make America Great" they need to force Americans to buy only American products. It's like they're living in some parallel universe of insanity. Indeed, if Trump loses in 2020 this will likely be the main reason. Just think about how much more growth we would have without the drag of tariffs which undoubtedly is reducing corporate investment.

Admittedly I'm not a Trump fan. I think he's basically lazy and stupid. Worse though, is he is most certainly NOT conservative. One point you did not raise was the debt ceiling and spending bill just passed. About the only thing our illustrious POTUS can agree on with the Dems is spending us into oblivion!

If trump wins in 2020 it will embolden him to increase tariffs. If he loses? Well, I don't even want to think about that.

steve said...

To b bolster my comments:

https://www.wsj.com/articles/the-trade-war-growth-slowdown-11564182695?mod=hp_opin_pos_2

Aside from JBD, does anyone seriously believe that Trump can outmaneuver Xi Jinping?

https://www.project-syndicate.org/commentary/china-takes-long-view-on-america-cold-war-by-stephen-s-roach-2019-07

The Cliff Claven of Finance said...

The weakness in the Chinese and German economies should be mentioned.
The U.S. is not an island detached from all other major economies.

Democrats all sound like socialists now -- that has to be hurting long term capital investments in this nation, in spite of the corporate tax cuts.

I'm not a Trump fan either Steve, because of his personality.

Obama could be charming ... while being wrong on almost every policy decision!

John said...

Interesting charts and analysis, as usual. So, assessing Trump's contribution to the economy, good bad or indifferent. What is the big (or otherwise) difference now compared to the economic conditions when Obama left office?

John A said...

Trump's tax cuts have achieved precisely nothing. Same jobs and GDP growth we saw under Obama. So what was the point of them, besides to swell the deficit?

Neither have those regulatory cuts accomplished anything, either, except to make the regulation-haters happy. All bluster, no effect.

Hopefully this will be a lesson for the supply-siders who've insisted for decades that tax cuts spur the economy. If tax cuts were supposed to spur the economy, how come we're not seeing a big boom after Trump's tax cuts?

And speaking of economic booms - or the lack thereof - it looks like jobs growth last year may be revised downward, perhaps substantially:
https://www.bloomberg.com/opinion/articles/2019-07-05/the-myth-of-the-tight-u-s-labor-market
"The latest QCEW data are available through 2018, but note how much worse the 2018 QCEW data look than the Establishment Survey data, even though the two appear fairly similar in previous years, for which the latter has already undergone the requisite revisions. The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%."

Al said...

Awesome graphs and post. Good to hear from you Scott.

David Templeton, CFA said...

Very nice post. Thanks for sharing your insight. And I couldn't agree more with your comment, "For weeks I've been struggling to come up with a post that puts recent events and trends into a coherent perspective. It's been difficult, however, since for every positive there seems to be a negative."

Benjamin Cole said...

as usual, great post and I love the numberered charts.

Like many others, including Ray Dalio, I think something has changed in developed economies in the last 20 years. For whatever reason, monetary policy may take on a new look.

If you look at Japan or Europe, the days of fighting inflation are over, and central banks appear able to buy back or monetize national debt without inflationary consequence.

We may have to get used to money-financed fiscal programs (yes, I know, heresy).

If interest rates drop to zero then evidently the public is indifferent to holding cash or Sovereign bonds---well, maybe the public would actually prefer to hold cash as so many sovereign bonds today pay negative rates of Interest.

In this odd situation, a government can monetize its debt without consequence.

Earnest and highly intelligent economists such as Paul Volcker or Martin Feldstein spent decades and decades warning that higher interest rates and inflation were pending. Instead we have seen decades of shrinking interest rates and inflation.

The trend lines are pointing to deflation and negative interest rates. I cannot say that will happen and the old joke is that making predictions is hard especially about the future.

My fear about Federal deficit is that we have a central bank unwilling to conduct QE on a permanent basis.

John said...

Fascinating comments. Benjamin's QE argument opens up a panoramic vista of policy implications. How do currency markets affect this whole inflation-deflation dichotomy? What determines the value of a nation's currency? Many things, I suppose. But what is the currency game all about? How do nations boost the value of their own currency, extend its global use, suppress the value of others? What if there were an international currency used by all nations?

Scott Grannis said...

Cabodog, re Truck Tonnage: The latest release of Truck Tonnage (https://www.trucking.org/article/ATA-Truck-Tonnage-Index-Fell-1.1-Percent-in-June) shows that the surge in April (which I noted in a post) was mostly reversed (but not entirely) in May and June. There has obviously been a great deal of volatility in this series of late. However, my Chart #1 in that post (http://scottgrannis.blogspot.com/2019/05/truck-tonnage-looks-quite-bullish.html) now shows that the lines for Truck Tonnage and the S&P 500 are right on top of each other.

honestcreditguy said...

China just had to rescue another bank, 100B, China has to find new buyers of its products. I would not say China is in good position other than the treasury holdings, that is there main leverage but where else is safe?

Tariffs are hurting China right now in a bad way, monetary efforts by chinese officials is all in....I would now after every pundit has called it far to early look for China to have a 2008 like moment....and it will have some affect here but not like it will there....1 billion desperate folks is not a good thing....

Benjamin Cole said...

Side question to Scott Grannis or anybody else: many nations are now issuing bonds with negative interest rates. Why do not these nations issue a lot of bonds and retire all positive interest-rate debt. Then these nations would actually be receiving payments for having issue debt.

And yes, we are living in Alice in Wonderland macroeconomics.

Grechster said...

Question related to Benjamin's:

Why don't countries who are able to issue debt at super-low and negative rates borrow more and invest in infrastructure and other things that have SOME return?

I've thought for a long time that the entire lend/borrow/invest function is broken. And if not broken, then certainly materially different from what any of us grew up to understand. This massive change is obviously related to the inability of the central banks to get inflation up to where they say they want it.

Alice in Wonderland, indeed.

Christophe said...

Scott, thank you for your analysis. For years now, you have helped many with staying calm and bullish while others were like chickens without a head climbing the “wall of worry”. I note my “ScottGrannis indicator” seems to be turning a bit more neutral. Can’t wait to read your next articles.... ;-)

I agree with Benjamin but would go even further in the Alice in Wonderland fantasy.
With negative borrowing cost why not buy major positions in strategically chosen publicly traded companies. In theory a country could discreetly be buying a major chunk of the worlds corporation for free? On top of the strategic power this would give the country a nice ~2% yield for free. A relatively small country like Japan has ~$10T in debt. Ownership of 51% market cap all firms in the SP500 cost ~$12T.

Peace!

Fred said...

The Trump "tax reform" has caused my taxes to go up because I'm not entitled to his special 20% deduction that his friends in the real estate trade receive and he slashed deductions that I used to get. Now I pay more in taxes and we have a ballooning deficit and the same mediocre growth we had under Obama. I used to believe tax cuts were stimulative but I just don't see the evidence. Look what happened in Kansas with their tax cuts.

steve said...

"Side question to Scott Grannis or anybody else: many nations are now issuing bonds with negative interest rates. Why do not these nations issue a lot of bonds and retire all positive interest-rate debt. Then these nations would actually be receiving payments for having issue debt."

A better question must be why the HELL does anyone buy negative yield bonds?

Benjamin Cole said...

Steve---

I don't know. My guess is that certain larger institutional investors buy bonds to park their money as they wait for an investment opportunity. Safe havens. Italy now can borrow money more cheaply than the United States. That makes no sense to me.

By the way more and more professionals are suggesting the next move in US bond rates is down, heading towards zero like Europe or Japan.

RSC said...

Perhaps I missed it but I haven't seen you mention the CAB indicator in quite some time. While it's trending down that could be validation of trade posturing.

Would love to hear your thoughts.